Confusing Effect With Cause

Mark Thoma links to an article by an historian by the name of James Livingston. He argues that the cause of the current financial crisis as well as that of the 1930s was inequality, or more specifically corporate profits constituting an abnormally high share of national income in both the late 1920s and in the last years of the boom that preceded the current bust. With profits being abnormally high, firms invest in asset markets instead of in real investments causing asset price bubbles.

There are several problems with this theory. For example, real investments did in fact rise during those booms sharply. But the most important problem with the theory is that it provides no credible explanation of why inequality and the relative share of corporate profits had risen so much. Given how weak unions were to begin with, it hardly constitute a credible explanation. And are we really to believe that unions strengthened dramatically during the Depression when profits collapsed and so labor's share of national income rose?

No, the real explanation, as I've explained repeatedly (see for example here) monetary policy. Money supply increases causes for various reasons prices to rise faster than wages, causing the profit share to rise. Furthermore, loose monetary policy cause stock prices to increase even faster than profits both by lowering interest rates (and so increasing the present value of projected future profits) and by creating a positive sentiment. This increase in asset values benefits for obvious reasons those who had assets to begin with, which is primarily the rich, and for that reason it increases inequality.

Increased inequality is in other words not the cause of the asset price bubble. Instead, it is like the asset bubble a related effect of inflationary monetary policies.