Financial Development and Inequality - Coursework Example

FINANCIAL DEVELOPMENT AND INEQUALITY By Financial Development and Inequality Introduction The issue ofthe financial development and inequality is the hottest topic of the discussion among the various economists. Over the past few decades to the onset of the global economic crisis, most countries of the OECD states have experienced widen income inequality. One of the most driving themes of the economic development is the country’s growth and the embarrassing income inequality; it reflects how the broad-based frustration in regard to how the sophisticated financial developments impacts on the overall economic development (Griffiths, et al., 2014). Therefore, the understanding of the effects of the financial development on the income distribution and the economic growth has critical vital implications than ever. The impacts of the financial development on the income inequality has been studied thoroughly. The financial development and the income inequality are thus clearly related, and this type of the relationship has for some time now occupied the minds of the economists from the Smith to the Schumpeter; although the directions and the channels of the causality still remains unresolved in both the empirics and theory (Machlup, 2014). This study attempts to answer some questions such as; do the financial development always lead to the reduction of the income inequality in the society? Are there differences within and across the countries on their stages of the economic development? This study, therefore, aims to empirically and theoretically analyse the relationship between the financial development and the income inequality. Income inequality has a positive correlation to financial development of an economy. The Links between Financial Development and Inequality In the recent past, research on the relationship between financial development and the world inequality has been quite intense. The economic growth has been quite often been given the priority as the ant-poverty measure while ignoring the negative links between the financial development and inequality by the policy makers (Bittencourt, 2010). The recent literature review of the different researchers indicates that both the financial development and the inequality relationships are quite complex and not clearly captured through the conventional linear regression analyses. Most of the empirical literature focuses on the direct growth or marginal effects while ignoring the role of the possible conditions, factors and the thresholds that can alter our thinking on how the financial development or the inequality can affect the economic growth (Honohan, 2004). Most of the economic theories predict that the financial development has a negative impact on the income inequality. The three main theoretical papers that explains the financial development and the income inequality nexus are by the Galor and Zeira (1993), Banerjee and Newman (1993) and Greenwood and Jovanovic (1990). Whereas Banerjee and Newman (1993) and Galor and Zeira (1993) predict that better developed financial markets result to the reduction in the income inequality, Greenwood and Jovanovic (1990) predicts that an inverted-U-shaped linkage between the financial development and the income inequality. This means that in the earlier stages of the financial development the income inequality increases. However, after reaching a certain stage of the economic and financial development, more of the financial development begins to lead to the reduction of the income inequality. Whereas specific economic mechanisms that is behind these predictions vary, the main reason why better developed financial markets reduce the income inequality is because better credit availability allows the household choices and the decisions made based on the economic optimality and less on the inherited wealth. Additionally, the relationship between the financial development and the reduction in the income inequality can be both correlational and causal, and the causality can run in both ways (Galor and Zeira 1993). For instance, as the share of the income that is held by the poor increases, the poor may increase their demands for the financial services that may have a positive correlation between the growth and finance. However, on increasing growth, the finance may contribute to the increased incomes for the poor. Therefore, the growth of income of the poor or alleviation of poverty in an economy has a positive effect on the financial development of a country because it increases the amount of finance help the low income earners and thus enabling them to consume and demand financial services, which leads to financial development (Galor and Zeira 1993). Financial Development and the Economic Growth The economic growth and financial development relationship has been widely discussed in several respects, among which the positive effects of the finance on the growth has become the mostly accepted result and the stylized fact. The neoclassical theory assumes that even though the financial systems play a fundamental role for the economy, the financial factors are not more often regarded as the main determinants of the economic growth (Xu, 2000). For instance, the growth theory explains the economic growth as the result of the human capital, innovation, and the physical accumulation while there is little attention that is given to the financial sector. Since the healthy financial system is the integral to the sound fundamentals of the economy, the designing policies for the economic development while ignoring the improvement of the financial system completely is one of the most significant oversight (Xu, 2000; Demetriades, & Hussein, 996). To expound this more, the growth theory explains that there are two distinct and yet complementary conduits by which the financial development can influence the economic growth-the total productivity (TFP) channel and the capital accumulation channel. The capital accumulation channel (quantitative channel) is largely based on the debt-accumulation hypothesis of the Gurley and Shaw (1955). The channel focuses on the financial sector’s ability to overcoming the indivisibilities through the mobilization of the savings. The mobilized savings are then channelled to the productive sectors so as to fund the investment projects, leading to the higher output and the increased capital accumulation. The TFP channel (qualitative channel), on the other hand, emphasizes on the role of the innovative financial technologies in the reduction of the informational asymmetries that hinders the efficient allocation of the financial resources and the monitoring of the investment projects (Gurley and Shaw, 1955). Additionally, an efficient financial systems facilitate the adoption of expensive new technologies. The different perspective on the relationship between the financial development and the economic growth can be traced back to the Schumpeter (1911), who stressed the vital role of the credit markets in the economic development process. He further argued that the entrepreneurs require the credit so as to finance the adoption of the new production techniques. The banks are viewed as the main agents in the facilitation of the financial intermediation activities and the promotion of the economic development. Therefore, well developed financial system can channel the financial resources to the most productive uses. Robinson (1952) argues that the financial development do not lead to the higher economic growth. He instead stated that, the financial development responds passively to the economic growth due to the higher demand for the financial services. When there is expansion of the economy, the households and the firms demand more financial services. In response to this increased demand, more financial products and services and financial institutions emerge leading to the expansion of the financial systems (Levine, 1997). Some studies have majorly focused on the merits of the market-based and bank-based financial systems in the promotion of the economic growth (Allen and Gale, 1999: 2000; Beck and Levine, 2002). Although the banks play a vital role in the allocation of the resources to fuel the economic growth, the increased vitality of the financial markets is commonly observed in the more advanced economies. The bank-based financial system has relatively less developed financial markets. Its main feature is that the firms rely more on the finance that is provided by the banks rather than those on the financial markets. On the other hand, the market based-financial system (such as the USA and UK) is characterized by the presence of the highly developed financial markets. The market-based financial system is usually more likely to have the short-term effects as the firms are concerned with their immediate performance. The financial intermediaries and the financial markets have mutually reinforcing roles in the overall development of the financial systems and the economic growth. Therefore, the economic growth of an economy has a positive effect on the financial development of a country because it increases the amount of finance the low income earners of the country and thus enabling them to consume and demand financial services, which leads to financial development (Galor and Zeira 1993). The Financial Development and the Income Distribution Most of the researchers agree that well-developed financial system can enhance the growth of the economy. However, there is no concrete conclusion that the financial development can benefit the whole population equally. As a result, there exists some conflicting arguments in regard to the impact of the financial development on the income inequality. Some of the researchers state that the relationship between the financial development and the income inequality can be as positive as the economic growth does, meaning that the financial development can be fundamental in the reduction of the income inequality (Beck, Demirguç-Kunt & Lavine, 2007). Usually the financial imperfections in the financial markets such as the transaction and information costs can bring consequences especially the poor that lack the collateral and credit histories. Therefore, the poor may be impeded from having to borrow adequately to invest the physical and human capital, something that implies that the financial development helps in the alleviation of the income inequality. Generally, the financial development removes the obstacles to the development of the capital allocation efficiency, more so for the poor, thus reducing the income inequality (Beck, Demirguç-Kunt & Lavine, 2007). To explain the definition of the income inequality more specifically, some of the other terms that are much more detailed than the Gini coefficient should be adopted. Varied levels of the quintile are sometimes used in the presentation of the different levels of the poverty and income. More specifically, the poorest quintile is sometimes considered to derive more benefit from the financial development. The financial development disproportionately boosts the income of the poorest quantile thereby reducing the income inequality (Iyigun, & Owen, 2004). Approximately 40% of the long-run effect of the financial development on the income growth especially for the poorest quantile is due to the reductions in the income inequality, while about 60% is due to the impact of the financial development on the aggregate economic growth (Beck, Demirguç-Kunt & Lavine, 2007). This is, therefore, clear that the financial system have a great importance for the poor. Contrastingly, some of the theories predict that the financial development largely helps the rich. The theories explains that the poor have less access to the financial services meaning that the improvements, especially in the formal financial sector inordinately benefits the rich. For instance, Greenwood and Jovanovic (1990) developed the model and assumed that the non-linear relationship exist between the financial development, economic development and income inequality. At all the stages of the economic development, the financial development leads to the improvement in the capital allocations thereby boosting the aggregate growth. However, the distributional impact of the financial development, and therefore the net effect on the poor largely depends on the level of the economic development. At the early stages of the economic development, only the rich can benefit from the better financial markets. However, at the higher levels of the economic development, majority of the people access the financial markets so that the financial development directly impacts/helps on the larger proportion of the society (Iyigun, & Owen, 2004). Since different theories provide the ambiguous and conflicting predictions in regard to the effects of the financial development on the income distribution, empirical studies are fundamental in solving this problem. The typical research that focuses on the link between the financial development and the income inequality should be based on the examination of the Gini coefficient-a measure of the variations from the perfect income equality. Using the data for the 83 countries over the period of 1960-1995, Clarke, Xu and Zou (2006) found out that the income inequality is lowered as the financial sector continue to deepen. However, the conclusion that non-linear of the financial development on the income inequality is not that robust. Another study by Beck, Demirguç-Kunt, and Levine (2007) attempted to examine the impact of the financial development on the innovation of the poverty and the income distribution. The study found out that there is a positive correlation between the financial development and the poverty reduction something that means that the financial development can reduce the Gini coefficient hence boosting the growth rate income for the poor. These two empirical studies share the common view that the financial development can effectively help in the reduction of the income inequality. However, the impact of the financial development on the income inequality are not clear. Additionally, the empirical results are limited to the impacts of the financial liberalisation on the poor and the income distribution from the survey of the Arestis and Caner (2004). Financial Development and Income Inequality around the World and Over Time The income inequality can be measured on the gross and on a net basis. The gross income excludes all the income from the non-private sources. The net income on the other hand includes all the types of the public transfers and the deductions. The net income measures the amount of the individual possesses and may use for the savings and consumptions (Iyigun, & Owen, 2004). Neither net income nor the gross income is the right instrument for the measurement of the market outcome. This paper, therefore, uses both the measures of the income inequality for the investigation of how the gross and the net income inequalities are affected by the financial development and the other explanatory factors or elements to illustrate the relation between income inequality and financial development. The income inequality can be measured with the Gini coefficients (Duclos, 2000). The Gini for the gross income and net income inequality is the normal distribution for the whole pooled sample having the mean of 44.3 and 38.4, standard deviation of 9.6 and 10.1, skewness of 0.36 and 0.41 respectively for the gross income and net income (Kawachi, & Subramanian, 2014). The income inequality is highest in the Sub-Saharan and Latin America. However, very high and increased levels of the gross income inequality is observed in the developed countries such as UK, US and Germany. The levels of the net income inequality is, however, much lower in the developed countries than the gross income inequality (Duclos, 2000). Contrastingly, even the countries that are widely considered as being equal, like Sweden, have found to have very high levels of the gross income inequality. This demonstrates that in the discussion involving equality aspects, one must be explicitly clear of whether the equality is constant compared to the gross inequality, unlike the United States and UK, where the gross and net inequality move in the parallel manner. The redistribution in the UK and U.S. is not responsive to the increase or decrease in the income inequality (Goda, Onaran, & Stockhammer, 2014). This is, therefore, a very interesting case on its own, as it shows how the different societies handles the issues of the income inequality distribution. The effect of the financial development on the income inequality is not explicitly clear. The estimation of the net income inequality and the financial development appears to generate the U-shaped response in inequality (Liu, & Wang, 2015). The fixed effect estimation can be used in the comparison of the levels of the income inequality across different countries. The correlation analysis of the net and gross Gini with the other explanatory variables that is used shows the net income inequality bears higher correlations with the most variables as compared to the gross income inequality (Duclos, 2000). From the theoretical review and with respect to some of the economic theories as aforementioned above, this study notes that the theoretical case of the financial development decreasing the gross income inequality might in fact be much weaker as compared to the case of the financial development decreasing the net income inequality. Additionally, the financial development may encourage the risk taking something that may increase the gross Gini; as the financial development may allow the countries and households in sharing their risks, thus leading to the reduction of the net Gini (Duclos, 2000). As expected the financial development is usually high with in the OECD countries, with the highest levels observed in the countries of Anglo-Saxon origin. The countries with the highest levels are the Luxembourg, United States, and Iceland. However, the financial development distribution across the various countries and time is not as normal as that of the income inequality. Financial Development and Inequality in Africa Not only is the levels of the poverty levels in Africa, but the income inequality as measured by the Gini-coefficient is also very high, although the African continent performs better than Caribbean and the Latin American. For instance, for the period 1992-2007, the Gini-coefficient for the African continent averaged at 0.44 while that of the Caribbean and Latin America averaged at 0.51. Tunisia and Cote d”Ivoire have the lowest Gini-coefficient average of 0.41 while Lesotho and Cameroon have the highest Gini-coefficient average of 0.54 (Ravallion, 2014). Generally, the level of the income inequality in the African countries, which are considered to be third world countries with high poverty indices have been observed to be very high and the persistent over the period (Rossouw, Claassens, & du Plessis, 2010). For Africa, not only are the financial systems shallow, but the access to the finance is also restricted because many people do have the pre-requisite factors to enable them obtain and demand financial services due to poverty and income inequality; hence hampering financial development. Generally, the access to the finance is lower in the poorer states than in the relatively developed states. For instance, Botswana has 481.4 deposit accounts per 1,000 people compared to the Madagascar that has 33.8 and only 6.1 for the DR Congo. The figures for the Mauritius and South Africa are 2,109.9 and 788.1 deposit accounts per every 1,000 adults (Menyah, Nazlioglu, & Wolde-Rufael, 2014). Additionally, in the countries such as Uganda, Ethiopia, Malawi and Zambia (where the poverty levels are very high) the loan accounts penetrations rates are usually very low (Batuo, Guidi, & Mlambo, 2010). Gini Coefficient (%) by Region Regions 1992-2007 Sub-Saharan Africa 44 China 47 Middle-east 37 Latin America 51 South Asia 35 East Asia-Pacific 43 Source: Unido Scoreboard database (2010) The development of the financial markets is very critical, not only for the long-term economic growth, but also for the reduction of the inequality. When Africa is compared with other regions such as East Asia, it’s found that the financial system in Africa lacks the appropriate depth and breath. For instance, measured by the money supply (M2) to the GDP, in 1980s, the financial markets/systems in the East Asia had relatively the same level of the depth at the 31% of the GDP. Consequently, by 2008, the financial depth in the East Asia had relatively increased to reach the 130% of the GDP compared to that of the Africa that still remains very low at 38% (Gupta, Pattillo, & Wagh, 2009). This trends is evident of the shallow financial markets and the growing inequity between the financial development and income inequality in Africa. Therefore, the financial developments is very essential for the reduction in the income inequality in the African countries. By widening the access to the financial markets, specifically by targeting those that are at the lower levels of the income cohorts and the rural populations will be helpful in the reduction of the persistent income inequality gap in the African continent. The financial policy reforms should focus on the encouragement of the better access to the financial service by segments of the community. Conclusion Despite the common agreement of the link between the financial development and the income inequality that states that the financial development helps in the reduction of the income inequality and the improvement on the economic growth, this doesn’t always mean that this conclusion is relevant for any country. Over the recent past the world has experienced the increasing financial development and income inequality in the many countries, especially the developed countries. The earlier empirical research on the nexus between the financial development and the income inequality confirms the diminishing impact of the financial development. This research explores that there is existence of the long-run relationship between the financial development and the income inequality in Africa. This research paper has examined the effect of the financial development on the income inequality and more specifically on African continent. The empirical results in this paper indicates that underdevelopment and imperfection of the financial sectors leads to the increased income inequality. With the strong supporting evidence of the financial development and income inequality in Africa and other countries, it can be deduced that the depth of the financial markets helps to alleviate poverty. However, other effective methods such as social welfare and the economic growth can be used to address the problem of the income inequality. Bibliography Allen, F., & Gale, D., 1999. Innovations in financial services, relationships, and risk sharing. Management Science, 45(9), 1239-1253. Arestis, P., & Caner, A., 2004. Financial liberalization and poverty: channels of influence. Atje, R., & Jovanovic, B, 1990. Stock markets and development. European Economic Review, 37(2), 632-640. Banerjee, A. V., & Newman, A. F., 1993. Occupational choice and the process of development. Journal of political economy, 274-298. 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