Extreme Inequality Helped Cause Both the Great Depression and the Current Economic Crisis

George Washington's picture

Washington’s Blog

It is clear that when banks become too big, it harms the economy. Economist Steve Keen says
that "a sustainable level of bank profits appears to be about 1% of
GDP", and higher bank profits lead to a Ponzi economy and a depression.

But most mainstream economists dismiss the idea that wealth inequality among individuals causes economic crises.

Of course, some ideologues will argue that even discussing inequality is waging class warfare, and smacks of an attack on capitalism.

However, the father of modern economics - Adam Smith - disagreed.

And as Warren Buffet, one of America's most successful capitalists and defenders of capitalism, points out:

There's class warfare, all right, but it's my class, the rich class, that's making war ....

And as I have previously noted, radical concentration of wealth actually destroys capitalism, turning it instead into socialism for the rich.

Is There a Causal Connection Between Extreme Inequality and Economic Crises?

More to the point, most mainstream economists do not believe there is a causal connection between inequality and severe downturns.

recent studies by Emmanuel Saez and Thomas Piketty are waking up more
and more economists to the possibility that there may be a connection.

economics professors Saez (UC Berkeley) and Piketty (Paris School of
Economics) show that the percentage of wealth held by the richest 1% of
Americans peaked in 1928 and 2007 - right before each crash:

Figure 1

As the Washington Post's Ezra Klein wrote in June:

Thumbnail image for inequalitygraph.jpg



says that he used to dismiss talk that inequality contributed to
crises, but then we reached Great Depression-era levels of inequality
in 2007 and promptly had a crisis, so now he takes it a bit more


The problem, he says, is finding a mechanism.
Krugman brings up underconsumption (wherein the working class borrows a
lot of money because all the money is going to the rich) and
overconsumption (in which the rich spend and that makes the next-most
rich spend and so on, until everyone is spending too much to keep up
with rich people whose incomes are growing much faster than everyone

Robert Reich has theorized for some time that there are 3 causal connections between inequality and crashes:

the rich spend a smaller proportion of their wealth than the
less-affluent, and so when more and more wealth becomes concentrated in
the hands of the wealth, there is less overall spending and less overall
manufacturing to meet consumer needs.

Second, in both the
Roaring 20s and 2000-2007 period, the middle class incurred a lot of
debt to pay for the things they wanted, as their real wages were
stagnating and they were getting a smaller and smaller piece of the pie.
In other words, they had less and less wealth, and so they borrowed
more and more to make up the difference. As Reich notes:

1913 and 1928, the ratio of private credit to the total national
economy nearly doubled. Total mortgage debt was almost three times
higher in 1929 than in 1920. Eventually, in 1929, as in 2008, there were
“no more poker chips to be loaned on credit,” in [former Fed chairman
Mariner] Eccles' words. And “when their credit ran out, the game

And third, since the wealthy accumulated more,
they wanted to invest more, so a lot of money poured into speculative
investments, leading to huge bubbles, which eventually burst. Reich
points out:

In the 1920s, richer Americans
created stock and real estate bubbles that foreshadowed those of the
late 1990s and 2000s. The Dow Jones Stock Index ballooned from 63.9 in
mid-1921 to a peak of 381.2 eight years later, before it plunged. There
was also frantic speculation in land. The Florida real estate boom lured
thousands of investors into the Everglades, from where many never
returned, at least financially.

Wall Street cheered them on in the 1920s, almost exactly as it did in the 2000s.

But I believe there may be a fourth causal
connection between inequality and crashes. Specifically, when enough
wealth gets concentrated in a few hands, it becomes easy for the
wealthiest to buy off the politicians,
to repeal regulations, and to directly or indirectly bribe regulators
to look the other way when banks were speculating with depositors
money, selling Ponzi schemes or doing other shady things which end up undermining the financial system and the economy.

For example, as John Kenneth Galbraith noted in The Great Crash, 1929,
Laissez-faire deregulation was the order of the day under the Coolidge
and Hoover administrations, and the possibility of a financial
meltdown had never been seriously contemplated. Professor Irving Fisher
of Yale University - the Alan Greenspan, Robert Rubin or Larry Summers
of his day - had stated authoritatively in 1928 that "nothing
resembling a crash can occur".

Indeed, when enough money is
concentrated in a couple of hands, the affluent can lobby to appoint to
government positions, pay to endow prominent university chairs, and
create think tanks and other opportunities for economics professors who
spout the dogmas "everything will always remain stable because we've
got if figured out this time" and "don't worry about fraud" to gain
prominence. For example, Bill Black has written about The Olin Foundation's promotion over the last couple of decades of these dogmas.

believe that the fourth factor exacerbates the first three.
Specifically, when the wealthy have enough money to drown out other
voices who might otherwise be heeded by legislators and regulators, they

  • Skew the tax code and other laws so that they can get even wealthier
  • Encourage
    a debt bubble (Bill Black has repeatedly explained that the fraudsters
    blow huge bubbles, knowing that the government will bail them out when
    the bust leads to defaults)
  • And create new Ponzi schemes for speculation

(Admittedly, there might not always be a direct connection, but all of the factors are at least intertwined.)

Reuters wrote an excellent piece on the issue of inequality and crashes (discussing the first three factors) last month:

are only beginning to study the parallels between the 1920s and the
most recent decade to try to understand why both periods ended in
financial disaster. Their early findings suggest inequality may not
directly cause crises, but it can be a contributing factor.




has one of the largest wealth gaps among advanced economies. Based on
an inequality measure known as the Gini coefficient, the United States
ranks on a par with developing countries such as Ivory Coast, Jamaica
and Malaysia, according to the CIA World Factbook.




is little agreement among economists about what precisely links high
inequality to crises, which helps explain why so few officials saw the
financial upheaval coming.


Rapid expansion of credit is one common thread.




Rajan, a professor at the University of Chicago's Booth School of
Business and a former chief economist of the International Monetary
Fund, believes governments tend to promote easy credit when inequality
spikes to assuage middle-class anger about falling behind.


"One way to paper over the rising inequality was to lend so that people could spend," Rajan said.


the 1920s, it was expansion of farm credit, installment loans and home
mortgages. In the last decade, it was leveraged borrowing and lending,
by home buyers who put no money down or investment banks that lent out
$30 for each $1 held.


"Housing credit gave you an instrument to
assist those falling behind without them feeling they're beneficiaries
of some sort of subsidy," Rajan said. "Even if their incomes are
stagnant, they feel really good about becoming homeowners."


theory is that concentration of wealth at the top sends investors
searching for riskier interest-bearing savings. When so much cash is
sloshing around, traditional safe investments such as Treasury debt
yield very little, and wealthy investors may seek out fatter returns


Mark Thoma, who teaches economics at the University
of Oregon, wonders if the flood of investment cash from the ultra-rich
-- both in the United States and abroad -- encouraged Wall Street to
create seemingly safe mortgage-backed securities that later proved
disastrously risky.


"When we see income inequality rising, we ought to start looking for bubbles," he said.


Dervis, global economy and development division director at Brookings
and a former economy minister for Turkey, said reducing inequality
isn't just a matter of fairness or morality. An economy based on
consumption needs consumers, and if too much wealth is concentrated at
the top there may be times when there is not enough demand to support


"There may be demand for private jets and yachts, but
you need a healthy middle-income group (to drive consumption of basic
goods)," he said. "In the golden age of capitalism, in the 1950s and
60s, everyone shared in income growth."


The fact that economists
are even examining the link between inequality and financial crises
shows just how much the thinking has changed in the wake of the Great




Ajay Kapur, a Deutsche Bank strategist, spotted the
inequality parallels between the 1920s and the most recent decade, but
didn't see the meltdown coming. The former Citigroup strategist created
a stir five years ago when he built an investment strategy around his
thesis that essentially divided the world into two camps: the rich and
the rest.


Kapur told clients in 2005 that the United States and a
handful of other economies were developing into "plutonomies" where
the wealthy few powered economic growth and consumed much of its
bounty, while the "multitudinous many" shared the leftovers.


come around only once or twice a century, he argued -- 16th century
Spain, 17th century Holland, the Gilded Age. The last time it happened
in the United States was during the "Roaring 1920s".




least one new arrival to Washington's policy-making scene, Fed Vice
Chairman Janet Yellen, has expressed concern that extreme inequality
could ultimately undermine American democracy.


"Inequality has
risen to the point that it seems to me worthwhile for the U.S. to
seriously consider taking the risk of making our economy more rewarding
for more of the people," she wrote in a 2006 speech.

For further background, see this, this and this.

Note: The graphics above are slightly misleading, as Saez notes that inequality is actually worse now than it's been since 1917.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Catullus's picture

For the much revered Wealth of Nations is a huge, sprawling, inchoate, confused tome, rife with vagueness, ambiguity and deep inner contradictions. There is of course an advantage, in the history of social thought, to a work being huge, sprawling, ambivalent and confused. There is sociological advantage to vagueness and obscurity. The bemused German Smithian, Christian J. Kraus, once referred to the Wealth of Nations as the 'Bible' of political economy. In a sense, Professor Kraus spoke wiser than he knew. For, in one way, the Wealth of Nations is like the Bible; it is possible to derive varying and contradictory interpretations from various - or even the same - parts of the book. Furthermore, the very vagueness and obscurity of a work can provide a happy hunting ground for intellectuals, students and followers. To make one's way through an obscure and difficult tract, to weave dimly perceived threads of a book into a coherent pattern - these are rewarding tasks in themselves for intellectuals. And such a book also provides a welcome built-in exclusion process, so that only a relatively small number of adepts can bask in their expertise about a work or a system of thought. In that way they increase their relative income and prestige, and leave other admirers  behind to form a cheering section for the leading disciples of the Master.


-- Murray N. Rothbard

Economic Thought Before Adam Smith Vol. 1

Chapter 16.1 The Celebrated Adam Smith

Future Jim's picture

No. Dude. He said Adam Smith would agree with him. That's settles it. He must be right.

gwar5's picture

"...because free markets themselves are necessarily beautiful choas, a dyamic living thing, with rightful claim to their own mystery and uncertainty. Only through supreme vigilant efffort does an English garden remain a  subservient English garden, manicured into obedience, before it once again reverts to the wild forest that it once was and always wishes to be. Describing such a phenomenon pretends not to control it, but to give the wanderer a guide to where sustenance may be found and briars may lay hidden."

Oxford student, 1891


chet's picture

Yep.  And only about 1% of people who cite Adam Smith have actually ever read the thing.

greenewave's picture

The horror of war and MASSIVE political and civil unrest is COMING TO THE UNITED STATES.

Please watch the video “Hero of War” at (http://youtu.be/z0XPqiQM92Q) and see what the MAINSTREAM MEDIA doesn’t want you to see.


Wow this look like a movie but the truth is that it’s not.

Malcolm Tucker's picture

Coming? It's already here. If you want to see tyranny and brutality watch this:


This is in Canada no less. 

Terminus C's picture

Yea, Herr Harper kindly spent $1 billion of our tax money to show us, the tax payer, just how much power the state holds over our heads.  He kindly used our money to demonstrate that our charter of rights and freedoms, enshrined in our constitution, is nothing but toilet paper.

Unfortunately if it was not Herr Harper doing this then it would have been Herr Iggy or... Herr Layton? (Hairy Layton maybe... not sure he would have done this but... the NDP... UHG... Triple the size of governmnet and they'd be happy)

Anyway, am doin my part to undermine fascism in my country.

Future Jim's picture

I wonder if those police were even Canadian. You never know. They look just like the rest of us - those Canadians.

In all seriousness, that was a very good video. I downloaded it before it disappears. It appears that the camera was hidden, like a pen camera, or else I'll bet it would have been confiscated and we would never have seen this. In addition to as many pen cameras as possible, I recommend as many cameras as possible mounted in cars or nearby windows and aimed at any protest, tea party, etc.

This reminds me of the collateral murder video, which I wrote about here: http://www.endofinnocence.com/2010/04/evil-exposed.html


Dr. Sandi's picture

Deja vu. Seems like I've seen this before somewhere!

You make the erroneous assumption that the MSM gives a rat's ass about what I see.

More Critical Thinking Wanted's picture


One small historic detail worth pointing out is that both the roaring 20s and the period leading up to the big 2008 crash were ruled by Republican presidents, with "free market", "hands off", deregulatory policies - a corrupt policy financed and cheered on by Wall Street.

That created/accelerated both the excesses, the inequality and laid the foundations for an inevitably big crash. Those eras had the mindset and intellectual limitations of Ron Paul, just on a grander scale.

Cleaning up the mess was left to democratic presidents.

Something to think about.


Rogerwilco's picture

Well that explains it! When Bill Clinton signed the legislation granting investment banks unlimited leverage, he became a Republican. Who knew?

Thanks so much for extending our knowledge.

More Critical Thinking Wanted's picture


Hey, why stop at Clinton, the president who (after a long string of republican presidents producing bigger and bigger debt) posted the first surplus quarter in decades and actually started reducing the debt?

So it's the fault of Kennedy ... or rather Roosevelt! It's true that he led the US into its biggest period of sustained growth, but he ... abolished the gold standard! Sure he must be at fault for 2008 too ;-)


Terminus C's picture

While your call on Republican presidencies rings true, the difference between Ron Paul and George Bush is that Paul would have let the banks fail... if he stuck to his beliefs and he would not have run up such a monstrous debt.

The main difference between 1929 and 2007 is the debt levels of America (public and private).  The mass borrowing of the thirties and forties was able to pull the U.S. out of the depression... this time it will not because we are heaping massive new debt onto massive old debt.

Also, the main common element to both of these major economic down turns was the manipulation of money supply by the U.S. Fed.

More Critical Thinking Wanted's picture

I'm not so sure about Ron Paul at all. Lets quote the man himself, from 2005, and see his actions at the height of the housing bubble:


The quiet campaign against provisions of the Sarbanes-Oxley Act may have had something to do with the proposal by Representative Ron Paul, a Republican from Texas, on Thursday to eliminate Section 404 entirely. In a statement, the congressman said the provision "has raised the costs of doing business, thus causing foreign companies to withdraw from American markets and retarding economic growth."

And what was "Section 404" that Ron Paul opposed? Anti-fraud provisions:

Section 404 requires companies and their auditors to assess the companies’ internal controls, which are the practices or systems for keeping records and preventing abuse or fraud.


Holy crap ...