Mauricio Larrain

Does Financial Liberalization Contribute to Wage Inequality? The Role of Capital-skill Complementarity

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Abstract:
Financial liberalization alleviates borrowing constraints, allowing firms to demand more capital. If firms exhibit capital-skill complementarity, liberalization should increase the demand for skilled labor relative to unskilled labor, increasing wage inequality in equilibrium. This paper estimates the causal effect of liberalization on inequality by exploiting differences in external financial dependence and capital-skill complementarity across industries. I analyze two independent episodes of reforms: deregulation of financial markets across countries primarily within Europe and bank branch deregulation across states within the U.S. My findings indicate that financial liberalization increases wage inequality disproportionally in industries with both high financial needs and strong complementarity. The differential effect on inequality is particularly strong in economies with rigid labor markets. I develop and calibrate a simple two-sector model with capital and labor market frictions to analyze the effect of liberalization on aggregate wage inequality. According to a back-of-the-envelope calculation, the contribution of financial reform to the rise in inequality in the U.S. and the U.K. during the last decades is sizable.

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