Income inequality and financial crises: evidence from the bootstrap rolling window

Abstract

This study aims to investigate the validity of the Rajan hypothesis, which argues that increasing income inequality plays a key role in the outbreak of financial crises. The relationship between income inequality and credit booms are examined in 10 developed countries: Australia, Canada, Denmark, Finland, France, the United Kingdom, Japan, Norway, Sweden, and the United States. In doing so, a bootstrap rolling-window estimation procedure is used to detect any possible causal link between inequality and credit booms in financial crisis sub-periods. The results reveal that the Rajan hypothesis is supported for the 1989 crisis in Australia, the 1991 and 2007 crises in the United Kingdom, and the 1929 and 2007 crises in the United States. Therefore, increasing income inequality has positive predictive power on credit booms in Anglo-Saxon countries. However, the hypothesis is not confirmed for Scandinavian and continental European countries. Our study is novel in its use of the bootstrap rolling-window procedure, which allows us to detect the possible relationship between inequality and credit booms in financial crises. The findings suggest that a progressive taxation policy or investments to accumulate human capital and increase the labor force are more beneficial than temporary solutions.