The roots of this economic crisis are very much centered in the growth in inequality over the past three decades. This becomes clear once we recognize that the financial turmoil is a minor aspect of the overall crisis, and that its primary cause is the economic imbalances created by the housing bubble.

The financial crisis produced great drama and headlines, as we got to watch the treasury secretary, the Federal Reserve Board chair and the CEOs of collapsing banks stay up late on weekend nights patching together bailout packages. However, this show was just a sidebar to those of us who don’t work for these banks or own large amounts of their stock. While the Fed and Treasury bailouts were sold as necessary to save the economy, they were mostly necessary to rescue Goldman Sachs, Citigroup and the other big financial institutions.

In the worst-case scenario, the major banks would have been taken over by the Fed and FDIC, leading to more uncertainty in financial markets and a tidal wave of lawsuits. This would likely have resulted in a sharper initial falloff than what we experienced, but certainly not the second Great Depression that the politicians threatened if we didn’t cough up the money to save the banks.

The first Great Depression was not just the result of mistaken policy during the initial banking crisis; it was caused by ten years of inadequate policy response. If the government had pursued sufficiently aggressive stimulus at any point in the 1930s, it could have restored the economy to full employment long before World War II forced such stimulus on the country. By the same token, failure to rescue the banks in the fall of 2008 would not have necessitated ten years of stupid policy; a second Great Depression was never in the cards.

It is also important to dismiss the claim that the downturn is being perpetuated by the unwillingness of banks to lend because of their weak capital positions. This story doesn’t fit the facts. The capital position of many cautious banks is just fine, yet they are not rushing to make loans and steal market share from wounded competitors. Similarly, large firms have no problem raising capital at very low cost right now. Yet Wal-Mart and Starbucks are not rushing to gain at the expense of the smaller businesses that can’t borrow from banks. The problem is simply that consumers are tapped out: healthy banks are not lending, and cash-rich companies are not expanding, because weak demand makes any investment very risky.

In short, the story of economic weakness being the result of a broken banking system is a complete fabrication. This is a good story if your intention is to get more money to the banks. It is not a good story if your goal is getting the economy back to full employment.

The real story is a very simple one of a burst housing bubble. At its peak in 2006, the wealth created by that bubble and the smaller bubble in nonresidential real estate was generating more than $1 trillion in annual demand. This took the form of more than $500 billion in excess construction demand, as builders rushed to complete projects that commanded bubble-inflated prices. It also led to more than $500 billion in additional consumption, as people spent based on $8 trillion worth of bubble-generated home equity.

As much as economists like to pretend to be sorcerers, they have no easy way to replace $1 trillion in annual demand. The Obama administration’s 2009 stimulus package went perhaps one-third of the way, but it was nowhere near large enough.

This brings us to the question of why we got the housing bubble in the first place, which goes directly to the issue of inequality. In the three decades after World War II, there were no notable bubbles in the economy. Productivity growth translated into wage growth, which in turn led to more consumption. The increased demand led to more investment, productivity growth and wage growth.

This virtuous circle was broken by Reagan-era policies intended to weaken the power of ordinary workers. Wages no longer kept pace with productivity growth, eliminating the automatic link between productivity growth and demand growth. This led to excess capacity in the economy, which was filled in the 1990s with demand generated by the stock bubble and in the 2000s with demand generated by the housing bubble.

If the institutional changes of the Reagan era had not weakened workers’ bargaining power, these bubbles would not have been possible. Demand would have kept pace with output capacity. The Fed would not have felt the need to lower interest rates to sustain demand. Furthermore, if the Fed had any concerns about inflation, which in that environment would have been driven by wage growth, it would never have lowered interest rates, as it did in the 1990s and even more in the past decade. Low interest rates alone cannot be blamed for the stock and housing bubbles, but it is safe to say that these bubbles could not have arisen in a high-interest-rate environment.

In short, rising inequality is at the center of the current economic crisis. And since that increase in inequality was not a natural process but the result of conscious policy, it can be reversed. Some of the remedies are well-known. Restoring some discipline to CEO pay would be a great first step. One way would be to change the rules on corporate governance and require that compensation packages be approved by stockholders, where only directly cast votes count.

A small tax on financial speculation would go a long way toward moderating the multimillion-dollar salaries on Wall Street. The tax rates being discussed in Congress would raise trading costs only back to the level of the late 1980s or early ’90s, but they would take a huge bite out of profits from the short-term trading at which the Wall Street crew excels.

Trade and immigration policy have been structured to put non-college-educated workers in direct competition with low-paid workers in the developing world, thereby putting downward pressure on their wages. We can instead restructure trade and immigration policy so as to subject highly paid professionals (doctors, lawyers, dentists, etc.) to the full force of international competition. This will help to bring down the pay of those in the top 2 to 3 percent of wage distribution. It will also raise real wages for the rest of the workforce by lowering the price of the goods and services produced by these professionals.

Finally, unions have long been a major force in reducing inequality. Whatever can be done to protect the right to organize and allow workers the option of joining unions will help to reduce inequality.

It is not difficult to develop policies to reduce the inequality that has given us a crisis-prone economy. The problem is getting the political will.  Also in This Forum

Robert Reich, "Unjust Spoils"

Katherine Newman and David Pedulla, "An Unequal-Opportunity Recession"

Orlando Patterson, "For African-Americans, A Virtual Depression—Why?"

Jeff Madrick, "American Incomes: Soaring or Static"

Matt Yglesias, "A Great Time to Be Alive?"