Why Does Inequality Matter?
The phenomenon of increasing wealth inequality has emerged as one of the major socio-political issues of our time. Whether you turn to TV stations, newspapers, or internet blogs to keep up to date with news and current events, there’s a good chance that you have already seen the topic come up with increasing regularity.
Like other hot-button issues in contemporary political dialogue, arguments are raised regarding inequality’s root causes, the most effective policy prescriptions, and even whether it is even a problem in the first place.1 The fact that the wealth gap is indeed widening, however, is one rare point of general agreement, no matter one’s views on those other questions.
Take, for instance, the August 2017 New York Times piece by David Leonhardt titled “Our Broken Economy, in One Simple Chart.” Leonhardt leads with a chart depicting the differences in income growth between 1980 and 2014, broken down by income percentiles. While those in the lower percentiles once saw higher income growth than those in the top, the situation flipped by 2014 in dramatic fashion, resulting in the so-called “hockey stick” curve, where income growth only skyrockets well into the top decile, particularly at the 99th percentile. Additional charts throughout Leonhardt’s piece all indicate a shift in the distribution of income growth over the past several decades, ramping up significantly in the last few years.
Ray Dalio Enters the Fray
While TV pundits and newspaper columnists continued to argue over the seemingly widening inequality, a LinkedIn blog post penned by famed hedge fund manager Ray Dalio surfaced in April of this year and kicked off another explosion of press coverage.2 Dalio, the billionaire founder of Bridgewater Associates, the world’s largest hedge fund as measured by discretionary assets under management, uses the blog post to defend his thesis that “capitalism is now not working for the majority of Americans.”
In the piece, Dalio acknowledges the productive power of capitalism, which he defines loosely as “the ability to make money, save it, and put it into capital.” At the same time, he believes capitalism has produced “self-reinforcing spirals” that in turn have created “widening income/wealth/opportunity gaps that pose existential threats to the United States.” By the end of Part 1, Dalio connects the phenomenon of widening inequality to the civil unrest and increasing ideological polarity that has led to the rise of populist political leaders worldwide as well as in the U.S.
Dalio engages with the ideas in his post from a systems engineering standpoint, placing emphasis on structural features of the economy. To that end, he slices and dices the data to produce graphs and statistics on such topics as income mobility, education, and health. While the structural reforms Dalio proposes are generally quite vague, he does more clearly spell out a series of investments he recommends focusing on. Areas that he believes have “great double bottom line investments for the country” include programs in early childhood education, microfinance, infrastructure, and public health.
Where the Fed Fits In
Although easy to miss amidst the many charts and statistical discussions of poor social outcomes and seldom discussed in mainstream media channels, Dalio regards the Federal Reserve as a key player in his “diagnosis of why capitalism is now not working well for the majority of people.”3 Recognizing that “reality works like a machine with cause/effect relationships,” Dalio states the following, emphasis added):
Central banks’ printing of money and buying of financial assets (which were necessary to deal with the 2008 debt crisis and to stimulate economic growth) drove up the prices of financial assets, which helped make people who own financial assets richer relative to those who don’t own them. When the Federal Reserve (and most other central banks) buys financial assets to put money in the economy in order to stimulate the economy, the sellers of those financial assets (who are rich enough to have financial assets) a) get richer because the financial asset prices rise and b) are more likely to buy financial assets than to buy goods and services, which makes the rich richer and flush with money and credit while the majority of people who are poor don’t get money and credit because they are less creditworthy.
Shortly thereafter, Dalio runs through a causal chain of events that he believes brought the United States economy to this point. Notably, central bank quantitative easing policy is the second entry on the list, preceding the widening inequality gap, rise of global and domestic populism, and social and military conflicts that Dalio fears will result. He largely repeats the same points as the quotation above when he states that the quantitative easing policies pursued by central banks following the debt crisis of 2008 “pushed asset prices up and pushed interest rates down,” which largely served to “benefit those with financial assets (i.e., the haves).”
Inequality and the Federal Reserve
That there is a causal relationship between central bank policy and the price of financial assets, is far from some esoteric economic theory. Even President Trump has implicitly recognized the connection between Federal Reserve policy and US stock market performance in the following tweet4:
If the Fed had done its job properly, which it has not, the Stock Market would have been up 5000 to 10,000 additional points, and GDP would have been well over 4% instead of 3%…with almost no inflation. Quantitative tightening was a killer, should have done the exact opposite!
— Donald J. Trump (@realDonaldTrump) April 14, 2019
In response to the general pressure exerted by the Trump administration, Federal Reserve Bank of Kansas City President Esther George was recently quoted saying, “Lower interest rates might fuel asset bubbles, create financial imbalances, and ultimately a recession.”5 Despite opposing President Trump’s wishes, Ms. George’s quote is perfectly consistent with the implications of his above tweet, as well as with Ray Dalio’s discussion of the consequences of central bank policy following the debt crisis of 2008.
Plenty of others are also taking notice of the apparent relationship between central bank policy and widening inequality. For instance, Twitter user Nid had this to say:6
Most important, least covered story in 20 yrs: Fed’s ongoing interference in Capital Mkts; inflating assets; devaluing savings, wages and productivity; promoting Corp malfeasance and balance sheet engineering; creating massive income and wealth disparities.
— Nid (@Jstoner64) March 8, 2019
Albert Gallo, a partner at Algebris Investments, corroborates Dalio’s central bank narrative, brief as it is, and places the brunt of the blame at the feet of central banks. In the April 26 Bloomberg article appropriately titled “Central Banks Have Broken Capitalism,” Gallo draws attention to the fact that central banks have injected “unprecedented amounts of cash into the global financial system” for a decade now, propelling stock market prices to record highs while also driving global debt to “more than three times world gross domestic product.” Meanwhile, sustained ultra-low interest rate policies have led to more leverage and risk in stock markets and increasing inequality by “giving large firms an advantage through cheap funding in bond markets.” In Gallo’s view, the unprecedented actions undertaken by central banks during the financial crisis of 2008 may have cushioned downturns until now, but only but in the process “have turned capitalism into a short-sighted game of kick-the-can.”
Meanwhile, over in the pages of the Economic Equality blog, Karen Petrou notes how prevailing economic orthodoxy assumes that extremely low interest rates promote equality by allowing more people to access debt. However, the ultra-wealthy have access to the best wealth managers and have a much better chance of beating zero or negative market returns. Low and middle-income households face a considerably more difficult situation, as quantitative easing has driven out asset classes that have traditionally provided lower but more stable returns. In addition, the connection between low interest rates and increased lending rates is also empirically dubious, as bank loans are less profitable as interest rates approach zero.7 In short, Fed policy has been great for hedge fund managers like Ray Dalio, but not for low-income households who have been largely frozen out of the loan market.
In his LinkedIn post, Dalio notes that real wages net inflation have not risen since the 1970s, It is curious, however, that he and many media pundits have quoted statistics to that effect without considering the other side of “real” economic variables.8 In short, changes in “real” variables over time can stem from movements in two different metrics, namely the nominal value of the variable in question and the rate of inflation. The stagnation of real wages, then, means that nominal wages have largely kept pace with inflation over the decades under observation.
To illustrate with a very simplified example, imagine that you earn $50,000 per year and the inflation rate during that time is 1%. If your salary remains the same at the start of the next year, your nominal income will still be $50,000, although your real income is now only $49,500. This is because goods and services cost 1% more than they did during the previous year, reducing your purchasing power to only 99% of what you enjoyed the year before. Of course, your salary may also rise to offset the inflation, as would be the case if you now earned $50,500. In this example with a 1% inflation rate and $50,000 base salary, it would take a pay raise greater than $500 per year to see an increase in real income.
Michael Lebowitz draws attention to the pernicious inequality-generating effects of inflation in his article “Two Percent for the One Percent.” Lebowitz draws attention to the disparate effects of the Federal Reserve’s targeted 2% annual inflation on those living paycheck-to-paycheck versus those with a portion of their wealth in financial assets.9 While those who consume most of their income and consequently invest very little struggle to maintain their standard of living, the wealthy are in a much better position to take advantage of investment products that can keep pace with inflation and benefit from financial leveraged that low interest rates make more accessible. Lebowitz concludes by pointing out how steady inflation “drives a negative feedback loop,” as those who suffer most under the inflation face an incentive to consume more in the present in expectation of future inflation.
The Cantillon Effect
Inflation can thus be considered a “silent tax” that decreases the purchasing power of wealth held in cash.10 Meanwhile, there is an additional aspect of inflation that further benefits the well-connected while leaving lower-income households to deal with the adverse consequences. To use economics jargon, money is not truly “neutral,” meaning that new injections of money into the economy do not lead to higher prices all at once. Instead, different sectors of the economy adjust to the increased money supply at different times.
This piece published by the Foundation for Economic Education explains the mechanisms of what is now referred to as the “Cantillon Effect,” named after 18th-century French economist Richard Cantillon. Cantillon posited that those who first receive newly created money can enjoy purchasing goods and services at old prices before adjustment has taken place resulting from the increase in the money supply. Instead, prices adjust gradually as the new money filters throughout the economy. In the end, those who are furthest removed from the source of the money creation are most negatively impacted by inflation, as they faced higher prices before a commensurate rise in nominal money.
So what does this mean in our economy today?
When the Federal Reserve announces any form of quantitative easing, investors expect prices to rise and seek to enter financial markets, bidding up the prices of these financial assets. Companies and individuals already holding financial assets enjoy this windfall and can in turn invest and consume at old prices using the new profits. Gradually, the new money travels through the economy, bidding up the costs of resources until prices have adjusted to the new supply of money. Wage earners face higher living costs before their incomes can rise commensurately and must demand raises over time to maintain their old purchasing power. While inflation does not affect real economic factors, in the long run, it does affect how resource prices adjust in the short run and serves to aggravate the phenomenon of widening wealth inequality.
As Ray Dalio warns in his LinkedIn post, a failure to understand why income inequality is becoming more extreme and how to change the situation could result in “a great conflict and some form of revolution that will hurt most everyone and shrink the pie.” Yet, it is still rare to hear mention of how central bank policies benefit the wealthy and well-connected while comparatively damaging the purchasing power of low-wage workers and households that rely upon savings rather than financial markets.
At CNote, we are committed to growing the pie of wealth by providing those otherwise excluded from the banking system the access to capital they need to pursue their entrepreneurial dreams and build businesses that increase prosperity for all. By investing with CNote, you can earn an annual return of 2.75%, more than keeping pace with the Federal Reserve’s stated inflation target, while making a real impact in the lives of many in underserved communities.
We hope you will consider joining us in our mission to give those struggling in our economy the tools they need to build a better life for themselves, their families, and their communities. Changing macroeconomic policy may seem too daunting, but that doesn’t mean we cannot drive change at a micro level.