Financial Liberalization, Capital-skill Complementarity, and Wage Inequality∗

Financial liberalization should reduce borrowing constraints and increase capital demand according to theory. If production functions exhibit capital-skill complementarity, liberalization should increase the aggregate demand for skilled labor relative to unskilled labor, increasing wage inequality in equilibrium. This paper studies the effects of financial liberalization on inequality through this theoretical channel. In particular, I test whether financial liberalization increases wage inequality, particularly in industries that are relatively more in need of external finance and have a strong degree of capital-skill complementarity. The test is conducted by studying two episodes of financial liberalization: deregulation of domestic financial markets across a group of countries (mostly European), and bank branch deregulation across U.S. states. I provide evidence that, in both episodes, financial liberalization led to a substantial increase in wage inequality in industries with high financial needs and strong complementarity. I also find that the differential effect on relative wages is particularly strong in economies with rigid labor markets, while the effect on relative labor flows is stronger in economies with flexible labor markets. I calibrate a two-sector general equilibrium model with capital and labor market frictions and analyze the effect of liberalization on aggregate wage inequality. I find that the contribution of financial reform to the rise in aggregate inequality on several countries starting in the 1980s is sizable. ∗I am extremely grateful to Yuriy Gorodnichenko, Ted Miguel, and especially Atif Mian for their encouragement and support throughout this project. Comments by David Card, Fred Finan, Mitchell Hoffman, Michal Jerzmanowski, Ross Levine, Ulrike Malmendier, Andres Rodriguez-Clare, David Romer, Emmanuel Saez, Alex Solis, Juan Carlos Suarez, seminar participants at UC Berkeley, PAC-DEV (UC Berkeley), Midwest Macro Meetings (Vanderbilt University) are also gratefully acknowledged. I am responsible for all remaining errors. I am grateful for financial support from the Kauffman Foundation and the Center for Equitable Growth at UC Berkeley. †Address for correspondence: Department of Economics, University of California at Berkeley, 530 Evans Hall, Berkeley, CA 94720. Email: [email protected]. Webpage: http://econgrads.berkeley.edu/mlarrain/.