How inequality is at the root of the Great Recession.

By most counts, the U.S. economy started growing in the middle of last year. For many Americans, though, it does not feel as if the Great Recession has ended—unemployment and underemployment are still alarmingly high, and job growth is weak. Many causes have been suggested for both the economic collapse and mediocre recovery, but one that is hardly ever mentioned is income inequality. This is a mistake. Growing income inequality in the United States and the policy responses it has spawned have done tremendous damage to our economy. And because we continue to ignore this underlying problem, the risks of our policies leading to another calamity will not go away, no matter what we do to reform the financial sector.

Since 1968, income inequality has been steadily increasing in the United States. I am not referring to the Croesus-like income of a John Paulsen, the hedge fund manager who in 2008 netted over $3 billion, about 75,000 times the average household income. I refer to a more worrying everyday phenomenon that confronts most Americans, the disparity in income growth rates between a manager at the local supermarket and the typical factory worker or office assistant. Since the 1970s, the wages of the former, typically workers at the 90th percentile of the wage distribution in the United States, have grown much faster than the wages of the latter, the typical median worker. Or consider the table below, which shows that the wages of occupation groups that are paid more than the national average in 2002 have grown much faster since then than the wages of occupation groups below the average:

Economists argue over the reasons for the growing inequality—changes in taxation, increasing trade, weaker unions, stagnant minimum wages, and growing immigration have all been flagged. Perhaps the most important, according to Harvard professors Claudia Golden and Larry Katz, is that although technological progress requires the labor force to have ever greater skills, our educational system has not kept pace by providing the labor force with greater education and skills. While a high school diploma may have been sufficient for our parents, an office worker in many knowledge-based industries today can’t get hired without an undergraduate degree. Yet, according to Golden and Katz, rates of graduation from high school in the United States have barely budged since the 1970s, and neither have male graduation rates from college. For the middle class, that has meant a stagnant paycheck and growing job insecurity, as the old well-paying, low-skilled jobs with good benefits disappear.

Politicians feel their constituents’ pain and anxiety. And they recognize that to stay in office, they have to respond in some way. But it is very hard to get at the real source of middle-class discontent by improving the quality of education. The causes of lackluster education are complex and difficult to remedy (poor nutrition and the lack of a safe learning environment just skim the surface of potential problems), and schools are especially difficult to reform because of the many vested interests that favor the status quo. Moreover, any change will require years to take effect and therefore will not alleviate the current anxiety of the electorate. What results, then, is a series of short-term policy fixes that may do more damage than good—in fact, some of these fixes helped to create the Great Recession.

Politicians are resourceful people. Their political skill lies partly in proposing solutions that keep their constituents happy without venturing into the rocky terrain of real reform. In the case of inequality, politicians know intuitively that households ultimately care most about their consumption over time; incomes are only a means to obtaining that consumption stream. A smart politician can see that if somehow the consumption of middle-class householders keeps rising, if they can afford a new car every few years and the occasional exotic holiday, and best of all, a new house, they might pay less attention to their stagnant monthly paychecks. And one way to expand consumption, even while incomes stagnate, is to enhance access to credit.

As a result, the government’s response to rising inequality—whether carefully planned or the path of least resistance—has been to encourage lending to households, especially but not exclusively low-income ones (the government push for housing credit was just the most egregious example). The benefit—higher consumption—is immediate, and paying the inevitable bill can be postponed into the future. Cynical as it may seem, recent administrations have used easy credit as a palliative to address the deeper anxieties of the middle class directly. As I argue in my recent book Fault Lines, “let them eat credit” could well summarize the mantra of the political establishment in the go-go years before the crisis.

The Federal Reserve has aided and abetted this explosion of credit. In response to the dot-com bust in 2001, Alan Greenspan’s Fed cut short-term interest rates to the bone. Even though over-stretched corporations were not interested in investing, artificially low interest rates were a boon to housing and finance. And an important benefit of an expansion in housing construction (and related services like real estate brokerage and mortgage lending) was that it created construction jobs, especially suitable for the unskilled. Unfortunately, the Fed-supported housing boom proved unsustainable, and many of the unskilled have lost their jobs, and are in deeper trouble than before, having also borrowed to buy houses that they could not really afford.

Depressingly, the policy response to the recent recession has been more of the same—tremendous government support to housing and housing loans, as well as ultra-low interest rates. Government housing policies are only delaying the inevitable adjustment in house prices (consider that whenever some support is withdrawn, as when the first-time home buyer’s credit recently expired, the housing market weakens). In the meantime, valuable taxpayer resources are wasted that could be spent on a more enduring fix. It would be better for the housing market to find its equilibrium quickly, with the government’s role focused on facilitating the adjustment process—for instance, easing the process of renegotiating underwater mortgages.

Similarly, the Federal Reserve’s ultra-low interest rate policy is having little useful impact on unemployment because the interest-rate sensitive sectors of the economy such as housing and automobiles have been over-extended by the last bout of monetary stimulus. It is unlikely the Fed will kick off a fresh housing or commercial real estate boom. Moreover, overleveraged households are trying to rebuild savings, and low interest rates are unlikely to tempt them to splurge once again on new cars or kitchens, and even if they were, these kinds of folks might have trouble getting a loan from local banks that have become far more circumspect on retail lending.

What is the alternative to creating new mountains of consumer debt? Instead of looking for ways to resuscitate spending by those who can ill afford it, and creating unsustainable bubbles in the process, we need to think creatively about how Americans can acquire the skills they need to enhance their incomes. The central problem is that too much of the U.S. workforce is unqualified for the good knowledge-related jobs that are being, and will be, created by its economy. Even though the unemployment rate is high across the workforce, it is much higher among those without college degrees.

Upgrading skills and education, however, is not easy. Retraining programs have a checkered history. And not all degrees are equally useful. Moreover, it is incredibly hard for a 40-year-old single mother of two to go back to school. But while realizing there are no quick fixes, we should be using resources during this tepid recovery to help out-of-work Americans, and those still in school, to build better futures for themselves. Active labor market policies—econo-speak for the kind of policies operative in Scandinavian countries that help the unemployed train for new jobs and then support them while they search actively—are well worth examining. So are new scalable technologies that reduce the cost of university education or skill acquisition. We also need to encourage stronger alliances between schools, local authorities, and businesses to create comprehensive learning programs whose end product is employable youth. Fortunately, there are many experiments and pilot projects already underway across the country. We need to learn quickly from them and scale up those that are most promising.  

If the United States does little to address inequality, and instead repeatedly tries to stimulate its way out of trouble, government and household finances will get even more fragile. Inequality, as studies suggest, will likely also cause U.S. politics to become even more fractured and polarized than it already is, making it harder for our politicians to make the right kinds of legislative decisions. And a slow-growing, politically-fractured United States that agrees only on penalizing the foreigner, could turn its back on openness and trade, attempting to protect domestic jobs even while hurting growth domestically, and elsewhere. Not just the United States but the entire world would be worse off.

Here’s what I’d like to see instead: the United States improving the capabilities of all of its working-age population and then providing exactly the creative and knowledge-based services that growing emerging markets need. As the demand in these markets expands, the dynamic U.S. economy will grow alongside, banishing current fears about unsustainable debt and unfunded entitlements. But to reach this future, America needs to accept it has more than a cyclical problem. It has to give more Americans the ability to compete in the global marketplace. This is much harder than doling out credit or keeping interest rates really low, but it will pay off in the long-run.

Raghuram G. Rajan is professor of finance at Chicago’s Booth School and author of Fault Lines: How Hidden Fractures still Threaten the World Economy (Princeton University Press, 2010).

For more TNR, become a fan on Facebook and follow us on Twitter.