Finance and Inequality

In the current context in which the consequences of the excesses of financial innovations are all too obvious, it is easy to underestimate the positive role played by the financial system. There is indeed a strong body of evidence which links better financial systems (as measured by their size, their depth, their efficiency, and their reach) with faster economic growth. In a recent NBER working paper, Asli Demirguc-Kunt and Ross Levine point to the often-neglected relationship between finance and economic inequality. By giving the poor enhanced access to funding, financial systems play a positive role in alleviating economic inequality and in promoting equality of opportunities. Its excesses aside, subprime lending ought also to be remembered for enabling home-ownership to millions of low-income households.

But, the authors argue, finance can also widen inequalities, by disproportionately enhancing the opportunities of the wealthy at the expense of the poor (for it is the former who possesses enough collateral to borrow). This, they argue has largely been neglected by economists, with the exception of Greenwood and Jovanovich 1990. One can however argue that, better access to funding by the rich, although bad for inequality, can be also be good for poor as this increases their employment opportunities. Indeed, in countries that have experienced sustained growth over several decades, the economic conditions of the poor have improved, often considerably. Hence, it makes more sense to look at how finance reduces poverty rather than inequality.

Demirguc-Kunt and Levine summarise a growing research on the topic and conclude that there is generally a  “strong beneficial effect of financial development on the poor and that poor households and smaller firms benefit more from this development compared with rich individuals and larger firms.” How do they benefit more? For small firms, the benefit is in terms of the ability to borrow when faced with liquidity problems. For poor households, finance allows them to “smooth their consumption”, i.e. to save and borrow whenever they need to, and this allows them to invest in education and to take more risks in general. In a study of Kenyan farmers, Esther Duflo, Michael Kremer and Jonathan Robinson found that, although the use of fertilizers is proven to significantly increase productivity in the growing of corn and even though they do not necessitate a large investment, farmers do not use fertilizers because they cannot even save the little that is required to purchase them and they are very reluctant to deviate from their old ways of farming.