Masked Instability: Within-Sector Financial Risk in the Presence of Wealth Inequality

Youngna Choi

doi:10.3390/risks6030065

Abstract

We investigate masked financial instability caused by wealth inequality. When an economic sector is decomposed into two subsectors that possess a severe wealth inequality, the sector in entirety can look financially stable while the two subsectors possess extreme financially instabilities of opposite nature, one from excessive equity, the other from lack thereof. The unstable subsector can result in further financial distress and even trigger a financial crisis. The market instability indicator, an early warning system derived from dynamical systems applied to agent-based models, is used to analyze the subsectoral financial instabilities. Detailed mathematical analysis is provided to explain what financial instabilities can arise amid seemingly stable economy and positive market data. The theoretical conjecture is verified by historical macroeconomic time series of the United States households among whom a substantial wealth inequality has been officially confirmed.

Highlights

It has been a decade since the outbreak of the 2007–2010 United States Subprime Mortgage Crisis that was followed by the 2009–2014 European Sovereign Debt Crisis
Reports have been made that the Great Recession exacerbated the uneven wealth distribution in the United States (e.g., Kochhar and Cilluffo 2017; Wolff 2014), and, at the same time, wealth inequality has been addressed as an increasing social problem by both organizations and scholars (e.g., Congressional Budget Office 2016; Organization for Economic Cooperation and Development 2016; Saez and Zucman 2016)
We investigate how wealth inequality can affect correct assessment of financial stability of an economic sector by showing that, when an economic sector is divided into two subsectors by extreme concentration of wealth and lack thereof, it may mask risk exposures within subsectors that are not readily observable from the aggregate

Summary

Introduction

It has been a decade since the outbreak of the 2007–2010 United States Subprime Mortgage Crisis that was followed by the 2009–2014 European Sovereign Debt Crisis. According to the Survey of Consumer Finances (2017) (SCF), the top 10% of the United States households possess more than 75% of the total wealth and about half of the total income while the consumer debt, including a dangerously high level of student loans as pointed by many (e.g., Foroohar 2017), reached a new peak in 2017 Q4 (Federal Reserve Bank of New. York 2018). When an agent goes through financial instability or is financially unstable, a shock on its wealth is transmitted to another agent or even propagates throughout the system Examples of such shock transmissions are default on a loan payment for a negative shock and over-investment for a positive shock.

Basic Setup

Wealth Inequality and Financial Stability

Case Study

Findings

Conclusions