Financial Development and Inequality in the Global Economy

• DOI: http://doi.org/10.1111/sjoe.12312
• Published date: 01 October 2019
• Author: Maximilian v. Ehrlich,Tobias Seidel
• Date: 01 October 2019

Scand. J. of Economics 121(4), 1533–1560, 2019

DOI: 10.1111/sjoe.12312

Financial Development and Inequality in the

Global Economy

Maximilian v. Ehrlich*

University of Bern, CH-3001 Bern, Switzerland

maximilian.vonehrlich@vwi.unibe.ch

Tobias Seidel†

University of Duisburg-Essen, DE-47057 Duisburg, Germany

tobias.seidel@uni-due.de

Abstract

We build a heterogeneous firms model with firm-specific wages and credit frictions to study

the role of financial development for inequality in the global economy. If there are many small

(non-exporting) firms, better access to external funds reduces wage and profit inequality as well

as unemployment. In contrast, if there are many large (exporting) firms, financial development

might have opposite effects – especially if trade costs are low. In summary,the implications of

financial development for inequality depend on the size distribution of firms and on the costs of

exporting. Trade liberalization, however, raises inequality unambiguously.

Keywords: Credit constraints; financial development; inequality; international trade

JEL classification:F16; F65

I. Introduction

The empirical literature on the implications of financial market development

for income inequality has produced a mixed picture. While some studies

have shown that financial development leads to less inequality (see, e.g.,

Clarke et al., 2006; Liang, 2006; Beck et al., 2007), others find that

financial development contributes to rising income inequality (see, e.g.,

Jaumotte et al., 2013; de Haan and Sturm, 2017) – even after controlling

for trade openness. We suggest a theoretical model that rationalizes these

heterogeneous findings by arguing that international trade and the size

distribution of firms might play a crucial role in understanding the link

between better access to external finance and income distribution. While

financial development raises income inequality in countries with many

highly productive (exporting) firms, the opposite is true for economies with

relatively more small (non-exporting) firms.

*Affiliated with CESifo and CRED.

†Affiliated with CESifo CRED.

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The editors of The Scandinavian Journal of Economics 2018.

1534 Financial development and inequality in the global economy

This topic is highly relevant as recent decades have revealed pronounced

developments of financial markets, international trade, and wage inequality,

especially within skill groups (see, e.g., Katz and Autor, 1999; Autor

et al., 2008).1While there has been some effort to link trade integration

to wage inequality, the implications of financial development for wage

distribution and unemployment are less well understood, especially in the

global economy.

Our model features three types of friction to rationalize the stylized

facts introduced above. First, moral hazard in credit markets leads to credit

rationing. As contracts cannot be written contingent on entrepreneurial

effort, lenders demand a sufficiently high entrepreneurial stake in the project

to render shirking unattractive. Otherwise, a project fails with certainty

and the lender loses the investment. Capital owners are endowed with

one unit of assets, but differ in their entrepreneurial skill in running a

firm. As higher skill translates into higher total factor productivity and

thus higher profits, entrepreneurs of low-productivity firms do not earn

a sufficiently high income to credibly commit to diligent behavior. As a

consequence, lenders do not grant external finance, causing credit rationing

of those firms. In essence, credit frictions affect the distribution of firms by

excluding the least productive enterprises from external finance and thus

entry. This mechanism is in line with empirical evidence that small firms

benefit most from a reduction in credit frictions (e.g., through better investor

protection or law enforcement), which we refer to as the source of financial

development.2

Second, there is a friction in the labor market giving rise to within-group

wage inequality. We assume that workers have fairness preferences where

firm-specific operating profits serve as the reference income for determining

the individual fair wage.3Due to firm heterogeneity, more productive firms

pay higher wages (e.g., Bayard and Troske, 1999), giving rise to a skill-

group-specific wage distribution.4As this positive relationship between firm

size and firm wages is central to the underlying economic mechanism in

the model, it is important to emphasize that this link can also be established

by using alternative modeling approaches to labor market frictions, such as,

1The ratio of private credit relative to GDP in the US and the UK has increased from a valueof

around one in the 1980s to around two in recent years. Similar trends are seen for France and

Germany, albeit at lower levels (World Bank Global Financial Development Database). World

trade has grown about twice as fast as global production since the 1980s (WTO, 2013).

2Aghion et al. (2007) show that for 16 industrialized and emerging economies “access to finance

matters most for the entry of small firms.” Further evidence is provided by Beck et al. (2005,

2008).

3See Akerlof and Yellen (1990).

4See Egger and Kreickemeier (2009, 2012) for similar approaches.

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The editors of The Scandinavian Journal of Economics 2018.