Income and wealth inequality is the root cause of financial instability. Capital, and the need for capital must be balanced for an economy to function stably.
If the accumulation of capital exceeds the need for capital to fund growth, the taxes on wealth and capital gains must be increased, and taxes on consumption and consumer income decreased .
If consumer demand, and the attendant need for capital, outpace capital accumulation, the reverse is required. Taxes then should be shifted from wealth and capital gains to consumption and consumer income.
Over the past several decades capital accumulation has outpaced the demand for capital, largely due to reductions in top bracket tax rates and stagnation of middle class incomes. The discussion that follows shows what happens when this occurs.
Enterprises need capital to expand and take advantage of new opportunities. This allows economies to grow to accommodate increases in population and the attendant need for new jobs.
If too little capital is accumulated, growth will be curtailed. If the effect is severe enough, sufficient growth will not be achieved to accommodate population increases and the need for additional jobs, and the standard of living will fall.
If too much capital is accumulated, rates of return on capital drop. As rates of return drop, capitalists seek ways to improve them through the use of leverage or the use of techniques to increase the demand for credit.
If leverage is used, risk increases, necessitating even larger rates of return. This leads to a potentially unstable situation. So there is a limit to the amount of leverage that can be used.
As the limits of leverage are reached, investment banks and hedge funds will look for ways to stimulate demand for credit. This can be done by relaxing the standards for issuing credit, and compensating by using techniques that hide risk.
By collateralizing debt and issuing insurance on debt capitalists can be made to feel more comfortable with less secure investments. Debt issued with relaxed credit standards can be mixed with more secure debt making it harder for rating agencies to correctly assess risks. If regulation does not keep up with these measures, or decreases, the value of the collateralized assets and insurance instruments will be jeopardized.
Excess capital can also result in additional risky speculation. When returns on productive investments are low and approaching inflation levels, capitalists will be willing to take larger risks in short term speculation on valuable assets and commodities, causing prices to rise. In turn, the rise in prices creates an upward momentum in asset prices that attracts even more speculation. Such price bubbles tend to be self sustaining as more and more capitalists are willing to take advantage of the upward momentum in prices, until eventually that trend cannot be sustained and the bubbles burst.
All of these measures are driven by the need to increase returns on capital, when there is just too much capital for the real investment needs of the country. This is the situation that has developed over the last few decades largely because returns have been going more and more to capitalists while workers wages have stagnated. With stagnating wages, the demand for goods and services has not kept up with the accumulation of capital.
The stagnation of wages has been caused largely by shrinkage in the manufacturing sector, causing consumers to seek returns in the financial sector and to tap available credit to sustain consumption. This is evidenced by the excessive growth of the financial sector. At the same time, high income and capital gains tax rates have been reduced, accelerating the income and wealth gap between capitalists and middle class consumers. Election laws have allowed capitalists to be the primary funders of elections, allowing them access to politicians, who then water down laws regulating capital and reduce taxes on capital formation.
Unless taxes are shifted to wealth and capital gains from consumption and consumer incomes, this increasing spread in income and wealth will continue to cause instability and the kind of financial crises we are now experiencing.