The question that has motivated this paper is whether financial crises and income inequality are systematically related. The long rise of inequality in many advanced countries prior to the Great Recession has inspired several authors (e.g. Fitoussi & Saraceno, 2010; Rajan, 2011; Stiglitz, 2009; Stockhammer, 2012) to argue that inequality is a root cause of this crisis. The suppressing effect of inequality on aggregate demand, these authors argue, has prompted many governments to adopt a debt-led growth model, which relies on over-borrowed, over-consuming households. Additionally, households on their own might respond to growing inequality by saving less, or borrowing more, in order to maintain a standard of living that they deem acceptable (Frank, Levine & Dijk, 2010; Kumhof & Rancière, 2010). This view thus sees inequality as a causal factor for rising debt and credit levels. But while debt and credit are the best predictors of financial crises (Jordà, Schularick & Taylor, 2011) the effect of income inequality on debt seems to be too weak to be considered a root cause (see, e.g. Bordo & Meissner, 2012). The co-occurrence of financial crises and periods of rising inequality may thus be caused by a third factor.
This study introduces equity prices as a possible explanation. Firstly, equity prices affect several sources of income with little delay: equity investments often pay dividends; they can potentially be resold at a capital gain; and the performance of company stocks might determine the compensation of top executives in financial and non-financial industries. Secondly, asset prices in general are an indicator of financial stability due to their systematic and interdependent relation to credit (Mendoza and Terrones, 2008), and they reveal a systematic boom-bust pattern around banking crises (Reinhart & Rogoff, 2009). The goal of this study is hence to examine these two properties of equity prices in more detail and connect them in order to establish a theoretical framework that explains why financial crises are often associated with a preceding rise in income inequality. Beyond this, the link between equity prices and top income shares will be empirically tested utilizing a panel of 18 advanced economies between 1913 and 2011. The significant results are then used to analyze the implications for inequality of income in times of crises.
Table of Contents
1. Introduction
2. A Theoretical Framework
2.1. Asset Prices, Credit and Financial Crises
2.2. Asset Prices and Income Inequality
2.3. Income Inequality and Credit Growth
3. Asset Prices and their Relation to Credit Growth and Financial Risk
3.1. Collateral
3.2. Wealth Effect
3.3. Bank Capital
3.4. Excessive Credit
3.5. Interest Rates
4. Income Inequality and Equity Prices
4.1. Wage Determination
4.2 Capital Income and Capital Gains
5. Inequality as a Cause of Financial Distress? An Assessment of Recent Literature.
6. An Econometric Model: Determinants of Income Inequality
6.1. Data Description and Pretesting
6.2. Estimator Choice and Results
6.3. Robustness Tests
6.4. Implications for the Relationship between Income Inequality and Banking Crises
7. Conclusion
Research Objectives and Themes
This master's thesis investigates the potential systematic relationship between financial crises and income inequality. The primary research goal is to determine if equity prices function as a critical link between these two phenomena, specifically analyzing whether asset price booms preceding financial crises disproportionately inflate top income shares.
- The theoretical framework linking equity prices, credit growth, and income inequality.
- The influence of asset price cycles on executive compensation, dividends, and capital gains.
- Empirical econometric modeling of the determinants of income inequality in advanced economies.
- A critical assessment of the literature regarding inequality as a potential root cause of financial distress.
- Analysis of how institutional frameworks shape the distribution of income during stock market fluctuations.
Excerpt from the Book
1. Introduction
The question that has motivated this paper is whether financial crises and income inequality are systematically related. The long rise of inequality in many advanced countries prior to the Great Recession has inspired several authors (e.g. Fitoussi & Saraceno, 2010; Rajan, 2011; Stiglitz, 2009; Stockhammer, 2012) to argue that inequality is a root cause of this crisis. The suppressing effect of inequality on aggregate demand, these authors argue, has prompted many governments to adopt a debt-led growth model, which relies on over-borrowed, over-consuming households.
One distinctive feature of financial crises is that most of them are preceded by booms and busts in asset prices. In fact, Reinhart and Rogoff (2009, p. 159) document a “trajectory in real housing prices around all the post-World War II banking crises in advanced economies”. They also identify a similar pattern for equity prices, which tend to peak one to three years before the onset of the crisis after building up for four years on average. Similarly, Borio and Lowe (2002) show that asset price deviations from long-run trends are a significant measure of financial distress. At the same time, various types of assets constitute an important source and determinant of income for many households. Especially top incomes are, for reasons explained in this paper, sensitive to movements in equity prices. According to Galbraith (2012), it is also the top of the income distribution that explains the largest part of the increase in income inequality for example in the US since the 1990s. It is thus reasonable to assume that equity price booms, which often are followed by financial crisis, can generate substantial increases in top incomes. Equity prices might hence be an important link between crises and income inequality.
Summary of Chapters
1. Introduction: Outlines the research question regarding the systematic relationship between financial crises and income inequality, proposing equity prices as a potential link.
2. A Theoretical Framework: Introduces the core hypothesis that equity price booms precede financial crises and generate income gains disproportionately for the top income distribution.
3. Asset Prices and their Relation to Credit Growth and Financial Risk: Reviews theoretical and empirical literature establishing the link between asset price inflation, credit growth, and banking crises.
4. Income Inequality and Equity Prices: Examines the channels—wages, capital income, and capital gains—through which equity prices affect top income shares.
5. Inequality as a Cause of Financial Distress? An Assessment of Recent Literature.: Critically assesses arguments that income inequality itself acts as a primary root cause of financial crises.
6. An Econometric Model: Determinants of Income Inequality: Presents an econometric model using a panel of 18 advanced economies to empirically test the impact of equity prices on income inequality.
7. Conclusion: Summarizes findings and suggests that equity prices are a significant, though not exclusive, factor in the relationship between inequality and financial crises.
Keywords
Income Inequality, Financial Crises, Equity Prices, Asset Price Booms, Banking Crises, Top Income Shares, Credit Growth, Econometric Modeling, Household Wealth, Capital Gains, Executive Compensation, Monetary Policy, Financial Stability, Advanced Economies, Wealth Distribution
Frequently Asked Questions
What is the core focus of this thesis?
The thesis investigates whether there is a systematic connection between financial crises and income inequality, specifically proposing equity prices as the missing link that connects these two phenomena.
What are the central fields of study?
The research combines macroeconomics and labor economics, focusing on financial stability, asset price bubbles, income distribution dynamics, and the determinants of top-level executive compensation.
What is the primary research question?
The primary goal is to establish whether equity price booms, which historically precede banking crises, lead to disproportionate income gains at the very top of the distribution, thereby increasing income inequality.
Which scientific method is utilized?
The author uses an econometric panel data analysis of 18 advanced economies, covering the period from 1913 to 2011, employing first-difference estimators to analyze annual fluctuations in top income shares.
What is covered in the main section of the paper?
The main sections establish a theoretical framework, conduct an extensive literature review on the credit-crisis relationship, and provide empirical evidence through regression modeling of equity prices against income shares.
Which keywords best describe this research?
Key terms include Income Inequality, Financial Crises, Equity Prices, Asset Price Booms, and Top Income Shares.
Does the author conclude that inequality is the root cause of the Great Recession?
No, the author argues that while inequality and debt levels are correlated, there is little empirical evidence at the macro-level to support the hypothesis that income inequality itself causes financial crises.
Why does the author focus specifically on the top 1 percent?
The focus is on the top 1 percent because their income sources—such as dividends, capital gains, and performance-based executive pay—are the most sensitive to stock market fluctuations compared to the broader population.
- Quote paper
- Matthias Runkel (Author), 2013, Equity Prices. The Missing Link between Income Inequality and Financial Crises?, Munich, GRIN Verlag, https://www.grin.com/document/285240
