Equity Prices. The Missing Link between Income Inequality and Financial Crises?

Master's Thesis from the year 2013 in the subject Economics - Other grade: 85 (out of 10) Maastricht University language: English abstract: 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).