An investigation of the effects of income inequality on financial fragility: Evidence from Organization for Economic Co‐operation and Development countries

• DOI: http://doi.org/10.1002/ijfe.1660
• Published date: 01 January 2019
• Author: Chrysovalantis Amountzias
• Date: 01 January 2019

RESEARCH ARTICLE

An investigation of the effects of income inequality on

financial fragility: Evidence from Organization for

Economic Co‐operation and Development countries

Chrysovalantis Amountzias

1,2

1

Department of Accounting, Finance and

Economics, Hertfordshire Business

School, University of Hertfordshire,

Hatfield, Hertfordshire, UK

2

Hertfordshire Business School, De

Havilland Campus, Hatfield,

Hertfordshire, UK

Correspondence

Chrysovalantis Amountzias, Department

of Accounting, Finance and Economics,

Hertfordshire Business School, University

of Hertfordshire, Hatfield, UK.

Email: c.amountzias@herts.ac.uk

JEL Classification: C33; D31; E51; G01

Abstract

The main scope of the paper is to investigate the proposition that rising income

inequality results in systemic financial instability in developed countries. In par-

ticular, 33 OECD (Organization for Economic Co‐operation and Development)

countries are studied in a panel Vector Autoregression (VAR) framework anal-

ysis over 1995–2015. There is a growing literature on the effects of income

inequality on financial crises. This study provides significant evidence in favour

of a positive relationship between income inequality and financial fragility,

when particular factors are controlled for. Complementary findings also suggest

that (a) debt accumulation in the private sector significantly depends on credit

expansion, (b) the debt levels of the private sector and households co‐move over

time, and (c) financial deregulation significantly contributes to financial insta-

bility. Therefore, policymakers should take into account regulatory reforms that

will promote institutional and financial innovations to restrict debt accumula-

tion and render the financial system more robust to destabilising shocks.

KEYWORDS

debt accumulation,financial deregulation, financial instability, income inequality, OECD

1|INTRODUCTION

The interactions in the financial markets in recent

decades resulted in the eruption of the financial crisis

of 2007–2009 emerging in the United States and, ulti-

mately, spreading across many countries. One of the

main reasons for this outcome is the private sector's

explosive degree of indebtedness causing the financial

markets to destabilize, thus affecting the economy over-

all (Fisher, 1932, 1933). Increasing debt accumulation

results in financial instability under which indebted

institutions cannot meet their liabilities. This outcome

is consistent with the financial instability hypothesis

of Minsky (1975, 1982, 1986) where periods of extreme

euphoria and growth are followed by financial col-

lapses. This is a result of speculative activities and

inefficient investment decisions undertaken by the pri-

vate sector.

1

The main rationale of this process lies in the assump-

tion that capitalist economies swing between states of

extreme robustness and fragility. When the economy is

rapidly growing, people and organizations are

overwhelmed by euphoria, thus leading to overinvesting

and speculative activities in order to maximize their

returns given their available resources. However, as such

actions do not always follow the efficient market hypothe-

sis (Fama, 1998), misdirected investments generate finan-

cial losses for many individuals that subsequently mark

the beginning of a potential economic downfall.

This research did not receive any specific grant from funding agencies in

the public, commercial, or not‐for‐profit sectors.

Received: 10 November 2017 Revised: 11 July 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1660

Int J Fin Econ. 2019;24:241–259. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 241

This process is extensively described by Kindleberger

(1978) under which asset price revaluation marks the

pre‐phase of a slump as the price of shares of many cor-

porations dramatically exceed their market value. Such

investments are driven by credit acquisition that

increases net debt exposure of the private sector. For this

reason, a sentiment of mania overwhelms investing activ-

ities where debt to income ratios increase and capital

ratios fall. Ultimately, when an incident occurs exposing

asset overvaluation, sentiments of panic arise in which

investors withdraw their money, especially from liquid

assets, in order to avoid losses. Consequently, asset prices

collapse, and if investments have been inefficient, then

liabilities may not be repaid. Therefore, rapid economic

growth results in speculative activities and risk by dra-

matically increasing the debt to income ratio (Borio &

White, 2003; Mendoza & Terrones, 2008).

2

An additional factor that has contributed to systemic

financial instability refers to income inequality. There is

a vast empirical literature providing evidence of a signifi-

cant positive relationship between credit expansion and

income concentration across many countries, supporting

that income concentration at the top of the distribution

has caused cumulative levels of debt (Fitoussi &

Saraceno, 2010, 2011; Atkinson & Morelli, 2010, 2011;

Kumhof, Rancière, & Winant, 2015; Perugini, Hölscher,

& Collie, 2015; Kumhof et al., 2015; Yamarik, El‐Shagi,

& Yamashiro, 2016).

3

This shows that when income and

wealth is concentrated at the hands of few individuals

and/or organizations, their investment decisions driven

by credit expansion may cause financial destabilization

and, thus, crises.

4

The present study builds on the contribution of Rajan

(2010) who argued that political intervention in the United

States to redistribute income to low‐income households

has resulted in increased debt exposure and real estate

prices leading to the financial crisis of 2007–2009. In accor-

dance with the aforementioned studies, the empirical

model tests the relationship between income inequality

and financial instability both in the long and in the short

run when particular control variables are accounted for.

However, the present empirical analysis departs from

the previous studies in the following respects: (a) The

debt‐to‐operating surplus ratio of the private sector is

employed as a proxy for financial instability instead of

credit provision as net debt accumulation is a more accu-

rate indicator, (b) the income inequality indicator is mea-

sured as the ratio of gross operating surplus over labour

compensation, thus reflecting the dynamics of capital

and labour and whether the earnings of the entrepre-

neurs have diverged from the earnings of workers (Goda,

Onaran, & Stockhammer, 2017; Kumhof et al., 2015), (c)

the leverage ratio of households and non‐profit

institutions serving households (NPISHs) is taken into

account to test whether a similar pattern persists with

the borrowing behaviour of the private sector, and (d)

the price of shares indicator is also included in the model

as overpriced assets usually signal the beginning of a

financial crisis. By utilizing these elements, we intend to

test Rajan's hypothesis and contribute to the existing liter-

ature of financial instability.

Consequently, this study introduces a new debt‐ori-

ented indicator of financial instability that is more reli-

able and accurate than the credit to GDP ratios

employed by previous empirical studies (Perugini et al.,

2015). Also, a new income inequality indicator is

employed capturing the relationship between capital

and labour earnings, and thus, it allows the investigation

of how the dynamics of this ratio tend to influence the

private sector's degree of indebtedness. Finally, the range

of countries taken into account corresponds to the vast

majority of the OECD group, as well as Cyprus, setting

the number of countries to 33. This means that a rela-

tively high number of units across the panel sample ren-

ders the final estimates more reliable and provide robust

results for the effect of income inequality on systemic

stability.

The paper is organized as follows: Section 2 provides a

review on the literature of inequality and financial insta-

bility; Section 3 develops the empirical model and

describes the data employed in this study; Section 4 pre-

sents the empirical results; and Section 5 offers a

conclusion.

2|FINANCIAL FRAGILITY AND

INEQUALITY: THEORETICAL

INTERPRETATION AND

EMPIRICAL EVIDENCE

The concept of financial destabilization has been investi-

gated over the years especially in periods of crises, where

it is considered to be the main contributor to this out-

come. Many studies have taken into account Minsky's

(1975, 1982, 1986) and Kindleberger's (1978) remarks

about the dynamics of the financial system that lead to

higher indebtedness and, possibly, to a Ponzi scheme

where individuals and institutions cannot meet their lia-

bilities. One of the main contributing factors to financial

instability identified in the literature corresponds to

income inequality. The main rationale is that as income

and wealth is concentrated amongst few people, invest-

ment decisions may not be productive and, thus, lead to

social inefficiency. For this reason, Rajan (2010) argued

that in the United States, politicians tried to redistribute

income by providing credit access to low and middle‐

242 AMOUNTZIAS