Over the past century, the United States has experienced two large-scale financial crises: the Great Depression of 1929 and the recent Great Recession, which began in 2007. These periods also represented peaks in the share of U.S. income collected by the top 1 percent of earners. In 1929, the top 1 percent accrued over 22 percent of total national income, including capital gains – a share several percentage points above its historical average, and one that would not be seen again until 2006. Notably, the number of bank failures in the U.S. – a proxy for financial crises – and national income inequality as measured by the Gini Index have followed a strikingly correlated pattern: a steady rise leading up to the Great Depression, followed by a sharp reduction that lasted into the 1970s, and then a steep escalation that peaked prior to the Great Recession (Exhibit 1, Exhibit 2). The correlation between income inequality and financial crises raises an important question: could it be that extended periods of increased income inequality help to cause financial crises? Evidence suggests this may well be the case, through three primary mechanisms that reinforce each other:
- Sharp increases in debt-to-income ratios among lower- and middle-income households looking to maintain consumption levels as they fall behind in terms of income;
- The creation of large pools of idle wealth, which increase the demand for investment assets, fuel financial innovation, and increase the size of the financial sector;
- And disproportionate political power for elite financial interests which often yields policies that negatively affect the stability of the financial system.
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*This paper was originally written while the authors were enrolled at Harvard Business School and the views expressed in it do not reflect those of the authors' current affiliations and employers. The authors give special thanks to Professor David A. Moss for his guidance.