The Unassuming Economist

From a new paper by IMF colleagues–Martin Cihak and Ratna Sahay:

“Global income inequality has fallen in the past two decades, in large part due to major strides in emerging market and developing economies to raise economic growth rates and reduce poverty. Financial sector policies and advances in financial technology are enabling financial inclusion, particularly in large economies such as China and India, allowing an increasing number of low-income households and small businesses to participate productively in the formal economy.

At the same time, we observe rising or high disparities in income and wealth within many countries. New data also show that economic mobility—the ability of the less well-off to improve their economic status—has stalled in recent decades. No wonder then that inequality of income, wealth, and opportunities is giving rise to populism and anti-globalization sentiments in some countries.

Can the financial sector play a role in reducing inequality? This study makes the case that it can, complementing redistributive fiscal policy in mitigating inequality. By expanding the provision of financial services to low-income households and small businesses, it can serve as a powerful lever in helping create a more inclusive society but—if not well managed—it can also amplify inequalities.

Our study examines empirical relationships between income inequality and three features of finance: depth (financial sector size relative to the economy), inclusion (access to and use of financial services by individuals and firms), and stability (absence of financial distress). We ask three questions.

First, does greater financial depth mean lower or higher inequality within countries? Building on new data sets, our analysis suggests that initially financial depth is associated with lower inequality, but only up to a point, after which inequality rises.

Second, does greater financial inclusion mean lower inequality within countries? We find that greater financial inclusion is associated with reductions in inequality. For payment services, we find evidence that benefits from inclusion are greater for those at the low end of the income distribution, reducing inequality. Both men and women benefit from financial inclusion, but inequality falls more when women have greater access. As regards access to and use of credit, the results are mixed.

Third, is there a relationship between stability and inequality within countries? Our study finds that higher inequality is associated with greater financial risks. Increases in inequality tend to be accompanied by higher growth in credit. For example, in the United States, too much credit, including to lower-income households, contributed to the 2008 crisis. Crises, in turn, lead to higher default rates, making lower-income households worse off and increasing inequality after a crisis.

Our key takeaway is that finance can help reduce inequality but is also associated with greater inequality if the financial system is not well managed. Our findings have five policy implications. First, financial inclusion policies help reduce inequality. Second, there is a case for promoting women’s financial inclusion, as inequality falls even more when policies are inclusive of women. Third, regulatory policies have a role to play in reining in excessive growth of the financial sector. Fourth, provided quality of regulation and supervision is high, financial inclusion and stability can be pursued simultaneously. Fifth, financial sector policies are a complement, not a substitute, for other policy tools—fiscal and macro-structural policies are still needed to help address inequality.”