The Cost of Inequality: Social Distance, Predatory Conduct, and the Financial Crisis

Abstract

Many have offered theories that attempt to identify the causes of the present financial crisis. Some blame deregulation and a culture of greed on Wall Street. Others argue that lawmakers and Presidents promoted homeownership too aggressively, sending mortgage credit to low-income communities to serve borrowers with poor credit and little likelihood of paying back their mortgage. Too often, these charges enjoy little empirical support. Taking a hard look at some of the economic indicators present in the buildup to the crisis, one fact stands out; prior to the crisis, the U.S. experienced a stunning increase in income inequality. This increase was reminiscent of a time when the U.S. experienced a similar increase in income inequality: the years leading up to the Great Depression. Given this phenomenon, this article explores empirically whether income inequality itself may have an impact on financial markets: asking whether such inequality can exacerbate, or even lead to, financial crises.

There are several possible explanations for the potential connection between rising income inequality and the great strains on the economy it causes. Did rising income for certain sectors lead to an ability to use that income to influence policymaking in such a way that favored those sectors? Did such income inequality pressure politicians to promote policies that favored easy access to credit as a way to mollify lower income constituents who might otherwise grow frustrated with their own stagnating wages in the face of such inequality? These are the types of explanations that some have offered to try to explain the link between income inequality and the Great Recession. In this work, I both analyze these explanations, but also offer a third: that both income inequality and racial inequality created greater social distance and this social distance, in turn, led to greater predatory conduct. That predatory conduct turned a mortgage market into an economic killing field.

The review of the empirical information presented here uncovers critical information that may reveal new insights into the potential causes of the financial crisis. First, differences in economic inequality within states correspond to differences in mortgage delinquency rates: i.e., the greater the income inequality in a state, on average, the greater the delinquency rate in that state. Second, the greater the generalized trust in a state, the lower that state’s delinquency rate. Third, the higher the social capital in a state, and the higher the level of volunteerism in a state, the lower its delinquency rate. Fourth, the higher the median income in a state, the higher the delinquency rate in that state. Fifth, an index of a series of indicators - income inequality within a state, the size of the African-American population in a state and the median income of the African-American population in that state - reveals a strong correlation between these indicators and delinquency rates. This correlation suggests not that low-income African-Americans are to blame for the foreclosure crisis, but, rather, that middle-class African-Americans were targeted for, and steered towards, loans on unfair terms, precipitating the foreclosures that are now concentrated disproportionately in communities of color.

After a discussion of the empirical data that supports these conclusions, this article assesses the legislative and market forces presently at work that are attempting to rein in risky practices on Wall Street. First, I review the recently enacted Dodd-Frank financial reform legislation, analyzing to what extent it addresses social inequality. Second, I turn then to reform efforts with respect to modernization of the Community Reinvestment Act. Last, I look to market-driven and consumer-oriented efforts to reform financial institutions, including the Move Your Money campaign, a consumer-led boycott designed to convince consumers and investors to utilize community-based financial institutions.

Keywords: Financial Crisis, Economic Inequality, Racial Inequality, Financial Reform, Mortgage Reform, Subprime Mortgage Crisis

JEL Classification: B25,C71, D60, D63, E61, E62, E65, E66, G21, G28, G38, J15, J70, J71, J78, K00, K11, K23, K42, N12