Master's Paper
John Voorheis
Draft 5/19/2011
Abstract
The nancial crisis of 2007-9 has confounded mainstream economists. The period directly before the
crisis has a number of salient features - accelerating increases in both household indebtedness and income
inequality, and the continued increase in the nancialization of the economy - that lend themselves to
analysis along the lines of Minsky. Additionally, the literature on the new economics of Income Inequality
(e.g. Picketty and Saez (2003)) can be instructive. Indeed, results from time series analysis provide
evidence for a synthesis of Minskyian nancial fragility and the new income inequality research.
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Contents
1 Introduction 4
2 Literature Review 5
2.1 From Keynes to Minsky: Debt and Financial Instability . . . . . . . . . . . . . . . . . . . . . 5
2.3 Assessing the Rubble: First Models of Inequality, Debt, and Crises . . . . . . . . . . . . . . . 9
5 Empirical Results 19
5.1 Vector Autoregression Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
7 Bibliography 25
List of Tables
1 Augmented Dickey Fuller Test Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
5 VAR(1) Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2
7 Short Run and Adjustment Parameters, VEC Model . . . . . . . . . . . . . . . . . . . . . . . 30
List of Figures
1 Income Inequality Measured by the Family-level Gini Coecient, 1948-2009. . . . . . . . . . . 12
3 A Comparison of Top to Median Income Ratios. Source: Picketty and Saez (2003) . . . . . . 13
4 Another Comparison of Top to Median Income Ratios. Source: Picketty and Saez (2003) . . 14
3
1 Introduction
On June 20, 2007, the investment bank Merrill Lynch seized $800 million in assets from a pair of hedge
funds, which were managed by Bear Stearns, another investment bank. The funds had been heavily invested
in derivative securities based on pools of so-called sub-prime mortgages. Two years later, neither bank was
still in existence, and the world economy was in the grips of the most severe recession since the 1930's.
Although the proximate cause of the nancial crisis was apparent to all - perhaps too late, even the (by then
former) Chairman of the Federal Reserve Alan Greenspan admitted that there was a bubble in housing - it
was also apparent that neither mainstream economics nor nance academics had a particularly convincing
explanation for the depths of the recession that followed the peak of the housing market. New (or at least,
dierent) models of the economy would be necessary to usefully examine the causes of the crisis.
The decade or so previous to the sub-prime collapse has been characterized by three trends. While the
years of the Clinton presidency coincided with a broadly shared rise in prosperity, the decade from 2000
onwards saw a much more uneven accumulation of wealth. Median incomes were largely stagnant, while
income distribution skewed increasingly upward (indeed, the largest increases in income over the period
occur not just in the top 5% of incomes, but in the top 0.01%.) The increasing nancialization of the
American economy from 1980 onwards (largely the result of regulatory policies) has unsurprisingly lead to
increasing household debt levels. The increase in household indebtedness starts to accelerate dramatically
after 2000. These trends of increased indebtedness and increased inequality have coincided with the increasing
In order to adequately explain the co-movement of these three trends - increased indebtedness, inequality
and nancialization - we must draw on two separate strands of research. First, the earlier post-Keynesian
literature on Minsky's nancial fragility hypothesis (which has been rehabilitated, to a degree, in the wake of
the nancial crisis of 2007-9) explains the relationship between debt and nancialization. Second, the recent
literature on income inequality suggests links between both nancialization and indebtedness. No Grand
Unied Theory of inequality, debt and crises has yet been discovered. There is, however, current research
which points towards an eventual solution - Kumhof and Ranciere (2010) incorporate inequality and nancial
fragility into a largely conventional modern macroeconomic model, and Krugman and Eggertsson (2010)
focuses on the debt-to-crisis relationship without treating inequality explicitly. Less formal presentations
from Rajan (2010) and Acemoglu (2011) have focused on the political economy of inequality and debt.
The current paper should not be read as an attempt to formulate a Theory of Everything with regards to
inequality, debt and crises. Rather, the focus of this paper is to listen to the data by careful examination of
the movements of the relevant variables over time, and through some (relatively simple) time series analysis.
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This survey shows that there is a relatively robust link from income inequality to economic crisis. The
existence of this link has policy implications for tax and scal policy that are likely to be controversial in
the current political climate. Holding other things constant, a link from inequality to crisis suggests that
a strongly progressive change to the tax code are welfare enhancing. Alternately, in terms that are likely
to infuriate market-oriented politicians and economists, failing to adequately tax the rich makes everyone
worse o.
The structure of this paper will be as follows. First, a detailed review of the relevant literature will be
conducted, focusing on the post-Keynesian literature on nancial fragility, drawing contrasts between the
earlier literature and the Minskyian revival post-2007, as well as the recent literature on income inequality.
Following this, a review of the data and stylized facts at hand will be analyzed, drawing on recent working
papers by Krugman and Eggertsson (2010) and Kumhof and Ranciere (2010). The core of the paper which
follows will focus on time series analysis (evidence from Vector Autoregressions, and cointegration models
will be presented) of the available data, with a formal presentation of the econometric theory underlying the
analysis. Finally, the paper will conclude with the policy implications and concerns which follow from the
analysis presented.
2 Literature Review
Amongst the earliest treatment of the relationship between indebtedness and nancial crises is Fisher (1933),
an analysis that is cited in most subsequent treatments of the subject. The debt-deation process as outlined
by Fisher occurs as follows. The precipitating incident for the Fisherian debt deation crisis occurs when
over-leveraged households and rms face a sudden loss of condence. They are forced to discharge their
debt in an expeditious fashion in order to repair their balance sheets. Since the overall debt level is out of
equilibrium, this liquidation causes a deationary crisis, which makes the balance sheet position of households
and rms still worse, as the real value of their debt increases. In Fisher's model, this debt-deation cycle
results in a drop in output, bank failures, and a general malaise. The New Deal banking regulations that
came into eect in the years after Fisher's article was printed were largely designed to mitigate the damage
caused by the debt-deation cycle he described - deposit insurance is designed to prevent mass banking
panics and failures, and stricter capital and reserve requirements on banks tamped down the amount of debt
issued.
Fisher had the bad luck to publish his article before John Maynard Keynes wrote his General Theory,
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and Hicks attempted to write down a mathematical model that roughly approximated it. For the next few
decades, Macroeconomists were largely preoccupied with arguments about money, employment, ination
(and later, expectations) largely ignoring the nancial sector. Essentially the only exception to this was one
Hyman Minsky. Minsky's work was often more narrative than technical. Nonetheless, even his informal
verbal models have proven to be quite inuential. A relatively comprehensive summation of Minsky's model
of nancial fragility and crisis can be found in Minsky (1982) and Minsky (1996).
Much like Keynes before him, it fell to Minsky's peers to attempt to formally model his ideas. Even
when such models were published, they often lagged behind mainstream macroeconomic models. Taylor and
O'Connell (1985) is one such attempt. It focuses on rms' expected prots as the transmissions mechanism
for a so-called Minsky Crisis (this contrasts with later denitions of Minsky crises, which generally involve
some combination of Ponzi nancing, deleveraging and condence.) Taylor and O'Connell's approach is
almost purely at the aggregate or macroeconomic level - the dynamics of nancial rms' nancing, which
are a major part of Minsky's theory, are largely absent. Taylor and O'Connell model assumes that there is a
large degree of substitutability within rms' and households' portfolio's, specically, between rms' liabilities
and households' money holdings. In this case, an exogenous negative shock to expected prots can produce
Keen (1995) oers a slightly more robust approach to modeling a Minsky-type model, albeit one which
rests on the now-antiquated Goodwin business cycle model. Keen's model makes explicit several predictions
from a Minskyian model - that cycles of euphoria should lead to increases in aggregate debt levels, that
excess debt tends to produce unstable outcomes, and that income inequality is also a destabilizing inuence
on the economy. Palley (1994) provides another theoretical interpretation, incorporating Kaldor's model of
the eect of household debt on consumption. Palley includes at least some empirical evidence for his model,
but the results are suspect, since the time series analysis does not include unit root or co integration tests.
Minsky passed away in 1996, mere years before two crises that t perfectly within his nancial fragility
paradigm - the series of Asian currency crises in 1998, and the collapse of the dot-com bubble in 1999-2000.
It would be another decade, however, before his legacy was fully revived. The crisis of 2007-9 has seen a urry
of activity by both post-Keynesian economists, many of whom worked with Minsky before his death, as well
as mainstream economists seeking to integrate Minskyian insights into a more conventional macroeconomic
framework.
Whalen (2009) and Palley (2009) are key examples of the initial, largely informal push to model the
nancial crisis of 2007-9 along Minskyian lines. Whalen's analysis is relatively straightforward - the move
from hedge nancing to speculative nancing to Ponzi nancing that denes a Minsky cycle can be seen
clearly in the decline in lending standards from 2002 onwards, and in the increased leverage of households.
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Whalen also stresses the importance of Minsky moments in the business cycle - just as the changes in
nancing during an expansion are non-linear, the collapse of a Ponzi-nanced bubble is highly non-linear.
The moment when actors are forced to recognize that their debt loads are unsustainable produces a rapid
move to de-leveraging and a freeze in credit markets. Whalen identies two possible Minsky moments for the
2007-9 crisis - the failure of the UK bank Northern Rock in 2007 and the aforementioned failure and seizure
of two Bear Stearns-managed hedge funds. Palley's analysis is slightly more macro in scope, focusing on
Minsky's later life attempt to synthesize his theory of short-run cyclical variation in capitalist economies (the
nancial fragility hypothesis) with Schumpeter's model of longer run cycles of creative destruction. Palley
refers to this synthesis as a super-Minsky cycle - the longer-run trend in economies towards more permissive
regulatory structures that mirrors the short run trends in private attitudes towards risk in the Minsky cycle
proper. Palley argues that this supercycle can be seen in the widespread capture of regulatory agencies and
The crisis of 2007-9 has also inspired some mainstream macroeconomics research informed by the major
conclusions of the Minskyian nancial fragility hypothesis. Two recent working papers, Kumhof and Ranciere
(2010) and Krugman and Eggertsson (2010) explicitly incorporate parts of Minskyian analysis. Krugman
and Eggertsson focuses on the debt-deleveraging process, while Kumhof and Ranciere models a link between
inequality and nancial fragility. Both papers will be discussed in more detail in Section 2.3.
In the period after about 1980, there has been a signicant increase in income inequality in the United States,
and, to vary degrees, in most other Industrialized countries. The data will be examined in more detail in
section 3. Traditional economic theory, following Kuznets (1955) runs contrary to the observed time series
of inequality. In the past ten years, a new literature has been developed in an attempt to explain the recent
rise in inequality.
A bulk of the new income inequality research has been focused on assembling ne grain data for income
shares across various time periods and countries. Working from micro-level data (e.g. the Census Bureau's
Current Population Survey) and leveraging modern computing power it is possible to estimate income shares
not just for deciles, but for quantiles as small as 0.001%. The most comprehensive of these data collection
endeavors (and most applicable to the subject at hand) is Picketty and Saez (2003). Picketty and Saez
calculate a database of income shares from tax return data for 1913-1998. The database is an ongoing
project, with data updated through 2008. The focus of Picketty and Saez is on the inequality within the
top decile, looking iteratively at smaller denitions of a top quantile. Two salient features of the evolution
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of income shares fall out from careful examination of the dataset. First, although there have been structural
breaks relating to tax code that that have caused one time changes to the mix of capital and labor income,
the period in question has seen an overall negative secular trend in capital income. Picketty and Saez coin
the term the working rich to describe the majority of top earners who receive most of their income from
wages. The second salient feature in the data is the importance of taxation to the inequality story. The
lower tax marginal income tax rates and estate tax rates that have prevailed after 1980 (and especially after
2000) seem to be correlated with the increase in income inequality and increase in average estate size in the
The increase in inequality has not, of course, been limited to the United States. Picketty and Saez
(2006) extend their analysis of income inequality using tax return data from the United States to a panel
of dierent countries. The notable result is the divergence among countries post-1970, with mostly English
speaking countries (USA, UK) seeing a dramatic rise in inequality, along an increasing gradient as the top
share denition shrinks, and other countries seeing much smaller increases in inequality.
These two strands - the long run history of income inequality, and the varying degree to which inequality
has increased across countries - have been extended and expanded upon in the recent paper by Atkinson,
Picketty and Saez (2011). Atkinson, et al (2011) extends the Picketty and Saez databases to 22 countries,
updating the data through 2005-8, depending on the country. Some care is taken in distinguishing between
inequality estimated using tax return data (which is extremely sensitive to changes in tax law, e.g. the
discontinuity around the 1986 tax reform) and inequality estimated using survey data (e.g. the Current Pop-
ulation Survey). Although the CPS data is in many ways preferable to tax return data, there is a structural
break in 1992, when the Census Bureau switched from paper and pencil data collection to computerized
entry. The signicant uptick in measured inequality from 1976-2006 is biased upward because of this break.
Adjusting for these discontinuities, between 1976-2006, the increase in the share of the top 1% increased by
between 4.0-7.0 percentage points, and the gini coecient increased by between 5.3-7.0 percentage points.
Atkinson, et al (2011) also note that the share of growth has been shifting towards higher incomes - the top
1% captured 45% of total growth between 1993-2000 (coinciding with the Clinton presidency), and captured
65% of total growth from 2002-2007 (coinciding with the Bush presidency).
The yeoman's work of collecting and estimating long run time series of income shares and income in-
equality has led to a urry of research not just in pure economics, but also in the political science and
political economy literature. Using data from, amongst other sources, Picketty and Saez (2003), Scheve and
Stasavage (2009) analyze the possible political sources of income inequality in a panel of 13 countries. They
nd that the presence of centralized collective bargaining has no signicant eect on inequality, but that
union density has a signicant and negative eect. Additionally, political polarization appears to have no
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statistically signicant eect on income inequality.
Galbraith (2008) works from a dierent data set (the University of Texas Inequality Project database) and
notes that while within country inequality has been increasing in the period after 1980 for many industrialized
countries, by some measures total world inequality has actually decreased in the period. In any case, it is
an empirical regularity that industrialized countries are, on average, more equal than poorer countries, a
fact that is consistent with a modied version of the Kuznets (1955) hypothesis. The data suggest three
interesting eects on inequality. Political regime and policy have some impact on inequality, but the eect
is extremely limited. Likewise, the functional distribution of income (capital vs. labor) has at least some
eect, but, again, this is rather limited. There is, however, evidence for a rather strong neighborhood eect
- countries that have either geographic or cultural proximity appear to have similar rates and trends in
inequality.
2.3 Assessing the Rubble: First Models of Inequality, Debt, and Crises
Macroeconomists, no less than playwrights or novelists, are in the business of telling stories. As time has
passed from the crisis of 2007-9 two chief stories have been told about the link between income inequality
and the nancial crisis. These stories are told rst as pure narratives, with more formal models following
shortly. The rst story is best characterized by the chief thrust of Raghu Rajan's book Fault Lines (2010).
The Fault Lines story runs along the following lines: the increase in income inequality from 1980 onwards
put pressure on US policymakers to alleviate the stress on lower and middle class families, who were not
fully sharing in the increases in prosperity. In order to alleviate the stress, the story goes, policymakers
systematically intervened in credit markets to pressure lenders to lower lending standards and extend more
credit (chiey mortgages) to the bottom half of the income distribution, allowing them to expand household
consumption even as their incomes remained stagnant. This expansion of credit fueled the growth of the
housing bubble which would ultimately bring about the nancial crisis of 2007-9.
Rajan's hypothesis, however, has been challenged by, amongst others, Daron Acemoglu, who oered an
alternative account of the possible link between inequality and the nancial crisis at a presentation during the
2011 AEA national meeting. Drawing on political science literature, particularly Bartels (2008), Acemoglu
argues that the increase in inequality after 1980 served only to concentrate eective political power in the
hands of the top 1%. Additionally, the increase in top inequality - the gap between the very rich and the
merely wealthy, is by an large a product of growing compensation in the nancial sector post 1999-2000. The
newly powerful rich, in this story, lobby for policies which benet the nancial sector (e.g. looser regulation).
This looser regulation, in turn, results in an expansion of credit, as nancial sector rms increase leverage in
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order to reap larger prots, buoyed by irrational exuberance. Simultaneously, the bottom half of the income
distribution, facing stagnant or declining wages, increases household leverage in order to maintain or expand
consumption.
Neither Rajan's nor Acemoglu's stories have been modelled formally, nor tested empirically. Concurrently,
however, several working papers have been circulated focusing on the modeling of various parts of the
inequality-debt-crisis relationship. Of particular interest for the purposes of this paper are the papers by
Krugman and Eggertsson, and Kumhof and Ranciere. Both papers were initially circulated in the fall of
2010, and are generally policy-focused, as would be expected of their authors - Kumhof and Ranciere are
employees of the IMF, Eggertsson is on leave from the New York Federal Reserve Bank, and Paul Krugman
is of course perhaps the most well known economic pundit in the world. Their papers are then focused on
Krugman and Eggertsson (2010) concerns itself with the connection between debt and crises, and draws
on the previously cited ideas of Fisher (1933) and Minsky (1996) to build a model of the macroeconomic
eects of a de-leveraging shock. Krugman and Eggertsson start from a New Keynesian model with a number
of simplifying assumptions in which there are two groups of people in the economy - patient agents, who lend
money to impatient agents (borrowers). The lending agents have an initial view of the maximum amount of
debt that borrowers can hold in order to be considered safe. However, if risk perceptions change, as in a
so-called Minsky moment, borrowers are forced into a painful deleveraging, which can in turn drive down
interest rates. If the deleveraging is large enough to drive interest rates negative, the economy would nd
itself in the famous liquidity trap. Krugman and Eggertsson model the eects of a deleveraging precipitated
liquidity trap as a backward sloping Aggregate Demand curve, which produces the seemingly impossible
results of what Krugman had earlier termed Depression Economics. These perverse results - not only the
well-known paradox of thrift, but also the paradox of toil, in which increases in productivity or potential
output actually decrease current output, and the paradox of exibility, in which increased price and wage
exibility (which can be shown as a steeper Aggregate Supply curve) decreases current output.
If Krugman and Eggertsson oers an explanation for a debt-fuelled nancial crisis of the sort seen in
the recent nancial crisis, the recent working paper by Kumhof and Ranciere (2010) provides an expanation
for how an increase in income inequality can lead to a rise in household indebtedness of the sort seen
immediately preceding the recent nancial crisis. A key part of the analysis involves the concomitant rise in
the nancialization of the economy as a result of the inequality-fueled increase in household indebtedness.
Kumhof and Ranciere build a considerably more complex model than Krugman and Eggertsson. In the
Kumhof and Ranciere model, an exogenous shock to the income dierential between the top 5% and the
bottom 95% shifts borrowing and lending/saving patterns - the bottom 95% borrow more and the top
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5% save (and lend) more. This in turn leads to a coincident increase in the size of the nancial sector
(nancialization). If, however, the incomes of the bottom 95% do not grow rapidly enough, the debt to
income ratio of households increases until a crisis (of the Minskyian sort) arises. The policy implications
presented are twofold - rst, strengthening the ability of the bottom 95%'s wage bargaining ability is an
eective way to prevent crises of this sort, and two, redistributive progressive taxation can retard the eects
rst take a quick surveyof the historical trends for each variable. Additionally, since the nancialization of
the economy has been noted to move in tandem with increasing leverage, nancialization will be examined
as well. What follows then, are a series of time series graphs that summarize said historical trends, paying
particular attention to the dierent historical trends for dierent measures of inequality, and the overall
There are, of course, a number of dierent ways of measuring income inequality. Perhaps the most
famous is the Gini coecient (or Gini ratio, depending on the usage). The Gini coecient represents
the sum deviation from perfect income equality. The procedure for calculating a Gini coecient using
discrete data (as in family income data from the CPS, for example) involves rst sorting family incomes in
increasing order, and aggregating families into n income quantiles. The Gini coecient can then be expressed
P
(n+1−i)F Ii
as: G = n1 n + 1 − 2 P
FI
, where F Ii is the total family income for the ith quantile, for all
i
i = 1, ..., n. In addition to the Gini coecient, several measures are often used, chiey simple quantile ratios.
These are cruder than, for example, a Gini coecient, but are often more illuminative, particularly when
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Figure 1: Income Inequality Measured by the Family-level Gini Coecient, 1948-2009.
Figure 1 shows the evolution of the family-level Gini coecient for the United States from 1948-2009.
The general pattern, which will be repeated for the other variables, is of relatively stable inequality through
about 1980, followed by a sharp increase coinciding with he Reagan presidency (with the sharpest increase
around the 1986 tax reforms). There is another sharp increase in the early 1990's, which is mostly the
product of a data artifact - the Census Bureau switched from pencil and paper data entry to computer entry
for the CPS in 1991. Income inequality measured by the Gini coecient increases generally from the mid
Figure 2 shows inequality measured by a simple income ratio, in this case the ratio of the top quintile's
income share to the bottom quintile's income share. A few notable dierences between the income ratio
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measure and the Gini coecient measure. First, the increase in income inequality from 1980 onwards is
much smoother for the income ratio measure - there is still a steeper increase during the 1980's, but the
spike associated with Census Bureau data collection changes is much less pronounced.
Figure 3: A Comparison of Top to Median Income Ratios. Source: Picketty and Saez (2003)
Figures 1 and 2 summarize historical patterns in inequality between on the one hand, median incomes
and top incomes, and on the other, top quintile incomes with bottom quintile incomes. There is, however,
another type of inequality which is of interest - the inequality within the top decile of incomes. Figures 3
and 4 demonstrate two dierent ways of comparing historical patterns in inequality, measured by income
ratios. Figure 4 shows the top 5% to median income ratio and the top 0.1% to median income ratio (note
that the units on each axis are unique.) It should be noted that both measures of inequality show similar
cyclical patterns. However, looking at Figure 3, we see that there has been a large divergence between the
top 0.1% to median ratio and the top 5% and top 1% to median ratio. From 1980 to 2008, the top 5% to
median income ratio about doubled (from 3.29 to 5.55), while the top 0.1% to median income ratio nearly
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Figure 4: Another Comparison of Top to Median Income Ratios. Source: Picketty and Saez (2003)
Using several measures, we can see that the post-1980 period has seen a signicant increase in income
inequality. The other variable of interest to us is household leverage. Figure 5 shows the historical evolution
of household leverage expressed as a ratio of household debt to GDP. There are two periods of signicant
growth in leverage - one coinciding roughly with the 1980's and the other with the 2000's - punctuated
by about a decade of much slower debt-to-GDP growth. The rst period of rapid growth can be at least
partially attributed to the Reagan era deregulation of the nancial sector, while the second period picks up
most of the credit bubble of the 2000's that ultimately led to the nancial crisis of 2007-9.
It is clear then, that income inequality and household indebtedness have seen concomitant increases from
1980 onward, and that these increases preceded the nancial crisis of 2007-9. Merely examining time series
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graphs is not sucient analysis, of course. To that end, we turn to more in depth statistical analysis of the
relevant data to better understand the relationship among income inequality, household indebtedness and
nancial crises.
of time series econometric techniques. For the purposes of this paper we will focus only on the United States.
Furthermore, due to data availability issues, the time series data used in the analysis will be annual - the
income inequality variable is calculated using Census Bureau gures which are only released yearly. This
necessarily will result in less powerful statistical results than would be ideal. With that in mind, we will
nonetheless attempt to overcome the limitations of our data set with a series of statistical techniques, each
of which should give more information about the relationships in question. A variety of models will be used,
but all will use the same four variables (or, in some cases, simple arithmetic transformations thereof ). These
variables are: LN U R, the natural log of the U-3 unemployment rate; LN IN EQ, the natural log of the ratio
of the top quintile's income share to the bottom quintile's income share; LN GDP , the natural log of Real
GDP; and LN DEBT , the total credit market obligations of households. All variables are annual, and cover
The rst order of business when dealing with time series data (especially over long time horizons) is to
determine the order of integration of the data series. Many time series have the property of non-stationarity,
that is, they have a mean and/or variance-covariance matrix that varies over time. This in turn implies that
the variance of the error term is innite. This presents problems for estimation using least squares, since
one of the central assumptions of the classical regression model requires that the error variance be constant
and nite.
In order to test for the stationarity of the variables in the study, the Augmented Dickey-Fuller test
approach is used. To test using the ADF approach two equations are estimated for each variable, of the
form:
p
X
∆yt = α1 + γyt−1 + βi ∆yt−i + et (1)
i=1
and
p
X
∆yt = α1 + α2 t + γyt−1 + βi ∆yt−i + et (2)
i=1
15
where y is the variable in question, α1 is a constant, and t is the time trend. In each case the number of
lagged dependent variables p is selected either in an ad hoc fashion (the minimum number of lags necessary
to whiten the data series, or remove autocorrelation) or through minimizing an information criteria such
as the Akaike Information criterion. In order to test for stationarity, we test the hypothesis that γ = 0 using
a modied t-test. Because of the possibly non-stationary properties of the data being tested, a normal t-test
is not appropriate. However, using Monte Carlo simulation techniques, it is possible to bootstrap critical
values for the test statistic for equations 1 and 2 above, as in MacKinnon (1996).
Table 1 summarizes the results of a series of Augmented Dickey Fuller tests performed on the four
variables of interest. Two variables - LN GDP and LN DEBT are unambiguously I(1), e.g. they must be
dierenced once in order to induce stationarity. The other two variables, LN U R and LN IN EQ, are not
unambiguously non-stationary. The ADF test for LN U R rejects the null hypothesis (of no unit root) at the
5% level for the constant-only case, while LN IN EQ rejects the null for the constant and trend case. In
order to alleviate this ambiguity, we must make use of another type of stationarity test.
The Phillips-Perron test is a generalized variation of the Augmented Dickey Fuller test. While the ADF
test corrects for the autocorrelation in the test regression by adding p additional lags of the dependent
and
and makes corrections to the t−statistic for γ to correct for autocorrelation. Table 2 summarizes Phillips-
16
Perron tests conducted for LN IN EQ and LN U R. The results suggest that that both variables are I(1).
Although the results are not quite as ironclad as possible, the weight of the evidence points towards all four
variables being I(1), and we will operate under this assumption going forward.
The workhorse model of time series Econometrics is the Vector Autoregression model, or VAR. VAR models
came to prominence largely as a reaction to the perceived shortcomings of previous structural Econometric
models. It should come as no surprise that the chief virtue of VAR models is their very lack of structure.
Rather than assume strongly exogenous regressors, VAR models allow all variables in the system to be at
least weakly endogenous. In this way, then, VAR models are often useful as a way of examining a variety of
A VAR model relates each variable to its own lags and lagged values of all other variables. In this way,
each equation has an independent error term, and each can be estimated individually without needing to
account for simultaneity bias. An n variable VAR with p lags can be expressed as the following:
p
X
Xt = α + βi Xt−i + et (5)
i=1
where Xt is an n x 1 vector of current values of the variables in the model, α is an n x 1 vector of constants,
the βi are n x n matrices of coecients (for lags i = 1, 2..., p), Xt−i are n x 1 vectors of lagged values of the
coecients in question (again, for lags i = 1, 2..., p) and et is an n by 1 vector of independent error terms.
In addition to the basic estimation of a VAR model, there are several post-estimation modes of analysis
which are often used. Of note for the purposes of this study is the analysis of impulse response functions.
It should rst be noted that the Vector Autoregressive model can be expressed as a Vector Moving Average
model in mcuh the same way that an AR(p) model has an MA(q) representation. The full derivation of
17
the IRF can be found in, for example, Enders (2003), but the end result is that a simple two variable VAR
∞
xt x̄ X φ11 (i) φ12 (i) εxt−i
= + (6)
yt ȳ i=0 φ21 (i) φ22 (i) εyt−i
where εxt−i and εyt−i are lagged values of the error term from the primitive form of the VAR (as opposed
to the reduced form used in equation 5. The elements of the coecient matrix - φjk (i) - are the impulse
response functions. So, for example, φ11 (i) gives the eect of a 1 unit shock to the error term of x on x itself
after i lags. It is standard practice to graph the φjk (i)'s against i for simplicity of presentation.
We have established that all of the variables to be used in our analysis are I(1), and that, as such, statistical
techniques that rely on least squares estimation are invalid without some form of data transformation (e.g.
rst dierencing.) However, the possibility remains that these variables have some kind of equilibrium, long
run relationship, which can be expressed as a stationary variable. This long run relationship, which is a
linear combination of the I(1) variables, is known as a cointegrating vector. More formally, for a vector of n
variables which are integrated of order d, then the variables are cointegrated of order (d, b) if there is some
vector β such that βxt = β1 x1t + ... + βn xnt is integrated of order (d − b) . The most common (and useful)
of cointegration involves a series of variables that are all I(1) that can be expressed as a stationary variable.
There are two chief ways of testing for the presence of cointegrating relationships - the Engle-Granger
methodology and the Johansen methodology. The Engle-Granger methodology relies on the fact that the
error term of a regression with I(1) variables can be expressed as a linear combination of the variables.
If the error term is itself stationary, then there is evidence of cointegration. This error term can then be
inserted into a regression with the rst-dierenced variables (a so-called error-correction model), allowing for
inference on short run deviations from equilibrium, as well as speed of adjustment back to equilibrium. The
Johansen method is a bit more complicated, but allows us to test for the number of cointegrating vectors.
After determining the cointegration rank, an error correction model generalized to a Vector Autoregression
framework (a Vector Error Correction Model) can be estimated. For our purposes, we will use the Johansen
method for testing for cointegration, although an Engle-Granger error correction model will also be estimated.
The Johansen methodology constructs a test statistic that follows a χ2 distribution. The test statistic is
18
Table 3: Johansen Cointegration Test Results (lag length 1)
Rank Trace test P-value L-max test P-value
0 57.309 [0.0043] 35.997 [0.0021]
1 21.313 [0.3487] 15.042 [0.2979]
2 6.2701 [0.6677] 3.7777 [0.8742]
3 2.4925 [0.1144] 2.4925 [0.1144]
calculated as follows. First, consider the simple V AR(1) system: yt = A0 + Ayt−1 + et . It is easy to see that
where A0 is a vector of constant terms, A is a matrix of coecients, and I is the identity matrix. Theoretically,
the rank of matrix (A − I) will equal the number of cointegrating vectors. However, in practice, the rank
of the matrix is unknown. It is possible, however, to estimate the characteristic roots (eigenvalues) of the
(A − I) matrix, which are denoted as λ̂hereafter. The Johansen procedure involves calculating two test
statistics, the trace test for the presence of at most r cointegrating vectors:
n
X
λtrace (r) = −T ln 1 − λ̂i (8)
i=r+1
and the λmax test of the null hypothesis that there arer cointegrating vectors against the altenative that
there are r + 1:
h i
λmax (r, r + 1) = −T ln 1 − λ̂r+1 (9)
There are a number of variations of these two statistics, based on changes to the denition of the V AR(1)
system in equation 7 (for example, the addition of a linear trend.) Table 3 summarizes the results of Johansen
test for up to 3 cointegrating vectors for a V AR(1) system containing the four variables of interest. The
two test statistics are in agreement - they both reject the null hypothesis of no cointegrating vectors, but
accept the hypotheis of 1 (and all higher) cointegrating vectors. This result implies that there is a single
cointegrating vector in the system. As such, then, either a VECM or Engle-Granger framework may be used,
5 Empirical Results
With these statistical tools in hand, we will proceed to perform a series of statistical tests in order to
better understand the relationship among household indebtedness, income inequality and nancial crises.
We will look for two dierent statistically signicant relationships for each of the models to be estimated.
19
First, there should be a statistically signicant and positive relationship between income inequality and
indebtedness, following from Kumhof and Ranciere (2010). Second, there should be a statistically signicant
relationship between indebtedness and crisis (proxied here by the U-3 unemployment rate), following from
Minsky (1986) and Krugman and Eggertsson (2010). Towards this end, we will look at evidence from a
Vector Autoregression, a Vector Error Correction Model and nally, an Engle-Granger Error Correction
Model. Each of these models gives some insight into the two relationships of interest. Taken together, the
weight of evidence points towards an Income Inequality to Debt to Crisis relationship that follows from
As a sort of rst pass analysis, we rst examine a Vector Autoregression estimated using the untransformed
data (e.g. in levels). Since we have established that all of our variables are I(1), direct inference is not likely
to be persuasive. Nonetheless, there is some information to be had. The VAR model is estimated for a lag
length of 1 (chosen by using AIC as the lag length criterion). The full estimation of VAR system can be an
unwieldly aair, with a large number of parameters and standard errors to be individually estimated. As
such the full table of results can be found in Appendix B. Several results are of note. First, the coecient
of lagged income inequality in the LN DEBT is statistically signicant and positive, providing evidence
for the hypothesis that income inequality increases household indebtedness. This estimated coecient is
implies that a 1% increase in the growth rate of income inequality increases household debt growth by
0.46%. Additionally, the coecient for lagged household indebtedness in the LN U R equation is positive as
In addition to the estimated coecients in the VAR system, calculating impulse response functions for
the variables in the model can give us furhter insight into the relevant relationships. In order to calculate
the IRF's, the data must rst be orthogonalized using a Choleski ordering, wherein the variables are sorted
from msot to least exogenous. There is some leeway for the applied Econometrician's judgement here, since
there are not usually unambiguous formal test results. For the V AR(1) system we have been examining,
the following Choleski ordering is used: LN IN EQ LN DEBT LN GDP LN U R . The Impulse
response functions are summarized in graphical form in Figure 6, wherein each graph shows the response of
one variable to a one standard deviation shock to the error term of another variable over 10 periods. Monte
Carlo estimates of a 95% condence interval are shown as the shaded gray area around the point estimate -
responses that do not include 0 in their error bound are then statistically signicant. We can see that there
is evidence for the rst of our hypotheses - a shock to LN IN EQ increases LN DEBT for almost all of the
20
Figure 6: Combined Impulse Response Graphs from VAR(1) Model
ten period window, with only the rst and last period being insignicantly dierent from zero. The Impulse
response graphs do not provide any evidence for the indebtedness-unemployment relationship, although they
Since we have already established that the variables of interest are all I(1), and furthermore, that they are
cointegrated, a simple V AR(1) model using the data in levels is misspecied. A better model would account
for both the stationarity of the variables as well as their cointegration. A Vector Error Correction Model
satisies these criteria. As in the V AR, by selecting the lag length with the smallest information criterion, we
choose a lag length of 1. The full results of the estimation of the VECM can be found in Appendix B, again
due to the unwieldly nature of such estimates. Of the short run adjustment parameters, neither coecient
of interest (either the coecient on inequality in the ∆LN DEBT equation or the coecient on debt in the
∆LN U R equation) are statistically signicant, although the direct eect of inequality on ∆LN U R is weakly
It is possible, as with a VAR model, to calculate impulse response functions from a Vector Error Correction
model. As with the VAR, the variables in the VECM are rst orthogonalized using the Choleski ordering
21
Figure 7: Combined Impulse Response Graphs from a V EC(1) Model
LN IN EQ LN DEBT LN GDP LN U R . Figure 7 summarizes the combined impulse responses
graphically, again for a ten-period window. The IRF results from the VEC model largely agree with those
from the VAR model. The impact of inequality on debt is statistically signicant and positive for all periods
after the rst two, and inequality has a direct and positive impact on unemployment. As in the VAR impulse
responses, there is no statistically signicant positive relationship between debt and unemployment.
Although as a general rule, Vector Error Correction models are preferable to a single equation approach (e.g.
Engle-Granger) to modeling cointegration time series, the Engle-Granger two-step estimation procedure has
certain advantages over a VECM, not least of which is the fact that it requires far fewer parameters to be
estimated. There are two chief issues with the Engle-Granger method - it does not account for the number
of cointegrating vectors, and so is invalid if there are more than one, and it requires the econometrician to
choose a left hand side exogenous variable. Since we have established that there is a single cointegrating
vector the former concern is alleviated. As for the latter, let us consider that we have strong evidence from
both a VAR and VECM for a positive relationship between income inequality and household indebtedness,
but have found little evidence for a positive relationship between debt and unemployment. It therefore makes
sense to choose unemployment as the left hand side variable in an Engle-Granger model.
The Engle-Granger two step process is relatively straightforward. After selecting a left hand side variable,
a regression is estimated using the data in levels. The error term from this regression is, as noted in Section
4.3, a linear combination of the variables in the model, and, as such represents a long run equilibrium
22
Dependent variable: d_LNUR
relationship. If we insert this error term, lagged once, into a regression model with the data in rst-dierence
form, we can estimate an error correction model, where the parameter on the lagged error correction term
can be interpreted as a adjustment period parameter, describing how quickly the variables return to long
run equilibrium after a shock. General practice is to include several lags of each variable (in rst dierence
form) and to iteratively omit variables until only statistically signicant variables remain, an instance of
general-to-specic modeling. Table 4 summarizes the nal results from an Engle-Granger model. The key
result for our purposes is the statistically signicant and positive (short run) relationship between debt and
unemployment. Additionally, there appears to be a direct and positive short run impact of income inequality
on unemployment, a result which is in line with the VEC and VAR evidence. Finally, it appears that a shock
to the system of variables is relatively slow to correct itself, taking nearly 7 years to return to equilibrium.
inequality and debt are borne out by formal statistical tests. From the estimation of VAR and VEC models
and impulse response functions, we nd a statistically signicant and postive relationship between income
inequality and household indebtedness, and a direct positive impact of inequality on the unemployment
rate. Additionally, evidence from an Engle-Granger two step model suggests that there is a statistically
signicant and positive impact of indebtedness on the unemployment rate, and conrms the direct impact
of inequality on unemployment. It would appear then, that income inequality can contribute to nancial
crises in two ways - both directly, as well as through the channel of increased household indebtedness. These
23
results provide strong evidence for the Minskyian nancial fragility hypothesis and the recent formal models
There is, of course a relatively straightforward policy implication that immediately arises from these
ndings. Any policy which reduces income inequality is potentially welfare enhancing, as reductions in
income inequality reduce the future probability of nancial crises (which, to a rst approximation, make
everyone worse o.) Traditionally, such policies (increasing the progressivity of the tax code, re-orienting
government expenditures in a pro-poor driection, etc.) have been justied by appealing to fairness, while
opponents of such policies have argued on the basis of eciency. However, the results from this study suggest
that even setting issues of equity aside, income inequality-reducing policies may still be justied on the basis
of eciency. Contrary to the prescriptions of supply-side economics the chief problem is not an ineciently
high tax rate on the top decile of the income distribution, but an ineciently low one.
24
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A Appendix 1: Variables List
All variables are annual, spanning 1948-2008.
LN GDP - the natural logarithm of Real Gross Domestic Product. Source: Bureau of Economic Analysis
LN U R - the natural logarithm of the U-3 Unemployment rate. Source: Bureau of Labor Statistics
LN IN EQ - the natural logarithm of the ratio of the income share of the top quintile to the income share
LN DEBT - the natural logarithm of the total credit market debt outstanding of the hosuehold sector.
27
B Appendix 2: Tables and Figures
The following are additional tables and gures too unwieldly to t nicely in the text proper.
28
VAR system, lag order 1
OLS estimates, observations 19492008 (T = 60)
Log-likelihood = 488.615
Determinant of covariance matrix = 9.92372e013
AIC= −15.6205
BIC= −14.9224
HQC = −15.3474
Portmanteau test: LB(15) = 226.552, df = 224 [0.4398]
Equation 1: LNDEBT
Coecient Std. Error t-ratio p-value
Equation 2: LNGDP
Coecient Std. Error t-ratio p-value
Equation 3: LNINEQ
Coecient Std. Error t-ratio p-value
30