Did Rising Inequality Cause the Recent Financial Crisis?

One of the possible explanations proposed for the 2007-2008 financial crisis is rising inequality in the United States. Rajan (Fault Lines, 2010) and others proposed the following explanation: i) associated with rising inequality, incomes stagnated or declined in the lower half of the earnings distribution; ii) this provoked distributional conflict; iii) the US political system prevents a response to this that would involve taxing the better off to provide income-supporting transfers to those experiencing stagnant or declining incomes; iv) but the political system has allowed a response to distributional conflict through a liberalization of access to credit including, in particular, access to mortgages for those with relatively low incomes; v) the financial crisis was caused by a boom in house prices caused by house purchases by those ill-equipped to make mortgage payments and this, in turn, caused a wave of mortgage defaults which provoked the crisis; vi) the aggregation of default-prone mortgages into securities (especially collateralized debt obligations) held by financial institutions ratcheted up risk in the financial system which, in turn, exacerbated the financial problems caused by defaulting mortgage holders. Rajan provides little evidence in support of this interpretation. This paper addresses the following questions. i) Did incomes stagnate or decline in the lower part of the income distribution in the decades leading up to the crisis? ii) Did distributional conflict cause the liberalization of credit in the form of sub prime mortgages? iii) Was it the provision of mortgages to low income house buyers that caused the boom and subsequent bust in house prices. iv) To what degree was increased risk in the financial system caused by policies encouraging the issue of sub prime mortgages? On the whole, the evidence raises doubts about the rising inequality account of the financial crisis.