Pascal Paul

To understand the determinants of financial crises, previous research focused on developments closely related to financial markets. In contrast, this paper considers changes originating in the real economy as drivers of financial instability. To this end, I assemble a novel data set of long-run measures of income inequality, productivity, and other macrofinancial indicators for advanced economies. I find that rising top income inequality and low productivity growth are robust predictors of crises, and their slow-moving trend components explain these relations. Moreover, recessions that are preceded by such developments are deeper than recessions without such ex-ante trends.

Financial crises occur out of prolonged and credit-fueled boom periods and, at times, they are initiated by relatively small shocks that can have large effects. Consistent with these empirical observations, this paper extends a standard macroeconomic model to include financial intermediation, long-term loans, and occasional financial crises. Within this framework, intermediaries raise their lending and leverage in good times, thereby building up financial fragility. Crises typically occur at the end of a prolonged boom, initiated by a moderate adverse shock that triggers a liquidation of existing investment, a contraction in lending, and ultimately a deep and persistent recession.