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The graph atop this post is one I think a lot about: It charts pre-tax income inequality over the last 100-or-so years, and seems to suggest that income inequality is a potential indicator for massive financial crises. As you can see, the two highest points on the graph directly precede both the Great Depression and the Great Recession.

The problem has been coming up with a mechanism. In his essay for American Interest, however, Tyler Cowen proposes one: The financial sector.

The story of the current run-up in income among the very rich is, Cowen says, basically a story of people involved in the financial sector making a ton of money. And so many of them are making so much money because so many of them are betting the same way at the same time. The way they’re betting is “short on volatility,” which put more simply means against unexpected things happening.

Cowen gives the example of the Washington Wizards: If you bet every year that the Wizards wouldn’t win the championship, you’d pretty much always make money. If everyone bet that way every year, everyone would pretty much always make money. If everyone borrowed lots of money so they could make bigger bets on the Wizards losing every year, they’d make even more money. But if the Wizards then won, everyone would then go bust, and they’d go bust all at the same time, losing lots of borrowed money, and wreaking untold havoc on the economy.

Well, not “untold.” That’s pretty much what happened in 2007. In this story, one of the things to watch for when we see very high levels of inequality is whether that money is coming from the financial sector. If it is, it probably means there are a lot of people on the same side of a bet. And if there are a lot of people on the same side of a bet, the prospects for a major financial crash are pretty good. Maybe not this year, or the next year. But eventually, even the Wizards win.

Ezra Klein