Distributional Effects of Crises: The Financial Channel

Who pays for financial crises? What are the mechanisms for spreading the cost across different social groups? The literature is only beginning to provide answers to these crucial questions. Several papers measure the depth and duration of crises, defined as the cumulative output loss and recovery time, and conclude that these crises have been very costly for developed and emerging economies. The period 1973-97 registered more than forty-four crises in developed countries and ninety-five in emerging markets, with average output losses of 6.25 percent and 9.21 percent of gross domestic product (GDP), respectively.¹

Crises do not hit all groups of people equally. Several papers analyze how crises affect different ranges of the income distribution; they identify four main channels through which crises affect households and, in particular, the poor.² First, financial crises generally lead to slowdowns in economic activity and, consequently, to a reduction in labor demand. Adverse income and employment shocks hurt the poor the most, because they do not have the means to protect themselves. They lack assets to hedge against these shocks and often have no direct access to credit markets to smooth their impact. Furthermore, unskilled workers (typically poor people) are often the first to lose their jobs, as firms hoard their trained labor force.³ Second, financial crises affect both the wealth and income of the poor through high inflation, which tends to accompany crises and their resolution. Since the poor normally hold a greater proportion of their wealth in cash than do the nonpoor, they tend to be more strongly affected by the increased rate of inflation (which is a tax on money holding). Inflation also leads to a decline in real wages, since nominal wages are not perfectly linked to the price index. This affects the poor more than the rich because poor people do not have capital rents, such that labor earnings constitute a much larger share of their total income. Third, crises may cause changes in relative prices that hurt the poor by aggravating the fall in real wages. Currency depreciation (which is usually associated with crises) may affect the price of imported food, increasing domestic food prices and thus hurting poor households that are net consumers of food.⁴ Fourth, the public spending cutback that is conventionally implemented in response to financial crises causes a severe impact on poor families. Public expenditure cuts, beyond causing declines in labor demand, affect cash transfers to households and the provision of social services. These cuts tend to hurt those who rely on public services, mostly the poor.

The common conclusion from this literature is that the poor are more strongly affected than the rich, but precise results vary across countries and episodes. Lustig shows that out of twenty crises in Latin America, all were followed by an increase in the poverty headcount ratio and fifteen of them by a rise in the Gini coefficient.⁵ Regarding the social costs of the East Asian financial crises of 1997-98, the evidence also indicates large impacts on poverty. In Indonesia the incidence of poverty rose from 11.0 to 18.0 percent in 1996-99, while in South Korea the urban poverty headcount index rose from 8.5 to 18.0 percent in 1997-98.⁶ Detailed studies of the Mexican crisis of 1994-95 show that the incidence of poverty increased between 1994 and 1996, although the richest ten percent also experienced losses and inequality dropped.⁷ Lokshin and Ravallion, who study the welfare impact of the 1998 Russian crisis, find that the expenditure-poverty rate rose by almost 50 percent from 1996 to 1998.⁸

In this paper we argue that the recent literature overlooks an important channel: the financial channel. We focus on financial crises that involve bailouts and ask who pays for bailouts and how bailouts affect income distribution. We first analyze transfers from nonparticipants to participants...