Does inequality lead to economic crisis and recession?

Let me recommend "Inequality and Its Perils" by Jonathan Rauch. It is based on The Price of Inequality by Joseph E. Stiglitz, a Nobel Prize-winning economist. The article suggests that the American economy is now so biased towards the rich that it has become dysfunctional.

Once it was argued that "a rising tide lifts all boats" -- that high rates of economic growth for the rich was needed to fuel economic growth, but that such rates were acceptable if all groups enjoyed economic progress. (The row boat and the ocean liner may rise the same amount, but the rising tide applies little force as it lifts a row boat and a huge force as it lifts an ocean liner.)

“There’s been enormous progress in measuring inequality—Nobel Prize-level progress,” said David Moss, an economist at Harvard Business School. As the data came in and the view got clearer, the picture that emerged was unsettling. 

“In the 1990s,” Moss said, “it began to appear that income was being concentrated among the very highest earners and that stagnation was occurring not just at the low end but across most income levels.” It wasn’t just that the top was doing better than the rest, but that the very top was absorbing most of the economy’s growth. This was a more extreme and dynamic kind of inequality than the country was accustomed to. 

According to a recent Congressional Budget Office report, those in the top 1 percent of households doubled their share of pretax income from 1979 to 2007; the bottom 80 percent saw their share fall. Worse, while the average income for the top 1 percent more than tripled (after inflation), the bottom 80 percent saw only feeble income growth, on the order of just 20 percent over nearly 30 years. The rising tide was raising a few boats hugely and most other boats not very much. 

It thus began to seem that the old bargain, in which inequality bought rising incomes for all, had failed—much as the Keynesian bargain (bigger government, faster growth) had failed two generations earlier. “The majority of Americans have simply not been benefiting from the country’s growth,” Stiglitz wrote, overstating things—but not by a lot.

It is also argued that the increasing inequality leads to political action to support consumption levels of the middle class, which in turn leads to economic instability.

In a democracy, politicians and the public are unlikely to accept depressed spending power if they can help it. They can try to compensate by easing credit standards, effectively encouraging the non-rich to sustain purchasing power by borrowing. They might, for example, create policies allowing banks to write flimsy home mortgages and encouraging consumers to seek them. Call this the “let them eat credit” strategy. 

“Cynical as it may seem,” Raghuram Rajan, a finance professor at the University of Chicago’s Booth School of Business, wrote in his 2010 book, Fault Lines: How Hidden Fractures Still Threaten the World Economy, “easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly.” That certainly seems to have happened in the years leading to the mortgage crisis. Marianne Bertrand and Adair Morse, also of Chicago’s business school, have found that legislators who represent constituencies with higher inequality are more likely to support the easing of credit. Several papers by International Monetary Fund economists comparing countries likewise find support for the “let them eat credit” approach. And credit splurges, they find, bring on instability and current-account deficits. 

You can see where the logic leads. The economy, propped up on shaky credit, becomes more vulnerable to shocks. When a recession comes, the economy takes a double hit as banks fail and credit-fueled consumer spending collapses. That is not a bad description of what happened in the 1920s and again during these past few years. “When—as appears to have happened in the long run-up to both crises—the rich lend a large part of their added income to the poor and middle class, and when income inequality grows for several decades,” the IMF’s Michael Kumhof and Romain Rancière wrote, “debt-to-income ratios increase sufficiently to raise the risk of a major crisis.”

I suppose that the Great Depression and the Great Recession are better than "the Terror" that gripped France in the French Revolution when the poor and the middle classes decided that they had finally suffered enough under the greed of the rich.