Is Rajan’s Hypothesis Confirmed by Empirical Evidence? A Critical Review

Abstract

Based on experience in the United States in recent decades, Rajan (2010) argues that there is an inequality-debt-crisis nexus, that is, income inequality may contribute to banking crises by stimulating the accumulation of household debt. Whether and to what extent Rajan’s hypothesis has been confirmed (or refuted) by the literature is investigated in this study. It is shown that the validity of Rajan’s theory depends on the level of strictness of the standards that are established to estimate the extent of agreement between theory and evidence. This conditional validity can be attributed to the multidimensional nature of the inequality-debt-crisis nexus, which is overlooked by Rajan. JEL Classification: D31, E51, G21, G51

On the Dynamic Relationship between Household Debt and Income Inequality in South Africa

“…Their study argues for consideration of the variables used in empirical studies and how they are interpreted. In Xu's (2022) study only one study supported the hypothesis.…”

“…Moreover, the international literature on inequality and household debt is inconsistent as some empirical studies have concluded a positive relationship whilst on the other hand others have found the relationship to be negative (Berisha et al 2021;De Vita and Luo 2021;Lombardi et al 2017). Xu (2022), for instance, uses a systematic literature review and finds the Rajan hypothesis questionable. Their study argues for consideration of the variables used in empirical studies and how they are interpreted.…”

“…In addition, some studies have investigated the relationship between income inequality and other measures of financial development (Koh et al 2020;Thornton and Tommaso 2020;Sotiropoulou et al 2023). Whilst broader measures of financial development signal the importance of income inequality in driving financial depth, Xu (2022) argues that some measures may not be appropriate in explaining the finance-inequality conundrum. Instead, household debt and specifically mortgage debt is argued to be more appropriate in the analysis.…”