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Income Inequality is About to Get Worse

Friday, June 6, 2014

The European Central Bank made history this week.  These are the kinds of stories we usually skip over because the details are so dry and boring.  But there is also a sense in which our "culture of experts" sends the message: "Don't worry about things like this; we have experts to handle it."

Be worried.  Especially when the "experts" tell you not to be.

Before diving into this, let's get to the point.  Economic growth is about two things: credit and production.  Credit is usually in a supporting role - if you want to build a better mouse trap you might take out a loan to buy the equipment for your factory.  But economic growth is usually about sales of the better mouse trap, not the loan.  But when credit becomes the main driver of growth, well, why would we be surprised to see the "creditor" getting wealthy well ahead of everyone else?

This should not be hard to grasp: The people to whom you owe money will always have more of it than you.  Income inequality is a real problem.  But as conservatives we seem to identify it with the Occupy Wall Street crowd.  This is unfortunate, because the increase in income inequality presents an outstanding opportunity for conservatives to articulate basic conservative ideas.  Income inequality is driven principally by excess debt... solve the problem of excess debt and we will also solve the problem of income inequality.

Now to the dry, boring stuff.

When you park money in the bank, in a typical savings account, you used to get a decent interest rate.  It is important to understand why this matters.  Let's say I ask you to loan me $2 so I can get a Coke from the break room.  Only I ask to be able to pay you back 10 years from now.  Before you loan me that money, first you have to think about how much that Coke will cost 10 years from now.  Let's say we both agree that the 16 oz. bottle of Coke will go from $2 today to $4 in 10 years.  The price has doubled - that's the easy part to wrap our heads around.  But what has happened to your $2?  This is harder - that $2 is 100% of the 'purchasing power' needed to buy a bottle of Coke - today.  In 10 years, because the price has doubled, your $2 will only be 50% of the purchasing power needed to buy that same Coke.  Your $2 will have lost one half of its purchasing power.

So what do you do?  You put 10% terms on your $2 loan.  Let's do the math:  10% of $2.00 is $0.20 (if you were a jock in school, that's two dimes).  Each year, for ten years, I have to pay you $0.20.  Multiply that by the 10 year term of the loan, and that is $2 of what they call 'coupon' payments in the 'bond market'.  After the 10 years is up I have to pay you back the original $2 ('redeeming' the bond 'at par' when it 'matures').  So you have received $2 from me in interest payments and then the original $2 - you now have the $4 it will cost you 10 years from now to buy that same bottle of Coke.  You have protected your purchasing power.

This is why it is so important to look at what our savings accounts are paying us in interest.  It is only then that we can really understand what the ECB did this week.

Central banks like the ECB and the Federal Reserve hold on to bank funds, paying the banks interest, exactly as the banks do for money they hold onto for us in things like savings accounts and certificates of deposit (CDs).  Only the ECB used to pay nothing.  (The Fed pays 0.25%)  This week the ECB decided for the first time ever to "pay" -0.10%.  Now if you look at that negative interest rate and say "wait a minute... doesn't that mean they're really charging 0.10%?" you are beginning to understand what is going on.  The ECB is now charging banks for holding on to their money.

Before you shrug your shoulders, think about how you would react if your bank - in addition to all of the fees they charge - decided to "pay" you a negative interest rate.  They would be charging you to save.  If it were not bad enough that price increases will erode your purchasing power (like for that 16 oz bottle of Coke), now not only would you not able to protect yourself from that loss, the negative interest rate will only make it worse.  The answer?  Pull that money out now and spend it while you know what you can get for it.

What the ECB has done here only applies to special bank accounts used by banks themselves - these negative interest rates are not coming to your savings account.  At least not quite yet.

But the point is the same.  The ECB wants the banking system to take the money they have on deposit and lend it out - creating more credit.  The banks are holding onto this money for a very simple reason.  Right now interest rates are ridiculously low.  They have to rise at some point.  Why loan out this money at 2% when you will likely be able to loan it out at 4% or more relatively soon?  Economic growth has become so dependent on debt (credit) that the ECB has to charge banks to hold onto their money in order to keep the credit spigot flowing.

So this brings us back to income inequality. Consider the chart below.  The dataset actually goes back before 1946, but I have chosen to start there to show how the end of World War II - which was a debt-driving event - resulted in a draw-down in income inequality.  It had risen as a result of the debt incurred to fight the war.  It bottoms out around 1972 and then starts rising again.  But we cannot point to the Vietnam War to explain this as that war was ending about this time.  Why does income inequality rise after the Vietnam War ends?

Because of the rise in gross public debt.  Consider this chart below.  It shows the aggregate of annual deficits.  The line stays pretty stable after the war, even though it is increasing.  Then, in the early 70's the rise in gross public debt really starts.  In my book I try to explain how this relates to how the dollar was taken off the gold standard in 1972, but that is not the point of this blog post.  The point here is to show how income inequality is driven by debt.  Again, when the growth of our economy is largely dependent on credit, we should not be surprised to see the creditor getting rich ahead of everyone else.

And, at least in Europe to start with, when banks start deploying their reserves instead of paying the ECB to hold onto them - by lending the money out - that extra money will start to chase the same amount of economic production.  The result is inevitable - a spike in prices.  With the way the world's economies are interconnected, there is no way this dynamic will not spill over into the U.S. economy.  As prices rise - especially for assets like stock (the Dow and S&P 500 are at record highs), real estate and precious metals, the people who own these things are going to get richer.  Those who do not are only going to see the purchasing power of what little money they do have erode even further.

Income inequality is about to get worse - much worse.

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