Why the Federal Reserve is a key driver of wealth inequality
Updated: Mar 3, 2022
Wealth inequality is constantly one of the hottest topics in both the political and economic debate, yet it’s one of the most misunderstood. In fact, there are two main common visions in public opinion:
The first one is that wealth inequality is the result of “the rich being greedy”, as they manage to use the capitalistic system at their own advantage to become richer at everybody else’s expense. Let’s call this the “personal responsibility” paradigm.
The second view is that wealth inequality is a product of bad taxation policies. According to this view, big wealth gaps are mostly the government’s fault, as it’s not capable or unwilling to impose higher taxes on corporations and the so-called 1%. Let’s call this the “tax the rich” paradigm.
Both views are extremely simplistic and inaccurate, as it’s often the case with complex issues that concern a large number of people. The goal of this article isn’t to discuss the impact of taxation on economic growth and wealth gaps, but to show why the factors that are commonly perceived as crucial are overestimated, whereas other incredibly relevant causes are ignored by the public. This misunderstanding generates further confusion between causes and consequences, pushing people to focus on the wrong aspects of the problem and allowing policymakers to make the same mistakes over and over (intentionally or unintentionally).
A history of wealth inequality
Societies have always been unequal throughout human history. However, the degree of inequality has varied and with global wealth growing to the highest levels ever, so did inequality. Despite what many people think, that doesn’t imply that the poor are getting poorer, and the rich are getting richer. Globally the poor are getting richer, and the rich are becoming disproportionately richer, but never before have we seen so many people lifted out of poverty, and many could argue that it’s just the result of a process that in the end benefits society as a whole. However, when it comes to the developed world, especially in the US, we have witnessed a different story: a sharp reduction of the “middle class” over the last 50 years. Unequal societies tend to be a threat to a nation’s stability, peace, and overall standard of living, ultimately becoming a threat to its economy as well. So, why is this happening?
World population living in extreme poverty (1820-2015), source: World Bank (2019)
After steadily declining in the years after WW2, the poverty rate in the USA flattened since the 1970's.
A research from Pew Research Center shows how the middle class has been shrinking since 1971
1971: The year it all started
Up until 1971, the USA had experienced enormous real economic growth since its inception, and it was widely shared among all households. However, this changed when in a perfect “coup d’état” style, President Nixon announced that the US would “temporarily suspend” the conversion of US dollars into gold. Following the Bretton Woods agreement of 1944, the US dollar had become the world’s reserve currency, because the US government was trusted for its ability to convert a fixed amount of those dollars into an ounce of gold. Suddenly, in 1971, this was no longer the case, and while many remember Nixon’s historical speech on national TV broadcast, few understand the implications on our everyday life.
The ability to print money indefinitely has always been the greatest and most dangerous temptation for any government throughout human history. Some historians even see it as one of the main causes that led to the fall of the late Roman Empire. Devaluing currencies to support excessive deficits that can’t be financed through taxation seems to be a more and more recurring theme since 2008, and while many so-called economists or politicians like to call it with fancy names like “modern monetary theory”, it’s one of the oldest tricks in the book which, as always, is not going to end well.
Real family income between 1947 and 2018, as a percentage of 1973 level (Source: CBPP)
One of the most iconic quotes from the 31st US President Herbert Hoover (August 10, 1874 – October 20, 1964)
The moment Nixon told the American public on August 15, 1971, that the administration along with the Treasury would immediately suspend the U.S. dollar’s convertibility into gold
Asset prices and inflation
Since the Greenspan era, which officially began in 1987, we have witnessed the construction of the very foundations on which the Federal Reserve’s policy is built. At every crisis, the pain could be stopped by lowering the Federal Funds Rate, which would increase borrowing (debt) in the economy and thus stimulate growth through money creation from commercial banks. It’s an easy choice when you start at a 20% interest rate in 1980, but it’s only a quick fix that manages to inflate asset prices instead of creating real growth. In fact, most of the liquidity has tended to flow into the stock market or the housing market, making those that already own the assets (the rich) richer, and those who live from their work poorer, as the cost of basic needs like housing, keeps accelerating much faster than wage growth. In addition to that, exacerbating and worsening the effects of zero interest policies, the Fed and many other central banks have started to adopt Quantitative Easing during the aftermaths of the 2008 financial crisis, by buying government (or even private) bonds through newly issued currency. Now that we have had zero percent interest rates for over a decade, and that we are in an everything bubble (housing, stocks, bonds, and many other assets are extremely overvalued by historical standards), what are we going to do when the next crisis comes? We have already hit the 0% bottom!
Inflation, of course, is running extremely hot at 7.5% YoY according to official data, outpacing the US GDP growth for 2021 of 5.7%, indicating that we technically already are in a recession. This is no surprise for those who were skeptical about the Federal Reserve’s record money printing in 2020. Now that the velocity of money (how fast money changes hands) is accelerating with the reopening of the economy, we are just starting to pay for what we didn’t have in 2020. The problem is that, as always, those that are going to pay the most are those who have the least, and ordinary people won’t even understand the real reasons why. With inflation at those levels, it impacts the most those who live off their salary, the poorest, as a 7.5% increase in costs represents a serious decline in the standard of living. Meanwhile, those who detain the assets, are happy to see them appreciate in value without becoming more productive. We are not going to address the issue of real inflation being far higher than reported and stick with official data, as we have already talked about this problem in previous articles, and would cause us to go off-topic.
Federal Funds Rate, historical (1950-2021)
Margin debt and the S&P 500 historical (1997-2021)
The “wealth effect”
Many economists, including Fed Chairman Alan Greenspan and those who came after his mandate, have supported the idea that higher asset prices are good for the economy because people feel richer and are more optimistic towards spending and investing. It surely doesn’t take a Nobel prize winner to see how flawed this theory is. In fact, the psychological damage of the “wealth effect” when asset prices inevitably decline, has a far greater impact on the economy than the opposite. A perfect example is Japan after 1987 when the country experienced what Jeremy Grantham describes as “the biggest asset bubble ever”. It took the Nikkei 30 years to reach those valuations again, and the implications on the economy have been dramatic, especially when it comes to people’s confidence in economic growth. There are many factors that play a role here, but the burst of the bubble surely has had a great impact, so great that the Japanese government has been trying to fight deflation for over three decades. Another great example is the 2008 financial crisis, which destroyed a $16.4 trillion net household wealth in America and brought the unemployment rate up to 10%. The 1999–2000 dot-com crash cost investors “only” $5 trillion.
Nikkei 225 index (1970-2021)
The Nikkei still hasn't managed to climb back to the level of 1990
Nasdaq composite (1990-2021)
It took the Nasdaq 17 years to recover from the dotcom bubble burst in 2000.
Boom and bust cycles
The economy (and the stock market) has always moved in cycles, it’s inherent with the structure of capitalism. Economists have never agreed about the role of government during those cycles, but whatever the idea might be, I think we can all agree that central banks shouldn’t exacerbate boom and bust cycles. What we have seen, since the Greenspan era, is that those cycles have become more frequent and more violent: Out of five major stock market crashes in US history (1929, 1987, 2000, 2008, 2020), four have taken place after 1987, and one more is about to happen (actually already happening). And guess who will be the first to lose their jobs when the economy enters a recession? Low-income households.
Current monetary policy is structured to act as a form of bailout for the economy. The problem with bailouts is that they take away efficiency from markets, at least temporarily, creating inefficient wealth allocations. We have seen this happening in 2008 with the bailout of the financial sector (after which banks were not split up or restructured), when everybody had to pay for the bank’s excessive risk-taking and stupidity. Another example are zombie companies in the post-pandemic environment ( See: Behind the bubble: the rise of zombie companies (1/2)), which have been kept alive by stimulus and expensive bond-buying programs without ever turning a profit.
In addition to the systemic moral hazard, there is currently an issue of conflict of interests at the Federal Reserve. One of the biggest trading scandals ever is going relatively unnoticed: Federal Reserve officials have been caught owning and trading the same securities the Fed itself has been buying, including Chairman Jerome Powell. The news is as astonishing as it is outrageous, since the present and future of the world economy are partially in the hands of those people, and it’s just incredible how they are resting in impunity. We will talk more specifically about this topic in our next article.
So, what now?
Many economies are currently in a difficult position, with high inflation on one hand and slowing economic activity on the other. In addition to that, debt levels are at all-time highs. Central banks have been kicking the can down the road for 30 years by lowering interest rates and printing more money at every crisis. However, economics is all about balance, and we will pay for these short-sighted policies in the long term, since all we have done is borrow future growth. The idea that we can stimulate real growth by printing money indefinitely (without any type of consequence on inflation and wealth inequality) is absurd, because at the end of the day what really matters is the number of goods and services produced, labor productivity, the pace of innovation, the education of the workforce, and the age of the population.
A solution to the problem could be favoring fiscal spending rather than monetary stimulus. Fiscal spending creates companies, jobs, innovation, and at the end of it, you are left with valuable infrastructure from which the economy will benefit as a whole for many years. It’s not a quick fix, it takes planning, and it surely doesn’t immediately take away the pain from the markets. But since when have high asset prices become a target of monetary policy? And when did it become acceptable to prevent those inevitable downturns by making the poor struggle and the rich richer?
We are on a short-sighted path of self-destruction, socially and economically. Those who are going to feel the most pain will be ordinary people who,not knowing who or what to blame, will listen to the same politicians that got us here in the first place.
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