Is Piketty too Pessimistic on Financial Development and Inequality?

Thomas Piketty’s recent book on inequality, the enormously popular best-seller Capital in the Twenty-First Century, explores the historical evolution of income and wealth inequality and its possible drivers.  The book demonstrates that developing as well as developed economies have seen a big upswing in income inequality in recent years, as measured by the share of total income accounted for by the top percentile:

Source: Chart adapted from Piketty’s originals by The New Yorker

Source: Chart adapted from Piketty’s originals by The New Yorker

Although the book is based on careful and painstaking empirical work when it comes to documenting these trends across a fairly broad set of countries, it’s less empirically driven when it comes to its discussion of how underlying factors, such as financial systems and financial development, may influence inequality and its evolution.

One perspective expressed in Capital is that while financial development has the potential to benefit all, it may in fact benefit the wealthy more than the relatively less well-off.  The wealthy may have better access to financial instruments, may be willing to take greater risks with their investments, and may be able to hire money managers to earn greater returns on their investments than would be realized for the less fortunate, leading to even greater inequality.

In Piketty’s words:

Is there a danger that the forces of financial globalization will lead to an even greater concentration of capital in the future than ever before?  Has this not perhaps already happened?  ... Many economic models assume that the return on capital is the same for all owners, no matter how large or small their fortunes.  This is far from certain, however:  it is perfectly possible that wealthier people obtain higher average returns than less wealthy people.  There are several reasons why this might be the case.  The most obvious one is that a person with 10 million euros rather than 100,000, or 1 billion euros rather than 10 million, has greater means to employ wealth management consultants and financial advisors.  If such intermediaries make it possible to identify better investments, on average, there may be ‘economies of scale’ in portfolio management that give rise to higher average returns on larger portfolios...

But what does the existing empirical work on this issue say?  The empirical evidence, to the extent that it exists, appears to support a different story.  A 2007 paper from researchers at the World Bank and Brown University uses a cross-country panel data analysis to argue that financial development reduces inequality and poverty. 

The authors – Thorsten Beck (World Bank), Asli Demirguc-Kunt (World Bank), and Ross Levine (Brown University) – construct a unique dataset of financial development to test their hypotheses, called the Financial Structure Database.  Their primary measure of financial development is Private Credit, or the ratio of the value of private credit extended by financial intermediaries to the private sector to GDP. 

They find that looking across countries and over time, financial development (1) reduces income inequality, (2) disproportionately raises the incomes of the poorest quintile, and (3) reduces poverty, as defined as the share of the population living on less than $1 per day.  They attribute approximately half of the poverty-fighting effects of financial development to its effects on overall growth, and approximately half to its effects on inequality.

This analysis isn’t perfect – it relies on panel methods applied to cross-country data that are known to have flaws – but it is broadly consistent with what we know from studies looking within developing countries on the effects of expanded financial access on poverty.  A complementary study by Burgess and Pande (2005) looking at the effects of expansions in rural bank branching in India during the 1970’s and 1980’s finds similarly that expanded financial access reduced rural poverty.

The study by Beck and co-authors is fairly broad in its definition of financial sector development, and it provides few guides as to which types of policy interventions might best target the poor.  It leaves plenty of room for additional research to understand whether and how more targeted interventions might matter.  But to the extent that we can see, the data paint a brighter picture of the effects of financial sector development on poverty and inequality than presented in Piketty’s influential Capital.