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Thomas Piketty and Inequality

I haven’t read this book, but judging from the blog reviews, it seems that is central point is that if the return on capital is higher than economic growth, then the owners of capital should become richer over time.

However, it seems that there are certain problems with this thesis. Firstly, an economy has an optimal capital stock, and thus can carry only a finite amount of wealth into the future. Attempts to save beyond this simply drive the return on capital negative. In the long run then, the capital stock approaches the optimal, and the return on savings should approach zero. Given the epic lack of capital in EM, we are still some 50-100 years from that, at least. On the other hand, we can comfort ourselves with the thought that even if Piketty is correct now, he won’t be correct forever.

If we think that the inequality in capital ownership is a problem, there is a simple solution. Simply have world governments buy up large quantities of the capital stock, say half of the stock and bond markets over a few decades. By reducing the supply of capital, savers, and by extension the wealthy, would have to compete for a smaller and smaller share of the optimal capital stock.

In the short term, this will drive up the price, but in the long run it limits the supply of available savings vehicles, and exposes the wealthy to inflation by giving them the choice between holding cash, or buying capital at such prices that returns are bound to be negative.

Of course, it seems that this would not be a politically acceptable move. For one thing, people seem to believe in the divine right of savers to reasonable returns. Of course, no one seems to equate the very wealthy with `hard working’ savers, but economically they are largely identical. To make it politically acceptable, the government would have to provide bonds at a reasonable rate of return. This could be managed, simply start selling bonds directly to savers at some limit such that no one person can own more than, say $500,000.  This is not very different from the UK’s pensioner bonds.

Driving down inequality by having the government buy up the capital stock. Its just the modern repackaging of Marxist ideas, but the difference is that we could do it now, without the terrible side effects. Just buy ETF’s and the government can be a silent partner in the world’s stock and bond markets. No interference in workings of capitalism, just lots more capital.

Low Interest Rates, Excess Saving, and Bubbles

It seems like the belief that low interest rates cause bubbles is all the rage. Its superficially such an obvious relation “low rates” means “easy money” which means people “bid up” assets and hey presto instant bubble.

Unfortunately, its all wrong. What really causes bubbles is too much saving. For a given level of technical progress, an economy has an optimal capital stock. We define the the optimal capital stock through its equilibrium condition: there is no productive investment (which can be made by the private sector) which has a risk adjusted return which is better than zero.

Now of course, in the real world there is always new innovation, and replacing deprecated capital, so we would really expect the optimal (real) rate to be slightly above zero. Nevertheless, zero real return on capital is where an economy wants to be, where it strives to be. However, the optimal stock is not fixed, it is in fact rapidly changing. New technology can create new possibilities for investment, or it can render old capital irrelevant. The new tech industries are much less intensive than the old “heavy” industries that they are largely replacing. Nevertheless, this capital stock represents the maximum stock of savings  that can be carried into the future. If people want to save more than this, they have no choice but to invest in assets with a negative real rate of return.

Real capital investments are funded by foregoing consumption in the present in order to get more later. This is what the interest rate asks, it says, how much extra consumption do you need in the future to persuade you to forgo consumption now, so that we can build this useful investment. The more people want to save compared tot he optimal stock of assets, the more negative the real rate of return must become. The more the real rate or return becomes negative  the more “bubbles” people will see.

There is really only one possible strategy for this, and it amounts to aligning the stock of capital investments with peoples desire to save. This is possible because:

(1) Often capital investments are inhibited by real world factors like unstable government, poor human capital, poor infrastructure. Stabilising Africa and parts of the IndoChina region would offer plenty of investment opportunities.

(2) Government funded spending. There are plenty of productive investments that only a government can make, and through either higher taxes (on those who over-save – the rich) or higher deficits (providing more safe assets). These include: Education – the state of UK and US public education is a joke, and severely inhibits future productivity; Infrastructure – some projects are simply too large for the private sector to undertake; Regulation – the UK house market is a typical example, where poor government regulation prevents housing stock being built at the required pace; Free trade – this is a little less obvious, but take for example, US energy protectionism (preventing the export of shale gas), this prevents the optimal level of investment in shale technology, by keeping the price artificially low. On the other hand, it raises the risk premium for investing in oil and gas outside the US (as it could be made unprofitable through an arbitrary regulatory announcement), which reduces investment outside the US aswell. Essentially, people aren’t stupid – they will not invest in a product which depends purely on regulatory trade barriers unless they are convinced that they are here to say.

(3) Transfer payments. By transferring income from those with a high propensity to save (rich people/middle class) to poorer people, you lower the overall savings rate.However, this is not likely to be too effective in a UK/US centric view, as most of the excess savings appear to be coming from Japan, Germany and China as a response to their coming demographic disasters. UK particularly does not suffer from excess savings 🙂

Any time the total quantity of saving is in excess of the total stock of capital, a bubble is guaranteed, by draining savings out the system through government investment, we get higher total productivity, higher interest rates for savers, and fewer bubbles. Win Win Win?

The Cause of the Crisis

Pretty much ever since the crisis of 2008, there are those who have been arguing that the sharp fall in NGDP/demand was the cause of the financial crisis, rather than the other way around. Further evidence has now come to light in both the US and the UK, courtesy of David Beckworth and Britmouse, suggesting that the causes of the crisis go back as far as 2005 at least, and largely vindicating the view that the fall in nominal incomes destroyed banks balance sheets. I strongly urge you to read the Beckworth post.

In particular, in the US, expectations of nominal income growth started falling in 2005:

By the time Lehman Brothers went under, income growth was already well below trend, with predictable results for default rates.

where as in the UK, Nominal income growth has been below trend since 2001,

That is a pretty big gap in incomes by 2010.

Interpreting why this happened is obviously tough, but I lay the blame on inflation targeting. If you wish to target the price level of outputs, in the face of real cost pressure on your inputs, you must restrict nominal wage growth. Since someones income is someone else’s expenditure, this means that you are restricting NGDP growth.

Ever since monetarism was put forward as a theory by Freidmann (and others), they have emphasised that there are two nominal variables which are important, income growth, and inflation. The first because income ultimately determines demand, and the second because nominal wage stickiness makes it hard for employers to adjust wages competitively. The first effort at monetarism, was the targeting of the monetary growth rate, the rational was that both incomes and inflation were strongly correlated to monetary growth. In the US and the UK this turned out to be a transient correlation, and money growth targeting failed (-although it largely succeeded in Germany and Switzerland for nearly thirty years, under a slightly different model, you can get a quick overview from this Mishkin paper).

The next logical step was inflation targeting. Why look to target some intermediate variable when you can target them directly. This works just great as long as the two remain strongly correlated. We targeted inflation and got stable income growth for free. :). Of course, this means that had we targeted nominal income/NGDP, we would have got stable inflation `for free’.

The graphs above demonstrate that this correlation started to break down. This is probably a result of falling world inequality. We outsourced a lot of our labour intensive manufacturing to countries where labour was cheaper. Now income in those countries are rising, and we in the developed world must therefore pay more for the basic raw materials that we use as inputs. Thus, by targeting two percent inflation under rising real costs, we crushed income growth. Over the long term this makes it harder for households to meet their debt repayments. Perhaps the small fall in income growth rate in the UK was stable enough not to contribute materially, but the much sharper fall in the US was probably the cause of the financial crisis.

The good news is that central banks can do a lot about this type of nominal problems. By expanding income growth we can put the unemployed back to work. On the other hand, rising wages in the developing world are not going away, so real cost pressures will remain, and higher inflation (in the UK) might be needed in order to keep incomes/demand on a stable trajectory. To my mind, a slightly higher price level is a small cost compared to millions sitting unemployed, so we should do that.

This picture also makes sense in of the UK’s productivity puzzle. If raw material costs increase 4%, productivity increases 2% and wage growth is 0%, we get get roughly two percent inflation. However, its not clear that this type of cost inflation is really captured by the productivity statistics. If productivity is measured by output, then it is negative in the above example, since I am producing the same amount of stuff at a higher cost, despite productivity increases.

A mixed bag for the Uk then: We must increase nominal wage growth to increase spending, and suffer slightly higher inflation as a result, since the central bank cannot overcome the real cost pressures that are a result of the rising living standards of much of the rest of the world.

On the Causes of Inequality

So there is a new blog I have been following, dajeeps, and I saw the following post, on the causes of inequality.

The problem is not inequality of income or wealth, it is a symptom. It’s a symptom of inequality of opportunity that comes with the consolidation of investment channels to such a degree that more than 50% of the nation’s potentially productive capital is under the control of only a handful of firms.

Perhaps the proponents of wealth gap argument are too busy looking for ways government can solve the problem by sticking it to the rich to notice that government has caused the problem. In a capitalist society, no one gets wealthy by working as a wage slave.

As I see it, in so far as inequality has a cause, it is `capital accumulation’. Fundamentally, if I want to save, I need to find someone who has a productive opportunity to spend it on capital given the current interest rate. For a while, demand for capital was high, and this favored savers. Since savers are generally the better off in society, this has favored `the rich’. Now we have a situation which, potentially, favors the poor(er). Interest rates, and hence return on capital, could very well be very low (or negative) for the foreseeable future. All those owners of bonds might very well be `the rich’, and about to suffer hefty losses if interest rates `normalise’. This is why changes in inequality look pretty similar across all developed countries, even though they have wildly different tax policies.

This capital accumulation (saving) is a feature of the economy right now. Sooner or later a technology shock will come along and render a goodly proportion of the capital stock redundant, and since all that represents someone’s savings, a lot of savings will be destroyed, and many of the wealthy will lose a huge proportion of their money.

The best historical example of this kind of shock was the destruction of the aristocracy. At the turn of the 17th century in the UK, land was the capital of choice. If you wanted to be rich, you got rich by saving your money and buying land. Those who had land schemed through marriage, politics, and sometimes assassination, to acquire more land. They got a store of the profits from selling the food from that land, and that, more or less, was the economy.

Then came advances in agriculture, the seed drill was invented, and that was just the beginning. By 1850, only 22% of the UK population was engaged in agriculture. Think about what that means – in 1600 the aristocrats got a share of essentially all of the produce of the economy, by 1850 they were getting a share of one fifth of the economy. More than that, we could now produce more than enough food easily, and so food prices had fallen dramatically. The aristocracy were ruined and replaced by merchants. By 1900 this transition was complete, and merchants, ship owners and bankers were the new elite, because the economy was based around trade. Raw materials came in by sea, and finished products were shipped out. World trade volumes were growing rapidly.

In all of this, what is often forgotten, is that land was saving. If we had had a modern financial structure, agribuisness would have been the titans of the 1700’s, only to see its share price collapse and end in a messy default sometime in the 1800’s. Today, amazon is on course to destroy the entire retail sector. The internet, with its ability to organised information, might one day render all kinds of professions pointless. Already auditing has become e-auditing. How long before information technology makes accounting something that anyone can do? There is already plenty of evidence that computers do much better than most financial planners. Anyone invested in a buisness runs the risk that a new technology will render it pointless.

Anyway, the key lesson is that Technology Giveth, and Technology Taketh Away. We have lived through an age in which capital accumulation was the name of the game. The efficiencies of mass production and urbanization required large investments in fixed capital, and high demand for savings led to a healthy return on investment. If, in the future, technology means that we get buy with much lower investment in physical capital, then it will be impossible for the rich to save effectively. There will simply be no long term investments for them to buy. The investments they collectively own will fall in value, and inequality will fall.

Below, I have put a graph of investment in fixed capital as a percentage of GDP, alongside an appropriately transformed gini coefficient (just subtracted 0.35 to make them appear nicely in the same graph). This number is probably a decent proxy for the savings rate. It has been rising for decades, if it falls in the future then inequality will probably fall to (with some appropriate time lag). Just like rises in the investment in capital are associated with rises in the gini coefficient.

This shows `capital formation’ as a percentage of gdp in blue. In red is the gini coefficient, with 0.35 subtracted to make them appear nicely on the same graph. Notice how the large rises in inequality is associated with a rise in the investment in capital.