Does Inequality Lead to a Financial Crisis? Revisited

• Date: 01 August 2014
• Author: Bihong Huang,Xinhua Gu
• DOI: http://doi.org/10.1111/rode.12099
• Published date: 01 August 2014

Does Inequality Lead to a Financial Crisis?

Revisited

Xinhua Gu and Bihong Huang*

Abstract

Financial crises have been attributed to rising income inequality via its induced high household leverage as

observed in the USA and similar economies. Alternatively it has been suggested this is not a general rela-

tionship since it was found that inequality had no bearing on crises in 14 advanced countries over 1920–

2008; instead, low interest rates and business cycle expansions are found to be the only two robust

determinants of credit booms leading to crises. Using a similar dataset, this paper provides no support for

the generality of the above findings by embracing country heterogeneity. The paper shows that real evi-

dence still points back to the inequality-leverage–crisis nexus for financialized economies. The implication

is that finance can hardly be sustainable under rising inequality.

1. Introduction

The 2007–2009 crisis originating from the financial sector meltdown of developed

economies has become the largest global crisis since the Great Depression and is still

severely affecting the world economy today. Numerous studies are devoted to exam-

ining the effects and causes of this financial crisis in the lead-up to what is now known

as the Great Recession (Bank of International Settlements (BIS), 2008; Obstfeld and

Rogoff, 2009; Keys et al., 2010; Eichler and Maltritz, 2011; Luca and Olivero, 2012;

Wisman, 2013; among others). The economic effects of the financial crisis have

become more apparent as they are unfolding. Identifying the real causes of financial

fragility to reduce crisis risk ex ante can be more desirable than ex post policy inter-

ventions such as direct bailouts, monetary loosening, or debt restructuring. As such,

current discussions have been centered on the determinants of financial crises in order

to draw useful policy lessons.

A controversial issue under discussion is whether income inequality is a root cause

of the financial crisis. Rajan (2010) attributes crises to inequality by arguing as

follows. Rising inequality piled pressure on politicians for redistribution that,

however, was difficult to implement; instead, they permitted mortgage finance as an

easy substitute for redistribution. This policy allowed low-income households to

borrow against mortgage-financed homes as “collateral” to maintain their living

standards despite stagnant real wages. The resultant lending boom created a massive

run-up in housing prices, so that they could borrow more for increased consumption.

High household leverage thus sowed the seeds for the financial crisis that broke out in

2007 when housing bubbles burst. Rajan’s argument attests the continuing relevance

of Schumpeter’s (1950) work of Capitalism, Socialism and Democracy for recent real-

ities. Formalizing the Rajan hypothesis in a theoretical model, Kumhof and Rancière

* Huang: Faculty of Business Administration, University of Macau, Av. Padre Tomás Pereira, Taipa,

Macao. Tel: +853-8397-4757; Fax: +853-2883-8320; E-mail: bhhuang@umac.mo. Gu: Faculty of Business

Administration, University of Macau. The authors are grateful to the University of Macau for financial

support (under grant MYRG081 <Y2-L2>–FBA11–GXH).

Review of Development Economics, 18(3), 502–516, 2014

DOI:10.1111/rode.12099

© 2014 John Wiley & Sons Ltd