How exactly did inequality fuel the crisis?

By M.S.

AS MY colleague notes, Raguram Rajan is among those who think that income inequality played a role in precipitating the global financial crisis. My other colleague likes the part of Mr Rajan's argument that blames the government, which Mr Rajan says pressed for more access to mortgage credit for low-income borrowers. It probably won't surprise anybody that this isn't the part of Mr Rajan's argument that I like. We all have places we're coming from, and they influence the types of arguments that sound convincing to us. But let me lay out what sounds unconvincing to me about this part of Mr Rajan's story.

As we all know, the collapse of housing prices didn't, in itself, cause the global financial crisis. The financial crisis was caused by the interlinkage between housing prices and vast quantities of derivatives based on those prices, and on the value of the loans taken out to finance them, held by a global web of financial institutions trying (in theory) to hedge themselves against...the risk of a collapse in housing prices. Raguram Rajan owes his status as a GFC oracle in large measure to having correctly perceived in 2005 that these derivatives, rather than insulating against risk, were creating greater systemic risk. By creating the illusion that all bets could be hedged, derivatives such as credit default swaps (CDSs) encouraged bankers to make riskier bets. When the bets on the housing market went sour, the hedging insured that they didn't take down one banker; rather, they took down the system. Or would have, if the government hadn't bailed the system out.