Inequality-Led Financial Crises: Does Wealth Inequality Threaten Financial Stability?

It is generally recognized that financial crises can exacerbate economic inequality. However, the reverse relationship − how economic inequality might precipitate financial crises − remains relatively underexplored. This study addresses this gap by investigating the impact of wealth inequality on the likelihood of financial crises. Building on economic theory, we adopt and provide evidence in support of the hypothesis that deeper wealth inequality can elicit credit expansions, potentially exacerbating financial fragility. In particular, we assess how deviations from long-term trends in wealth inequality influence the likelihood of financial crises by means of the credit channel. We propose a threefold econometric model: a two-stage logit model applied across two datasets − the Jordà-Schularick-Taylor Macrohistory Database and the ECB/ESRB Database − and a fixed effects linear model applied to the Financial Stress Index developed by (Ahir et al. 2023). Our findings suggest that, in the medium run, rising wealth inequality undermines financial stability. The estimates indicate that a 5% concentration in the stock of wealth held by the top 10% of wealthholders relative to its long-term trend is associated with a 0.8% to 1.3% rise in the five-year credit levels. Conversely, a 1.3% increase in the five-year credit level raises the likelihood of a financial crisis by 17% to 25%. We conclude by outlining possible implications of our findings for central banking policies, and potential monetary instruments capable of monitoring wealth inequality.