In search of lost social finance: How do financial instability and inequality interact?

The 2008 crisis and COVID-19 pandemic have highlighted the impacts of financial shocks on the vulnerable, emphasizing the challenges posed by financial instability to social finance. However, academic studies on financial instability and income inequality present mixed results. They often focus on specific instances of financial crises rather than evolving effects, examine uni-directional causality rather than interactions, and rely on slowly changing annual data instead of higher-frequency data. This study fills these gaps by examining the time-varying bidirectional relationship between financial instability and income inequality in the US, using a newly developed monthly database from January 1990 to March 2023. We demonstrate the existence of a vicious cycle in which persistent financial instability leads to increased income inequality, which in turn triggers financial crises through the harmful effects of credit deregulation. Based on these findings, we argue that a “Robin Hood strategy” of progressive taxation to improve access to quality education and healthcare could offer a more effective solution to tackle inequality than easing credit access for low-income groups through deregulation.