Inequality causes banking crises

Recent works within the literature have forcefully suggested that income inequality might have been one of the structural determinants of the onset of the recent crisis. All the arguments are essentially linking income inequality to the unsustainable surge in household indebtedness within the economy, which in turn has been singled out as one of the major predictor of banking crises (e.g. see Schularick and Taylor 2012).Footnote1 In particular it has been pointed out that inequality may be contributing to: (a) Reduce the aggregate demand and therefore economic performance in the economy. This argument follows from the distribution of the marginal propensity to consume across the income distribution, with rich individuals consuming substantially lower portions of their income. (b) Increase the demand for credit of those individuals left behind in order to keep up with the rising living standard. With the conceptual support of the ‘relative income hypothesis’, the argument suggests that the increase in income inequality may have pushed households to work more, consume more and take on more debt in response to the shift of their income in comparison to richer households. (c) Increase the supply of funds available in the economy as richer individuals search for new investments. Similarly, inequality may push governments to ease access to credit in order to face the mounting pressures for redistribution within the economy as well as the depressed aggregate demand. Different versions of the arguments above were suggested by Milanovic (2009), Stiglitz (2009), Fitoussi and Saraceno (2010), Rajan (2010) among others.Footnote2