Does Inequality Lead to a Financial Crisis?

The recent global crisis has sparked interest in the relationship between income inequality, credit booms, and financial crises. Rajan (2010) and Kumhof and Rancière (2011) propose that rising inequality led to a credit boom and eventually to a financial crisis in the US in the first decade of the 21st century as it did in the 1920s. Data from 14 advanced countries between 1920 and 2000 suggest these are not general relationships. Credit booms heighten the probability of a banking crisis, but we find no evidence that a rise in top income shares leads to credit booms. Instead, low interest rates and economic expansions are the only two robust determinants of credit booms in our data set. Anecdotal evidence from US experience in the 1920s and in the years up to 2007 and from other countries does not support the inequality, credit, crisis nexus. Rather, it points back to a familiar boom-bust pattern of declines in interest rates, strong growth, rising credit, asset price booms and crises.

Michael D. Bordo and Christopher M. Meissner

Journal of International Money and Finance

March 2012

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