Financial Crises, Poverty, and Income Distribution

• Author: Emanuele Baldacci, Luiz de Mello, and Gabriela Inchauste
• Position: Economists/Senior Economist, in the IMF's Fiscal Affairs Department

How do financial crises affect income distribution and the poor? A recent IMF study shows that poverty rises and, in some cases, so does inequality-underscoring the need for adequate and flexible safety nets, ideally in place before crises strike.

Much of the debate surrounding globalization and the poor centers on what happens to the poor when average income rises during periods of economic growth. The consensus view is that the poor become better off. But what happens to the poor during economic downturns triggered by financial crises? The conventional wisdom is that they not only become worse off but that they suffer disproportionately to the nonpoor. Is this actually the case?

This issue is important because we know that developing and transition economies are especially prone to financial crises. Crises are expected to deepen poverty and worsen income inequality in a number of ways:

Weaker economic activity. A financial crisis can cause workers' earnings to fall as jobs are lost in the formal sector, demand for services provided by the informal sector declines, and working hours and real wages are cut. When formal sector workers who have lost their jobs enter the informal sector, they put additional pressure on informal labor markets.

Relative price changes. A financial crisis typically involves a large currency depreciation, which changes relative prices. For example, the price of tradables rises relative to nontradables, causing earnings of those employed in the nontraded goods sector to fall. At the same time, increased export demand boosts employment and earnings in the sectors producing the exports. The currency depreciation may also affect consumer prices, and the higher cost of imported food hurts poor individuals and households that spend much of their income on food.

Fiscal retrenchment. Governments often respond to crises by tightening the monetary and fiscal stances, often leading to cuts in public outlays on social programs, transfers to households, and wages and salaries.

How exactly do these channels work? What is the magnitude of the impact of financial crises on the poor and income distribution? And what are the characteristics of poverty and inequality that policymakers should take into account when they formulate responses to crises? To explore these questions, we looked at the relationship between financial crises and poverty across countries and then checked these results against what actually happened in Mexico after the financial crisis that followed the peso's crash in December 1994. This article examines our findings and the implications for policymakers.

The toll of financial crises

The first part of our study looked at what happened to a wide variety of countries-mostly developing countries-during financial crises that struck between 1960 and 1998. We defined financial crises in terms of currency crashes, using Jeffrey Frankel and Andrew Rose's definition of currency crashes "as a nominal depreciation of the currency of at least 25 percent that is also a 10 percent increase in the rate of depreciation." Here, we were most interested in precrisis and postcrisis average changes in indicators of poverty and income...