This paper has presented stylized facts and a theoretical framework that explore the nexus
between increases in the income advantage enjoyed by high income households, higher debt
leverage among poor and middle income households, and vulnerability to financial crises.
This nexus was prominent prior to both the Great Depression and the recent crisis. In our
model it arises as a result of increases in the bargaining power of high income households.
The key mechanism, reflected in a rapid growth in the size of the financial sector, is the
recycling of part of the additional income gained by high income households back to the rest
of the population by way of loans, thereby allowing the latter to sustain consumption levels, at
least for a while. But without the prospect of a recovery in the incomes of poor and middle
income households over a reasonable time horizon, the inevitable result is that loans keep
growing, and therefore so does leverage and the probability of a major crisis that, in the real
world, typically also has severe implications for the real economy. More importantly, unless
loan defaults in a crisis are extremely large by historical standards, and unless the
accompanying real contraction is very small, the effect on leverage and therefore on the
probability of a further crisis is quite limited. By contrast, restoration of poor and middle
income households? bargaining power can be very effective, leading to the prospect of a
sustained reduction in leverage that should reduce the probability of a further crisis.
The framework we have presented uses a closed economy setting. In future work we aim to
extend this to an open economy. It is clear that the same mechanism presented in this paper,
namely the increase in lending by high income households in the country that is subject to a
bargaining power shock favoring high income households, would then extend not just to
domestic poor and middle income households, but also to foreign households. The counterpart of this capital account surplus in the foreign country would of course be an increase in its current account deficit. In other words, this provides a potential mechanism to explain global current account imbalances triggered by increasing income inequality in surplus countries.