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December 28, 2012 | Research Feature

Minding the Gap

As financial markets deregulate, income inequality grows.


In September 2011, the Occupy Wall Street movement took its grievances about income inequality between the “99 percent” and the rich, particularly bankers and investment companies, to the sidewalks of New York City and beyond. Its movement, Occupy said, represented the frustration of middle-class employees, unemployed college graduates, and unskilled workers across the country and around the world.

“The Occupy movement was concerned that 1 percent of people were getting really rich while the wages of the bottom 99 percent of earners stagnated,” says Professor Mauricio Larrain. “Previous research has found that an economy full of inequality doesn't allow a democracy to work well and leads to social unrest.”

Even within the ranks of the 99 percent, Larrain says, there is growing wage inequality. According to the Bureau of Labor Statistics, employees with bachelor's degrees earned $1,053 per week on average in 2011, compared to $638 for those with high school diplomas. Between 1980 and 2005, the wage gap between workers with some college education and those with only high school education increased by 25 percent. Increasing wage inequality in the United States, most notably between skilled and unskilled workers, is believed to be a key factor in the financial crisis of 2007–08. As the gap between college-educated top earners and everyone else widened, politicians responded by relaxing financial regulations that in turn eased consumers' access to credit.

But why has wage inequality between skilled workers — those with college educations who perform non-routine tasks — and unskilled workers, who usually have only a high school education and perform routine tasks, increased in the last few decades, both in the United States and abroad?

For an answer, Larrain followed the Occupy lead and looked at Wall Street and the finance markets. He noticed that the increase in income inequality paralleled a period of financial liberalization fueled by deregulation policies in US states and European countries. In the United States, banks were restricted from branch expansion both within and across state lines prior to the late 1970s. At that time, states began lifting these restrictions, a decade-and-a-half–long process that culminated in the 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act, which allowed bank holding companies to acquire banks in any state. European countries followed a similar trend starting in the 1970s.

For the United States, Larrain calculated wage inequality using the Current Population Survey (CPS), which provides national household wage and education data. He compared wages and education levels before and after the dates when each US state eliminated geographical restrictions on banking. Similar information from the EU-KLEMS dataset (which collects information on labor and wages by education level) provided a comparison of wage inequality and financial liberalization for European countries.

Larrain found that when an economy deregulated its financial markets — whether a US state or a European country — wage inequality increased the most in industries where employees conduct very routine tasks, such as manufacturing. (View chart; JPEG 44 KB) Although other sectors — such as retail — also employ unskilled workers, those fields in which machines, computers, and equipment can perform routine tasks and replace unskilled workers experienced greater increase in wage inequality.

“When an economy liberalizes its financial market, much more credit is going to flow to companies from banks in the form of loans. With these funds, companies can buy capital — those machines and computers [that can replace unskilled labor] — that need to be operated by skilled workers,” Larrain explains. “That leads to an increase in the demand for workers with college educations, while reducing the need for unskilled workers.”

Although financial liberalization is not the only factor in increasing wage inequality, Larrain found that liberalization accounts for about 20 percent of the overall increase in income disparity in the United States and the United Kingdom in the last three decades.

One implication for policymakers, Larrain says, is for the government to temper wage inequality by promoting policies that increase the number of college-educated workers. “With more skilled employees on the market — increased human capital — the supply can better meet the demand, the two groups’ salaries level out, and everyone wins. This might mean reforming government student loans or providing specialized training that will help more people attain the skills they need.”

Larrain says that while there are many dimensions to understanding the connection between financial markets and the macro-economy, focusing on wage inequality is an important start. “There is a clear link between Wall Street and Main Street that we don’t understand well enough.”

Mauricio Larrain is an assistant professor of finance and economics at Columbia Business School.

Read the Research

Mauricio Larrain

"Capital Account Liberalization and Wage Inequality"

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