Do Financial Crises increase Income Inequality?

Abstract

This paper investigates the impact of economic crises on income inequality. Important evidence has emerged that in the aftermath of crises politics becomes polarized and economists have linked this to greater differences in income due to crises. The evidence however on whether crises can be linked to divergent incomes is weak and plagued by i) the possibility of a reverse effect going from great disparity in incomes to major economic crises; ii) the persistent nature of income inequality; and iii) important measurement error in both the dependent and independent variables. We use the longest time stretch of available data on crises and types of crises (Reinhart and Rogoff 2011) and income inequality (Solt 2009), as well as General Method of Moments and Error Correction Models to more credibly tackle the complex theoretical and empirical relationship between crises and inequality. We find strong evidence that currency, banking, inflation and debt crises increase inequality, particularly in the long run.