The idea that the Great Recession of 2008 may have been caused not just by careless banking but also social inequality is currently all the rage among macroeconomists.

Much of the impetus for the current debate stems from the widely discussed 2010 book Fault Lines, written by Raghuram Rajan, a former chief economist of the International Monetary Fund. Rajan argues that many lower- and middle-class consumers in the United States have reacted to the stagnation of their real incomes since the early 1980s by reducing saving and increasing debt. This has temporarily kept private consumption and thus aggregate demand and employment high, but also contributed to the creation of the credit bubble which eventually burst.

In Rajan's view, a large portion of the blame for this falls on misguided government policies, which promoted the expansion of credit to households. But the "Rajan hypothesis" also contradicts the dominant textbook theories of consumption, which see no link between persistent income inequality and aggregate private consumption, and hence no need for government action stimulating consumption demand and jobs in response to higher inequality.

These theories, known as the permanent income or life-cycle hypotheses, are based on the assumption that consumers form rational expectations about their long-term income. Short-term fluctuations of income due to, say, unexpected job loss, or lower than average stock market returns, have only a limited impact on current consumption since households expect them to be only temporary. According to this view, households can insure against windfall losses through efficient credit markets and "smooth" their consumption over the longer term.

Up until the crisis, a very influential view inspired by this standard theory was that the rise in measured inequality since the early 1980s reflected temporary, not permanent, inequality. It was argued, for instance, that the information technologies of the "new economy" brought about more rapid structural change, faster labour turnover and thus higher job insecurity than in previous decades – leading to higher short-term risks and opportunities for workers and investors, but not necessarily higher inequality of lifetime incomes. The idea was that rising personal credit was an efficient market response to higher temporary earnings dispersion. Most economists therefore welcomed the deregulation of the credit market.

In 1996, Alan Greenspan, then chairman of the Federal Reserve Bank, noted in response to growing concerns about rising inequality that "wellbeing is determined by things people consume [and] disparities in consumption … do not appear to have widened nearly as much as income disparities". In a similar vein, Fabrizio Perri and Dirk Krueger suggested in an influential scholarly article published in 2006 that "consumers could, and in fact did, make stronger use of credit markets exactly when they needed to (starting in the mid-1970s), in order to insulate consumption from bigger income fluctuations".

However, recent empirical work, for instance by Emmanuel Saez and others, strongly suggests that the rise in inequality over the past decades has been largely due to the permanent rather than transitory components of income. In other words, many households have lived beyond their means and were lured into dubious credit they could not afford.

There are alternatives to the outdated paradigm of rational consumers and efficient financial markets. In particular, there is the relative income hypothesis, first formally stated by James Duesenberry back in the 1940s and more recently developed by behavioural and Keynesian economists: it says that consumers care about their consumption relative to others as a signal of social status. This means that higher inequality can lead to increased pressure for the lower and middle class to keep up with consumers at the top. Similarly, the basic Keynesian insight that middle-class incomes need to grow in line with productivity in order to sustain robust aggregate demand appears today more relevant than ever.

There is ample evidence that, especially in the US, households reacted to higher inequality by working longer hours, lowering savings, and increasing debt in an attempt to maintain their relative consumption status. Up to a point this allowed them to pay for medical bills, the ever-increasing costs of children's college education and a house; but eventually the bubble burst. The situation is not dissimilar in the UK.

The renewed interest among economists in inequality as a macroeconomic risk is highly encouraging. Undoubtedly more research is needed to pin down the macroeconomic implications of inequality under different country-specific circumstances. But it should be clear that, in hindsight, the dominant textbook economic theories of consumption look almost as toxic as some of the credit products that ultimately caused the crisis.

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