Abstract
This study aims to investigate the validity of the Rajan hypothesis, which argues that increasing income inequality plays a key role in the outbreak of financial crises. The relationship between income inequality and credit booms are examined in 10 developed countries: Australia, Canada, Denmark, Finland, France, the United Kingdom, Japan, Norway, Sweden, and the United States. In doing so, a bootstrap rolling-window estimation procedure is used to detect any possible causal link between inequality and credit booms in financial crisis sub-periods. The results reveal that the Rajan hypothesis is supported for the 1989 crisis in Australia, the 1991 and 2007 crises in the United Kingdom, and the 1929 and 2007 crises in the United States. Therefore, increasing income inequality has positive predictive power on credit booms in Anglo-Saxon countries. However, the hypothesis is not confirmed for Scandinavian and continental European countries. Our study is novel in its use of the bootstrap rolling-window procedure, which allows us to detect the possible relationship between inequality and credit booms in financial crises. The findings suggest that a progressive taxation policy or investments to accumulate human capital and increase the labor force are more beneficial than temporary solutions.
Highlights
In pioneer studies of crisis theories, Fisher (1932, 1933) argued that all economic booms and depressions emerge through excessive borrowing and subsequent deflation
This study makes three contributions to the literature: i) This is the first study to investigate the causal relationship between income inequality and financial crisis using a rolling-window causality procedure in its selected countries. ii) As using unit root tests that ignore possible structural breaks may provide misleading results, this study employs a unit root test with multiple endogenous structural breaks. iii) This study provides a methodological contribution by employing a bootstrap rolling-window estimation method, which has never been previously used in such research; this methodology lets us separate the findings into sub-sample periods
Data and methodology This study examines the relationship between income inequality and financial crises in 10 selected countries—Australia, Canada, Denmark, Finland, France, the United Kingdom, Japan, Norway, Sweden and the United States—including annual data with different sample periods for each country based on data availability
Summary
In pioneer studies of crisis theories, Fisher (1932, 1933) argued that all economic booms and depressions emerge through excessive borrowing and subsequent deflation. Following this argument, Minsky’s (1975, 1982, 1986) financial instability hypothesis argued that financial instability primarily occurs due to excessive borrowing, but these hypotheses are based on corporate debt and investments rather than household debt and consumption. Financial instability has been explained following these perspectives, and by incorporating many factors: banks’ herd behavior (Kindleberger 1978); credit policies based on (2019) 5:21 inter-bank dependency caused by the information problem (Rajan 1994); underestimated risks (Borio et al 2001); existing government guarantees (Corsetti et al 1999); loose credit standards (Dell’Ariccia and Marquez 2006); borrowers’ limited commitment (Lorenzoni 2005); and the nature of business cycles and financial accelerators (Bernanke et al 1999). Many researchers have proposed an alternative view that income inequality may have had an important role in the outbreak of the 2007 financial crisis (Rajan 2010; Reich 2010; Roubini 2011; Milanovic 2009; Galbraith 2012; Stiglitz 2012; Krueger 2012; Palley 2012; Van Treeck 2014)
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