In the last 40 years, income and wealth inequality in high-income countries has been rising dramatically.
Recent research by Credit Suisse reports that the richest 1% of people currently own half of the total wealth in the world. Those suffering the most from this situation are low and middle-income households.
In the US, where the trends are one of the most extreme in the world, the richest 10% of people saw their incomes rise by 29% since the 1980s, while incomes of the poorest 10% of the US population declined by 4% in the same period (US Current Population Survey). Stagnant earnings coupled with privatisation of public services since the 80s means that nearly one in five households in the US has taken on more debt than they can afford.
The aim of my research is to examine what causes income and wealth inequality in high-income countries. Specifically, I investigate how the rise in inequality has been related to the massive expansion of financial sector operations in USA.
Financial sector expansion was enabled by numerous deregulation policies during the 80s, which allowed consumer banks to engage in investment banking, leading to consolidation of the banking sector into a few powerful megabanks.
Their operations were based on securitisation, ie creation of new financial instruments backed by loans to households and firms (the so-called Collateralised Debt Obligations – CDOs). Since CDOs allowed for transfer of the lending risk among many agents holding the loan, they became highly demanded by financial investors.
To keep up with this rapidly growing demand, new non-bank intermediaries emerged specialising in the provision of subprime credit to social groups previously excluded from access to credit, such as the young, women and racial minorities. As a result, the size of the stock market rose from 41% to 146% of GDP between 1980 and 2014, while the proportion of credit provided by financial institutions to the private sector relative to GDP skyrocketed from 90% in 1980 to nearly 200% before the Great Recession of 2007.
In my recent research paper, which was awarded the EAEPE-Simon Prize for the best young scholar paper presented at the 28th Annual Conference of the European Association for Evolutionary Political Economy, I develop a theoretical model of why inequality arises and test it against the US data before and after the Great Recession.
My hypothesis is that the processes of financial sector expansion described above made the structure of income and wealth among different households more complex. On the one hand, it allowed the rich to accumulate profitable financial assets with minimal risk. On the other hand, greater credit availability meant that more households could step onto the housing ladder.
However, due to the relatively large debt holdings by the poorer population groups, their wealth became dependent on house price movements and was subsequently wiped off during the Great Recession. In this context, wealth becomes a crucial driver of inequality.
The findings of my theoretical model confirm this hypothesis. Differences among households in the sources of income and wealth related to financial sector expansion have an important impact on inequality levels. The model is also able to reproduce the real life values of inequality measures in the US. Notably, it highlights the importance of studying inequality after the Great Recession – while the conventional indicators of income inequality show a decline since their pre-crisis peak, wealth inequality continues to rise.
In future research, I plan to test my hypothesis regarding the link between finance, household wealth and inequality using empirical household-level data in the US. This will lead to the formulation of potential policy strategies to reduce inequality.
Such research is needed because inequality affects us all. Firstly, uneven distribution of resources slows down economic growth. Economic literature argues that inequality was one of the fundamental causes of the Great Recession as unsustainable indebtedness of households associated with uneven income and wealth distribution lowered demand in the US economy and contributed to the collapse of the financial sector.
Secondly, in unequal societies problems such as violence, segregation and social exclusion become worse. Moreover, inequality undermines democracy, as resources and power are concentrated among the few.
Last but not least, it has a direct impact on the wellbeing of future generations – high inequality today means unequal opportunities for our children. Consequently, research into the determinants of inequality is important as it is only by understanding how inequality emerges that we can reduce its negative impact on society, particularly in the context of economic and political instability in the world economy nowadays.
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The views expressed in this article are those of the author and may not reflect the views of Leeds University Business School or the University of Leeds.