Crisis caused by income equality or government intervention?

There is a thought provoking interview with Raghuram Rajan in the December issue of Money magazine. Mr. Rajan is one of the few economists that warned our current financial crisis was coming and the article is primarily about Mr. Rajan’s theory that the current crisis is caused by income inequality:

“In the 1980s we saw a widening of income inequality. Typically the political reaction to that is to redistribute wealth. But in the ’80s and ’90s there was a sense that we’d had too much redistribution, too much welfare. So you had to find something else, and housing fit the bill for both political parties.

The Democrats thought it was wonderful to support home ownership for the poor, their natural constituents. The Republicans figured property owners would eventually vote Republican.”

Mr. Rajan then goes on to explain how the political issue of income inequality led the United States federal government to create the current crisis with their attempts to cure income inequality. I see a great deal of truth in what Mr. Rajan says but I would like to point out one crucial difference in how I view the problem.

It wasn’t income inequality that caused the current economic crisis. The direct cause of the crisis was the political response to income inequality. The difference is subtle but completely changes the diagnosis of the problem and if we misdiagnose the problem it is impossible to come up with the correct solution.

If income inequality is to blame for our current economic crisis then the federal government could prevent future crises by eliminating income inequality. In that case the the solution would be for the federal government to continue various forms of political intervention in the hope of solving income inequality. Of course Marxism and Socialism are two examples of such attempts and their results have been devastating.

On the other hand, if the current economic crisis was actually caused by clumsy political responses to income inequality we need to look for a different kind of solution. Maybe we could start by having politicans recite the Law of Unintended consequences: “An intervention in a complex system always creates unanticipated and often undesirable outcomes”. Then we could change the oath of office to “First, do no harm”. 

The interview with Mr. Rajan can be found online at CNNMoney.com

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