How could income inequality cause bank crashes?

This is dynamite:

David A. Moss, an economic and policy historian at the Harvard Business School, has spent years studying income inequality. While he has long believed that the growing disparity between the rich and poor was harmful to the people on the bottom, he says he hadn’t seen the risks to the world of finance, where many of the richest earn their great fortunes. 

Look at his graph. Sorry I cannot open it here, but it is worth the click.

It relates income inequality measured as share of income held by the top 10% of the pile compared to bank failures going back to 1917. There is a very clear correlation between income inequality and bank failures. It is strong backing evidence for the position of the Equality Trust -  that greater equality is better for social cohesion.

Now correlation is not causation, though causation must always be accompanied by correlation.

Naturally the Free Market Fundamentalists (="neo-liberals") will wish in to deny causation, because it negates their assumptions.

They have an easy task, because it is impossible to "prove" causation.

The Scottish empirical philosopher David Hume (1711–76), "An Enquiry Concerning Human Understanding" said "The falling of a pebble may, for aught we know, extinguish the sun; or the wish of a man control the planets in their orbits. It is only experience, which teaches us the nature and bounds of cause and effect, and enables us to infer the existence of one object from that of another ".

Causation is not a matter of irrefutable positive logical deduction, but rather a matter of inference, of pattern recognition. This recognition is very much related to our basic assumptions, as well as a mounting body of evidence. Neo-liberals will be far slower to recognise causation in David Moss' observation than someone who understand the scientific truth that man is a social animal.

One of the elements of recognising causation is that of finding a plausible mechanism to relate cause and effect. So the question is, how could income inequality cause bank crashes?

I am going to dip into psychiatry to advance a possible mechanism.
I do not claim to be a scientist or a scholar, but I do know about bipolar (manic-depressive) conditions.

In bipolar illness, the moods of an affected individual swing between the extremes of happiness and unhappiness, euphoria and dysphoria. Now, it is a common feature that in the upswing ("high" or hypomanic phase), the individuals will believe themselves to be rich. It is common for them to spend absurd amounts of money and wreck their bank accounts in an upswing. Conversely, in the depressive phase, they will feel poor. Even very rich people suffering from depression will feel poverty-stricken.

As an interesting aside, in the other main form of psychosis, schizophrenia, the sufferer is more likely to regard money as meaningless. They may regard love or some other abstract value as a more meaningful entity, and give money away.

Now there is a very clear parallel between individual bipolar illness and the behaviour of the markets. Boom is high, bust is low. Bull markets are euphoric, bear markets dysphoric. Is this just an intriguing, fortuitous comparison, or could there be a common mechanism in play?

It is agreed the "Market" is the summation of a multiplicity of individual actions of buying and selling. Human actions are influenced by many factors, from absolute needs such as eating, to emotional factors such as how the trader is feeling that day. In a bull market, when share prices are going up, and most traders leave work significantly wealthier than they were at the beginning of trading, they are going to feel good. That feelgood factor will influence their actions on the trading floor the next day, and the summation of the euphoria of the individual traders will affect the judgments and guesses of all the market traders. There is a also a group consciousness going on; if we find ourselves among an excited crowd, we are going to pick up on the excitement.

There is a positive feedback factor; feel good, buy in the expectation of more profit, get profit, feel good. The market as a whole is bouyant; nothing could go wrong. Buy, buy! And so it goes on, activity spiralling upward, until the whole system parts company with reality* (exactly as occurs in the course of an individual's manic phase), and the rake handle of Reality connects with the nose of the Market, which goes into free fall, wiping out whole fortunes.

Whereupon the market goes into a decline, just as the hypomanic sufferer suddenly realises that they have blown their bank balance, and made a fool out of themselves, and plunges into depression. The market goes into recession, which if it lasts long enough will be called a depression. The choice of words endorses the parallel between the individual, psychiatric state, and the collective, financial/economic state.

Depression  is just as much capable of generating false beliefs as mania. This is very relevant to our present economic situation, where Osborne is about to slit the nation's economic wrists in the belief that if he does not do so, the Market will come and take away our AAA rating.

In this view of things, Osborne's economicidal cuts, in the face of double dip recession, can be seen as a delusion of poverty, the mirror image of Gordon Brown's hubristic "we have abolished boom and bust".

The UK is certainly up financial shit creek, but at least we still have a paddle - a functioning economy. Unfortunately Osborne is trying to saw it into bits and sell it for firewood.

To summarise: the Market is composed of the summation of individual trading actions, and those traders are also influenced by emotions. There is a positive feedback loop between trading success and market euphoria, which drives those who are profiting from a rising market to make ever more euphoric guesses and judgments until contact with more basic economic realities bring about a deflation. In the boom phase, the profits accruing to bankers (who are in the top 10% of the economy) will expand, which is a plausible mechanism to explain Moss' observation that growing inequality precedes a market crash.

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*Even more than it already is. The financial market is commonly distinguished from the "real economy" of manufacturing and production, and the whole orthodox dys-economy itself is divorced from the basic reality of ecological economics.

This is an edit of a post from 2010