What were some of the causes of the 2008 crisis? We will start a more in-depth analysis, primarily from Geithner (2014) as source material. I would suggest there were five main causes of the crisis, but there are other important causes not covered in this writing. The following five major causes are: (a) record income inequality, (b) record household debt, (c) relaxed financial regulation, (d) decline of household discretionary income, and (e) an over extension of overseas operations. With these five major causes, a confluence of factors became magnified causing the economic system to collapse. These dynamics can be explained through chaos theory.
Any one of the five major causes most likely would not bring down the whole financial system, but when added to together there are special nonlinear dynamics exhibited. As more aspects of a system are defined there are more degrees-of-freedom. With a system of high degrees-of-freedom, unexpected system dynamics result due to strange chaotic attractors. This is true even with a totally deterministic system, whereby no random functions are present in the system. In financial markets there are stochastic variations making this type of system a nondeterministic system—leading to even more strange chaotic attractions. When a certain threshold is reached a new system dynamic emerges. Let’s look at some details of the five major causes of the crisis.
In terms of record income inequality, Piketty(2014) showed that income inequality is cyclical. This cycle of income inequality in the United States can be shown over the last hundred years or so. One can conclude that very similar income inequalities exist as of this writing compared to the late 1920’s. The first big drop of income inequality was after the 1929 stock market crash. But the biggest drop in income inequality was during World War II. After the war it took approximately 4 decades for the income inequality in the United States to rise. A big part of this rise was deregulation of markets coupled with low taxation policies initiated in the Reagan and Thatcher era. More of the executive compensation, especially starting in the 1990’s, is through stock options—leading to exponential grown in income for the managerial class of workers. We see this in the average income of the executive staff of a publicly held company earning much more that the average worker—the multiple might be as high as 400 times more within some companies.
Higher income inequality might be great for a selected few in society, but it seems that this social dynamic is not healthy for the economic ecosystem. Case-in-point, from the 1940’s through the 1970’s income inequality remained stable at about 33 percent of national income for the top 10 percent of the wealthiest in the United States. During this period the middle class was growing and aggregate demand was strong. But as income inequality increased to nose bleed levels the middle class had lost approximately 15 percent of national income—primarily due to the lack of capital to participate in asset price appreciation. It is hypothesized that increased income inequality helps feed stock market bubbles, and therefore deeper stock market corrections. In chaos theory we describe this dynamic as a chaotic attraction; when one part of the system is out of equilibrium with another part of system. In this case too few people are controlling too much of the national income and leading to unhealthy economic ramifications.