Inequality, Asset Price Bubbles, and Depressions

It's great to be reminded, both by Steve's and by Rob's recent posts here, of recent, alarming trends in the direction of heightened wealth- and income-inequality in America.  It's also lovely to be reminded, in this connection, of a terrific post by Steve this past July.  I want in particular to recommend the double-issue of The Nation that Steve cited in that post.  It is available here: http://www.thenation.com/article/36894/inequality-america .  In addition to Robert Reich's piece, there are thoughtul pieces by Dean Baker, Jeff Madrick, and others.

Reich's mention, in his contribution, of a possible link between growing wealth- and income-inequality on the one hand, and asset price bubbles and busts -- hence recessions and depressions -- on the other, is especially worth noting and exploring.  It is striking, for example, that wealth- and income-inequality measures in America circa 2008 had returned for the first time to what they had been 80 years earlier, in 1928.  But this is just one interesting comparison.  For as it happens, two old acquaintances of mine, Dave Moss at the Harvard Business School, and Richard Freeman with Harvard's Economics Department and NBER, have in separate empirical studies found a pronounced correlation between wealth- and income-inequality on the one hand, and financial asset price bubbles and busts on the other hand, that is much more general.  And the link is robust across continents and centuries. 

The mechanisms that Moss and Freeman posit to account for the correlations, however, I think inadequate.  They speculate that as the rich grow richer, they are able to procure laxer and laxer regulation of financial markets.  While there is doubtless some truth in that, I think the story inadequate because I don't think asset price bubbles are the product of lax regulation so much as they are the product of central banks' and other government organs' failures to recognize the sense in which bubbles and bursts are collective action problems, and their consequent failures to use monetary and tax policy, respectively, to address those problems on behalf of the collectivity.  (I've harped on this point before, and linked to some articles I've written on it, so I won't harp much now.) 

If I am right about this, then the role that wealth- and income-inequality play is that of instigating and fueling the collective action problem that is the asset price bubble itself.  More specifically, the story is a Keynesian one, in which greater wealth yields a diminishing marginal propensity to consume and a correspondingly higher marginal propensity either to invest or to speculate.  The first of those developments of course yields lower consumer demand and hence lower working class incomes and growing consumer debt meant to maintain purchasing power.  The second for its part yields hyperinflation in financial asset markets -- a vicious cycle of price rises that can only be slowed either by (a) higher interest rates or tightened money supplies that risk worsening the lower consumer demand and lower working class income problems, or (b) higher capital gains taxes that tamp down the incentives of rich speculators to speculate and at any rate channel the 'winnings' to the general public. 

A colleague and I are now at work on an empirical project aimed aimed at testing this hypothesis.  Details to come.  But what can be said even now is that it is somewhat suprising that so few seem thus far to have considered this proposed mechanism.  Reich in this respect represents a refreshing change of pace.  Thanks again to Steve, and for that matter to Rob, for effectively drawing our attention both to him and to the issue that so concerns him. 

Cross-Posted at ReligiousLeftLaw