The risk of financial crises: Is there a role for income inequality?

• Our results are based on a dataset of 14 developed countries over the 1870–2008 period.
• We use both in-sample and out-of-sample analyses.
• Income inequality is found to have the highest individual predictive power of financial crises.
• The role of bank loans diminishes considerably when controlling for other factors.
• Income inequality is found to be a relevant predictor of financial crises especially when it is at a relatively high level.

Could macroeconomic factors such as income inequality be the real root cause of financial crises? We explore a broad variety of financial and macroeconomic variables and employ a general-to-specific model selection process to find the most reliable predictors of financial crises in developed countries over a period of more than 100 years. Our in-sample results indicate that income inequality has predictive power beyond loan growth and several other financial variables. Out-of-sample forecasts for individual predictors show that their predictive power tends to vary considerably over time, but income inequality has predictive power in each forecasting period.