Inequality, credit and financial crises

In the three decades leading up to the financial crisis of 2008/09, income inequality rose across much of the developed world. This has led to a vigorous debate as to whether widening inequality was somehow to blame for the crisis by driving private sector credit booms. However, despite growing interest, empirical evidence on an inequality-fragility relationship is limited. Based on a panel analysis of eighteen OECD countries for the years 1970-2007, this study finds a statistically significant, positive relationship between income concentration and private sector indebtedness, once other traditional drivers are controlled for. The implications are twofold: (i) the view that the distribution of income is irrelevant to macroeconomic stability, as implicit in mainstream approaches, needs a second look; (i) to make the financial system more robust, policy-makers should cast the net wider than regulatory and monetary policy reforms, and consider the effects of changes to the income distribution.