Inequality, household debt and financial instability: An agent-based perspective

Abstract

Our paper contributes to the literature on the causes of the 2007–2008 financial crisis in the United States. By means of an agent-based model, we replicate an artificial credit-network economy in order to assess the impact of growing income inequality in the presence of peer effects and home equity borrowing. We show that the resulting debt-financed consumption boom jeopardises the stability of the economic system, thus paving the way for a financial crisis. Our model includes a behavioural rule for consumption based on expenditure cascades, a hierarchical structure of household finance, an articulated credit market with collateralised consumption loans and mortgages and a simple housing market. Results show that the model is able to capture the economic and social pressure of inequality on low and middle income households that pushes them to increase their consumption via home equity extraction. Rising non-performing loans lead to higher bad debt on the banks’ balance sheets and, consequently, to the emergence of a crisis as an endogenous dynamic.