The Risk of Financial Crises: Does it Involve Real or Financial Factors?

Abstract

The recent financial crisis appears to point to credit booms as the most important driver of crises. However, could macroeconomic factors such as income inequality potentially be the real root cause of financial crises? We explore a broad variety of financial and macroeconomic variables and employ a general-to-specific model selection process to find the most reliable predictors of financial crises in 14 developed countries over a period of more than 100 years. Our in-sample results indicate that income inequality has predictive power in addition to and above loan growth and several other financial variables. Out-of-sample forecasts for individual predictors in different time periods show that their predictive power tends to vary considerably over time, but income inequality yields individual predictive power in each forecasting period.