Income distribution and the current account

In this paper, we investigate whether changes in income distribution can explain current account developments in a sample of 20 countries for the period 1972–2007. We analyze the relationship between the personal and the functional income distribution in our sample, before disentangling their effects on the current account. A consistent finding is that rising (top-end) personal inequality leads to a decrease of the current account, controlling for standard current account determinants. By contrast, a fall in the share of wages in national income leads to an increase in the current account. We further analyze how different measures of income distribution affect the financial balances of the household, corporate and government sectors and discuss potential theoretical explanations of our findings. We conclude that changes in personal and functional income distribution have contributed considerably to the widening of current account balances, and hence to the instability of the international economic system, prior to the global financial crisis starting in 2007.