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How income inequality can lead to more financial crises

Daily Ticker

There is "absolutely no doubt" in Thomas Piketty's mind that increased inequality in the U.S. contributed to the financial crisis that slammed the housing and financial markets in 2007 and 2008.

The author of this year's hot-selling economics book, Capital in the Twenty-First Century, writes, "One consequence of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes in the United States, which inevitably made it more likely that modest households would take on debt, especially since unscrupulous banks and financial intermediaries .... offered credit on increasingly generous terms."

Related: U.S. inequality looks like Europe before WWI: Thomas Piketty

And that borrowing, as we know, left many mortgage holders with much more debt than they could handle. Foreclosures soared, mortgage lenders failed and some top Wall Street firms heavily involved in the mortgage-backed securities market like Bear Stearns and Lehman Brothers went bankrupt.

Related: Thomas Piketty's Rx for income inequality: "You don't need to go all the way to socialism"

Income inequality wouldn't be as big a threat to the financial system, says Piketty, if growth were robust or if tax policy was changed to make the system much more progressive, such as levying a wealth tax on the country's richest 10%, which would reduce taxes for many in the bottom 90%.

Related: Tax the rich more if inequality gets worse: Robert Shiller

But that's not likely to happen anytime soon, which raises the question: Will growing inequality beget more financial crises in America?

In the video above, Piketty says, "When you have stagnant incomes this puts pressure [on] for extra household debt, extra borrowing, and this contributes to make our financial system more fragile."

And history shows just how fragile the financial system can become when income inequality grows.

Related: Income Inequality Is the Enemy of Economic Growth: Robert Reich

In addition to Piketty, Harvard Business School economic historian David Moss and former Labor Secretary Robert Reich have each pointed to the parallels between income inequality in 1928, just before the Great Depression, and in 2007, just before the Great Recession. At both historic turning points the top 10% of earners accounted for 50% of total national income; and the top 1% for half of that.

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