The role of financial systems for cross-country differences in the link between income and consumption inequality

ABSTRACT

This article discusses why consumption inequality stays low despite high income inequality in the U.S; but income inequality is closely followed by consumption inequality in China. We show that different financial systems can play a critical role in shaping the cross-country different links between income and consumption inequality. This phenomenon is consistent with the cross-country different relationships between income inequality and saving rates. Consumer credit expansion in the U.S. makes inequality much less serious for consumption than for income, and this result holds to an even larger extent if more domestic credit can be financed by foreign savings. But this is not the case in China, whose financial system focuses only on investment and trade while neglecting liquidity constraints on consumption. Our assertions accord well with evidence found from the U.S., China, and other related economies.

KEYWORDS:

• Saving rates
• income and consumption inequality
• consumer credit
• capital inflows
• global imbalances

JEL CLASSIFICATION:

• D63
• E21
• O14
• O24
• F43

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Financial and marketing services create an income illusion through asset bubbles (Soman and Cheema 2002). Prior to 2007, U.S. consumers increased their borrowing based on the rising market values of their homes, which were widely misperceived as their increased permanent incomes (Brown 2008). It is problematic that poorer consumers with low or no income were allowed to borrow more debt relative to their income, which should have been but was not treated as their equity to compute their leverage ratio (Kumhof and Ranciere 2010). Instead, the rise in home prices should not have been but was taken as an increased equity for more consumer credit. This unusual practice in mortgage finance and consumer credit was a long-run policy response to rising income inequality in the U.S. (Rajan 2010).

² A smaller C_T/C_B given Y_T/Y_B suggests a lower consumption inequality relative to the income inequality. A larger deviation of C_T/C_B from Y_T/Y_B indicates a greater incompatibility between consumption and income as more borrowing opportunities are available. This deviation encouraged by credit expansion actually signals a serious macroeconomic distortion with a direct implication for financial fragility since high leverage implies high crisis risk.

³ The notation ‘≪’ used here means ‘much less than’. More ‘<’s stacked together indicate a greater deviation.

⁴ This is indeed the case, as is proved for only group B without dividing it into subgroups for the sake of simplicity. Suppose group B people borrow for more consumption in the sense of C_B = C_B° + D_d > C_B°. Setting α’_B (=C_B/(Y_B + D_d)) > α_B° (=C_B°/Y_B) yields Y_B > C_B° or α_B° < 1. Going on the other way around completes the proof.

⁵ In the U.S., lower inequality in consumption than in income due to financial intermediation implies both higher returns on saving for the lending top group and greater indebtedness to the borrowing bottom group, thereby increasing income inequality further. To maintain small consumption gaps between different groups of the population under rising income disparities, the bottom group’s need to borrow and the top group’s willingness to lend increase simultaneously, thus stimulating the rapid expansion of the U.S. financial sector and consumer credit business (Philippon 2008).In China, financial and housing markets are used by its elite, not to smooth consumption for its public, but to plunder wealth from them (Yao and Luo 2009), hence aggravating income inequality. It is unclear whether consumption inequality exacerbates its income counterpart, and both inequalities are likely to be co-determined by the same underlying factors. While moving together due to limited consumer credit, they cannot have any significant influence on the financial system that is a state-owned, bank-based, and slowly-reformed institution.These possible cases of causality or no such relation can be formally tested. The testing result is available upon request.

Additional information

Funding

This work was supported by the Universidade de Macau [Grant Number MYRG2015-00133-FBA].