Central Banks, Financial Stability and Inequality

When you ask a central banker what her job is, she will most probably answer: “keeping inflation under control!” Indeed, securing price stability constitutes the current raison d’être of most, if not all, central banks around the world. In parallel to this objective, however, many central banks are also tasked to foster financial stability. In fact, half of the G20 central banks mention financial stability in their mandate.[1]

The ultimate embodiment of missing this objective is a financial crisis. Financial crises have a profound negative impact on the real economy. They also weaken the transmission mechanisms of monetary policy and thus the effectiveness of central banks’ actions. This is a major worry for monetary policymakers, whatever goals they pursue. Understanding the causes and triggers of financial crises, as well as, to the degree possible, preventing or mitigating them, must therefore be of key concern not only to policymakers in general, but also to central bankers in particular.

In that context, the role of inequality as a possible cause for economic and financial crises should rank high on our agendas. Raghuram Rajan, the current governor of the Reserve Bank of India, provided an important case in point for this back in 2010:  His book Fault Lines argues that rising inequality forced low and middle-income households in the U.S. to borrow more than reasonably in order to maintain their relative consumption levels. This led to excess borrowing (i.e. credit bubbles), which in turn paved the way for the 2007‑08 U.S. financial crisis.[2]

Using a framework which reflects the observed pre-crisis large increases in inequality and in leverage for low-income households, Michael Kumhof and Romain Rancière[3] offer further theoretical support to underpin this argument. Based on a model with two groups of agents referred to as “investors” which account for 5% of the population and “workers” that make up the remaining 95%, they show that a rise in investors’ income is partially recycled into loans and thus increases credit supply. Simultaneously, a decrease in workers’ income pushes them to ask for more loans in order to maintain their level of consumption. Larger loan demand by workers is met by greater loan supply by investors, leading to excess credit and a weakening of the financial system, potentially triggering a financial crisis.

A recent study by Cristiano Perugini, Jens Hölscher and Simon Collie[4] now provides further empirical insights: Based on data from 18 OECD countries between 1970 and 2007, they uncover a statistically significant, positive link between income inequality and private sector indebtedness.[5]

Against this background, evidence is building up that central banks ignore inequality at their peril. As Perugini et al. emphasize: “in order to make the financial system more robust, policy makers should cast the net wider than monetary policy and regulatory reforms and consider the effects of changes to distributive patterns”. Getting central banks to report on how they take distributive effects into account and what their views are on the potential links between inequality and their mandates, would be an important first step. The fact that Raghuram Rajan and many other central bankers have already engaged on the topic will hopefully provide further impetus in this direction.

[1] Source: Central Bank websites and establishment laws.

[2] Rajan, R. G. (2010). Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton University Press, Princeton, N.J.

[3] Kumhof, M. and Rancière, R. (2010). “Inequality, Leverage and Crises”, IMF Working Paper, WP/10/268.

[4] Perugini, C., Hölscher, J. and Collie, S. (2015). “Inequality, credit and financial crises”, Cambridge Journal of Economics, doi: 10.1093/cje/beu075.

[5] For further empirical evidence on the link between inequality and credit bubbles see the overviews by Till van Treeck (2014, “Did inequality cause the U.S. financial crisis?”, Journal of Economic Surveys, 28(3), 421-448) and by Rémi Bazillier and Jérôme Héricourt (2014, “The circular relationship between inequality, leverage, and financial crises: intertwined mechanisms and competing evidence”, CEPII Working Paper, no 2014-22, December).