In 2007, Economists Thomas Piketty and Emmanuel Saez found that the income share of the richest Americans was an enormous 18.3%, indicating too few Americans earn too much income. Not since the Gatsby era of Long Island mansion parties – when the equivalent statistic reached 18.4% – has American income disparity been so uneven. What caused this huge economic divide?
For the past decade, much of the world’s policy elite have eluded to the ‘Davos consensus’ – the notion that inequality itself was less important than ensuring that those at the bottom were becoming better off. This principle was personified in the expansion of credit to the poor in the recent decade.
Raghuram Rajan of University of Chicago and author of Fault Linesblames easy and excessive credit to the poor for helping lead to the financial recession of 2008. He argues that many governments and banks used credit as a short-term tool to prop up the living standards of those at the bottom of the economic pile. The most famous example of these excessive risky loans is the subprime mortgages written before the recent economic crisis.
Home ownership has long been a staple of the American dream. Before the recent recession, banks were eager to write ‘subprime’ mortgages to borrowers without good credit. These subprime loans were given to Americans of all socioeconomic backgrounds, but overwhelmingly to ‘NINA’s – lenders with No Income or No Asset.
Sounds like bad business, right? The banks didn’t think so. They wanted to sell as many mortgages as they could. Why? Because they would turn around and sell the rights of collection on these mortgages to other banks – a process known as securitizing loans. Considering the prices of American homes continued climbing for the better part of a decade, banks and realtors alike were convinced of limitless prices. This motivated the financial sector to pool the rights to collect on millions of American mortgages and sell these rights to unknowing investors. Sounds illegal? It isn’t.
After decades of this practice, the foundation started to crack and crumble, as home prices plummeted, leaving the occupants paying the bank more than the home was valued. After waves of defaults and foreclosures, the once-gilded financial house of cards fell – giving way to Treasury-raiding bailouts and high, sustained unemployment.
The politics of credit expansion is well intended but has unforeseeable consequences. Combating inequality is a more complex issue requiring more than the single-pronged approach of easy credit. There are more contributors to America’s embarrassing inequality. Irrational exuberance and a willingness to bet on constantly home prices rising forever were likely much bigger contributors to the recession than credit expansion to unworthy lenders.
Nonetheless, Mr. Rajan criticizes the United States government for using this as a tool to get people out of poverty. Improving schools and training workers, he says, would have proved to be a much more effective and safer solution. He may be right, as fewer subprime mortgages and risky loans would have lessened the fiscal calamity after the ’08 recession.
But this logic skirts the overall issue – what to do about the less than 1% of the population making almost a quarter of the income? The US government should abolish its largesse that favors specific industries. Forcing banks to hold more capital and pay for their implicit government safety net is the best way to tame Wall Street’s riskier institutions without compromising free market rules and the age-old incentive of profit.
Governments must focus on pushing up the bottom and middle rather than dragging down the top. Improving the quality and accessibility of public education, abolishing rules that prevent the able from getting ahead and refocusing government spending on those that need it most combats the problem much better than simply expanding credit access.