Investment Strategy:  First Quarter 2022 – For Richer, For Poorer

For Richer, For Poorer

The last couple of years has seen an acceleration of many trends, some are obvious such as increased working from home, video-conferencing or online shopping, but one has been steadily building for the last 35 years and the pandemic has exposed it for all to see. Increasing wealth inequality is happening across many countries and across many divides, whether that be race, gender, generation or class. In what will form a series of articles, in this piece our Assistant Investment Manager, Finlay Holland, tackles rising wealth inequality between the generations.

Boom Time

The impact of the Baby Boomer generation has been well documented, but I wanted to briefly explore why they came to such prominence. Their size relative to the generations that followed and preceded them was significant (all figures US), 23 million in the Silent Generation, 65 million Gen X, and 71 million baby boomers (people roughly born between 1946-1964). Their relative size has been described by Goodhart & Pradhan[1] (G&P) as a ‘Demographic sweetspot’, as through the 70’s and 80’s reduced fertility rates and greater longevity were responsible for pushing dependency ratios lower, meaning the number of those of working age rose sharply relative to the dependent young and dependent old. This resulted in a mass of broad-shouldered baby boomers to bear the associated cost. On top of this, G&P go on to attribute much of the economic boom of this period to the emergence of China’s labour market, which could deliver cheap goods to developed market consumers in an ever more globalised economy. This allowed domestic economies to grow faster than they otherwise would have done, and companies enjoyed a golden era of higher profits. The economic boom paired with lower financial pressure from generational dependents allowed significant wealth accumulation for this generation. Their wealth and size allowed them enormous political influence and an era of extensive deficit spending followed. This can be illustrated by looking at the history of US government debt. Even before the pandemic, debt was at $22tn and 107% of GDP and has broadly risen since the mid 70’s. This level of public spending hugely benefitted the generations that lived through it. One of the driving forces of this generational inequality has been a prolonged trend of lower interest rates, which we will now explore in how they perpetuate wealth inequality.

Why Rates Matter

There have been several studies look at causes of the neutral interest rate lowering over the years. This is the interest rate that is expected to prevail once output is at a sustainable level and inflation at target. One key aspect of this is the supply of savings, which is seeking return. If there is a greater supply of available funds than there is demand for credit, then rates must decrease to attract borrowers. It is generally accepted that this is a core factor for the trend in lower rates, what is debated is whether this is as a result of growing income inequality between generations or between high and low earners (Likely a bit of both). Whichever way you slice it, as wealth increases, the marginal propensity to consume is reduced and the proportion of savings is increased, so when greater amounts of income is held by the rich, a lower proportion of that money is actually spent in the real economy and more is saved. This has a number of effects, the first being, if wealthier people are holding greater amounts of income, save more than the less wealthy, and have a desire to increase their wealth, then there is an increasing amount of savings searching for a return, which puts downward pressure on rates. Rates then fall far enough to encourage borrowing, which is generally done by lower income households. In terms of national expenditure, it is the lower income households that really drive spending which accounts for about 70% of US GDP. There is a follow-on effect of this which I will come to shortly, but firstly let us explore how lowering rates impacts asset prices.

As rates fall, asset prices rise because most assets are valued by discounting future cash flows back to today. If a cash flow for an asset was discounted at 3% p.a. for 10 years but rates subsequently fall, then those same cash flows become more valuable in today’s terms, which drives the value of that asset ever higher. Another driver is liquidity, as rates decrease and asset prices increase, banks feel comfortable lending more and consumers feel better off because debts they already have can be refinanced on cheaper terms and this increases disposable income, which is why rates are cut in a recession to try and encourage demand. Thus, if there is an increase in the supply of money then this can encourage spending and borrowing as people look to move to a bigger house, buy a second home or other assets, such as stocks or bitcoin. Since both liquidity and transactions increase this drives the prices of those assets, making those who already hold the assets ever wealthier and further increases the gap between the ‘haves’ and the ‘have-nots’. The Boomers saw this play out in the housing and stock markets. The 1980’s and 1990’s witnessed particularly strong returns for equity markets as well as the tremendous run following the Global Financial Crisis (GFC). To make matters worse for wealth equality, whilst those with assets have seen wealth soar, real wages have stagnated as inflation over the last decade has been hard to muster despite lower and lower rates. In short this is a core reason why rates matter, they drive the self-perpetuating feedback loop of wealth inequality, an increasing share of income goes to the wealthy, excess savings of the wealthy depresses rates and low rates push up asset prices (mostly owned by the wealthy).

Now to revisit the earlier point on lower income household spending. As rates are reduced to the point that lower income households can afford to borrow (often out of necessity), the debt is a call on that household’s future income, which reduces their future spending in order to service the debt. If inflation is low then wage growth is likely to be low, meaning the debt servicing cost as a percentage of disposable income stays broadly the same instead of decreasing as it would in a more inflationary environment. This permanently reduces total spending in the households who typically spend a greater percentage of their income on consumption, which suppresses growth in the economy. Not only this but as rates are lowered and debt levels rise in households, the economy becomes more fragile and prone to financial crises. As a speech by Gertjan Vlieghe[2] (external Monetary Policy Committee member) highlights, this increases the tail risk of macroeconomic outcomes (i.e. makes crises more likely) which means central bank rates must remain low so they don’t destabilise the fragile economy. Further cause for concern is that once rates enter the lower bound, the effectiveness of lowering rates in a crisis becomes less and thus potential severity of the crisis increases. This is something we have experienced post the GFC with Quantitative Easing (QE) being brought in to bolster easy monetary policy, QE further increases demand for assets and forces rates down.

Inequality & Social Mobility

This brings us to the current situation, one where wealth inequality is one of the most prominent problems our society faces, none more so than because greater wealth inequality is linked with lower social mobility. This is something which Miles Corak[3] has researched extensively, exploring ‘intergenerational earnings elasticity[4]’ (vertical axis). This tries to express the degree to which a child’s earnings are attributable to their parent’s earnings, essentially a lower elasticity means a society with greater mobility. This data is plotted against an inequality measure known as the Gini coefficient (horizontal axis), which come together to form what is known as the Gatsby Curve (Figure 1). This shows an empirical link in countries where income inequality is high correlating with lower social mobility. The data is inherently backward looking and with social mobility we have to wait for children to grow up and enter the labour market, so the most recent studies are on children that were born in the 1980’s. However, wealth inequality data can be much more recent so if the relationship between the two variables is causal rather than just correlational then we can use this to shape policy which looks to reduce further income inequality. Either way, given the direction of the data, things do not look promising especially for young Americans. Data from the Federal Reserve showed that for the first time since they began collecting wealth distribution data in 1989, this year, the top 1% of earners held more than the middle 60%. Furthermore, Congressional budget data showed that share of national income taken home by the middle 60% of earners had reduced between 1979 and 2018 from 50.8% to 45.1% and the share taken by the top 20% over that time had increased to 49%. The latter data is pre-pandemic so given what we know of the divergence that has occurred, I expect that data will now be meaningfully worse.

So why should we be concerned about low social mobility anyway? The problem with having a society with low social mobility is that it discourages younger people from low income households from participating in the labour market or pursuing higher education as a means to move up the socioeconomic ladder, since so many life aspirations such as owning a house, having a decent retirement, or being able to afford to start a family seem so frightfully out of reach. They become disaffected by a society which they see as working against them, in other words the antithesis of the ‘American dream’. Over time, this gap pulls at the very threads of our social fabric and destabilises our society, politically fuelling the rise of populist leaders and economically creating two groups; the ‘haves’ and the ‘have-nots’, with little discourse encouraged to bridge the space left behind. It is of course unrealistic to achieve a society with complete equality of opportunity, but if as a society we do not reinforce the message that people can change their circumstances through hard work then we’re all equally de-stabilising the very base we all stand on. This all sounds quite scary, but recognition is the first step and the pandemic has highlighted some of the flaws of our current system. This has not gone unrecognised by politicians around the world and next time we will look at what solutions lawmakers are considering to reverse this trend.

[1] BIS Working Papers No 656 Demographics will reverse three multi-decade global trends by Charles Goodhart and Manoj Pradhan

[2] Running out of room: revisiting the 3D perspective on low interest rates Speech given by Gertjan Vlieghe

[3] Inequality from generation to generation: The United States in Comparison by Miles Corak

[4] The percentage difference in earnings of a child’s generation that is associated with the percentage difference in the parental generation.

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