The Economics of Equity

At the most fundamental level, the basic problem of economics is how to produce the most human satisfaction at the least cost in resources. One of the subsidiary issues that arises is how this satisfaction is distributed. You could say there are two issues: 1) How to bake a bigger pie, and 2) How to divide it up.

Much of conventional economics views it as a sort of contest. At one extreme, all rewards go to those who produce the most. This presumably incentivizes producing more, so that you get a bigger pie, but might leave too many with too little. At the other, the rewards are divided equally among all citizens; but by assuring equal outcomes regardless of effort or productivity, this presumably produces a smaller pie. Political economy, and therefore much of politics, is a competition between those who would leave more to the free market to allocate according to productivity and those who would have government assume a bigger role in distributing the fruits of human endeavor.

There are good reasons to question this simplistic view. And that’s what we will do.

Most Americans fall somewhere between the extremes. One one hand, they strongly support safety net programs like Social Security and moderately leveling policies like a progressive tax code. On the other, if you were to invent a cure for cancer or commercialize cold fusion, they would eagerly agree you’re entitled to get rich.

At the same time, few would disagree that frustration and animosity have intensified in recent years. Political partisanship is notoriously described as having grown extreme. People, especially via the media, are increasingly identified less as individuals and more as members of groups, whether based on gender, racial or ethnic heritage, economic status, and even by generation, as is seen in the social media rivalry between so called “millennials” and “boomers”. It is my belief that much of this is driven by a deep sense of inequity. People instinctively realize they’re not getting a fair shake, and are casting about in search of devils. The greater their sense of inequity grows, the more intensely emotional the divisions become.

Yet according to the assumption that government serves to equalize outcomes, this shouldn’t be happening. Government has grown bigger than ever, yet outcomes are less equal than at any time in living memory. Millions struggle from paycheck to paycheck and still fail to make ends meet, all while an incredible proportion of wealth and power have become concentrated in just a handful of giant corporations. And our modern rich are richer than ever, even in relation to the size of the economy, more so than those in the days of yore when government was much more limited. Economic historian Martin Hutchinson gives us a bird’s eye view:

The Bear’s Lair: How to Produce Trillionaires

Something is deeply wrong. As a whole, American prosperity is in decline, yet economic inequality is on the rise. According to our simplistic view of a tradeoff between overall prosperity and equality of outcomes, this shouldn’t be happening.

When you encounter a contradiction, examine your premises. The assumption that economic inequality has been caused by excessive “wild west” free market capitalism needs reexamination. People not only sense that they’re working harder for less reward, but that the gains of “the 1%” far exceed their economic contributions. Something more than the natural operation of free market economics is at work.

We could find endless possible devils in the details. But I believe there are two related, overarching themes that have received much less attention than their due.

One is obvious once you’re aware of it. Expansive monetary policy in general, and especially ultralow interest rates, have blown out the wealth gap. Former Federal Reseve Chairman Ben Bernanke explicitly made rising asset prices – creating a “wealth effect” – a policy objective. The theory was that as people saw the value of their investments rise, they would feel wealthier and spend more, “stimulating” the economy. More of the same policy extended under his successor Janet Yellen. Of course it is by definition the wealthy who own most of the assets, so this was an epic game of reverse Robin Hood. It was “trickle down economics” at best, yet so few were aware of it the term was unheard. And since rates and yields connect cash flows and asset values, it’s unsurprising there is in general a sweeping historical inverse correlation between the level of interest rates and the size of the wealth gap. The current Chairman of the Federal Reserve, Jerome Powell, has cited this inequity-inflating aspect of past policy as part of his rationale in using higher rates to fight inflation.

Long time readers have heard this before because I’ve referred to it often over the years. But there is another mechanism at work that has never occurred to me. The eye opener was this article on Advisor Perspectives by James Montier of GMO:

The Curious Incident of the Elevated Profit Margins

Apparently there is a strong relationship between corporate profits and government deficits. Montier points out that beginning in around 2012, federal deficits (normalized to GDP) about doubled their previous central tendency. And so did corporate profits. Not only does Montier cite the statistical association, but delves into the mechanism as well. This period incidentally spans presidential administrations and congresses of both major US political parties, so there appears to be little grounds for partisan finger pointing. Regardless, government has had its thumb heavily on the capital side of the labor balance. No wonder socialism is finding favor in the younger generation.

The common thread between these two drivers of growing economic inequity (by the way, I use the term “inequity” as opposed to “inequality” to emphasize outcome dispersion not due to productive merit) is that they have nothing to do with free market capitalism. Few would claim a central committee setting interest rates or exploding federal deficits is intrinsic to free markets.

These two drivers are not independent either. The mechanism by which interest rate cuts “work” is by making borrowing cheaper. Money is created by being lent into existence, partly as base money directly created by the central bank and partly via the broader banking system via the fractional reserve money multiplier effect. Government is not immune to this incentive; it’s likely no mere coincidence that this deficit explosion occurred as part of an economy-wide debt binge in the wake of the ultralow rate and quantitative easing regime put in place after the GFC.

There are grounds to suspect however that the pendulum may soon swing the other way. As already mentioned, the Federal Reserve has moved sharply away from the ultralow rate policy that has dominated the past decade and a half. Stock prices have given back some of their gains, and if our market outlook is even in the right ballpark, there is more to come. Possibly partially as a byproduct, bipartisan negotiations are under way not only to raise the debt ceiling, but to introduce the first tentative deficit restraint in years. I’m not predicting deficits will imminently fall back to the 3% of GDP territory Montier cites, but any step in that direction has the potential to help bring down economic disparity towards more natural levels. Along with more normal interest rates, should these trends continue by next decade we could be enjoying both greater and more widely shared prosperity. They are not competing goals … they go hand in hand.

Between now and then though, the hangover could be intense. Years of monetary and fiscal stimulus advertised to make the economy more resilient have instead embrittled it and narcotics withdrawal is never pleasant. It would mean belt tightening on Wall Street and in Silicon Valley as well as Washington. Large swathes of the economy have turned from production and investing to speculation and gambling, seen in the explosion of digital assets and ultrashort term options trading, paralleling the rise in political conflict. So much human time, talent and energy being diverted from making products and services, producing affordable housing, medical care, and maintaining high quality infrastructure – from making a bigger pie to scrambling for the crumbs – has been weighing heavily on living standards, and retooling the productive side of the economy will take time. Ultimately, about the only thing we can say for sure is that things will get better … or they will get worse.

3 thoughts on “The Economics of Equity

  1. jk says:

    qe and zirp were indeed supposed to stimulate the economy via a wealth effect, and significantly increased inequality.

    interestingly, last night i watched a conversation [recorded nov ’22] among zoltan pozsar, perry mehrling, adam tooze and others in which pozsar suggested that qt and rate rises were explicitly aimed at reducing inequity, among other targets.

    in fact the lowest decile of income earners are experiencing the greatest percentage wage gains in the last 3 years.

    also if rising asset prices increase inequality, driving assets lower – as the fed seems intent on doing – should have a reverse effect.

    1. Bill Terrell says:

      For sure … as suggested above I think this is part what’s driving current Fed policy. I don’t have actual quotes, but Powell has cited inequity more than once in recent press conferences. And there’s also that incident mentioned in Cognitive Dissonance where Powell apparently purposely hammered stock prices on live television. Not being a part of its official mandate, the Fed can’t come right out and say it’s targeting stock prices, but it’s often been obviously trying to kite them and now for a change is providing a bit of counterpoint.

      Fed put meet Fed call.

      But it lost momentum late last year when it stepped down the size of rate hikes. It spurred a bullish narrative around an eventual pivot that the FOMC has been trying to buck since. Even since the last FOMC announcement, widely spun as indicating a “pause”, short term treasury yields have been creeping higher. From May 5 to yesterday for instance the one year has risen from 4.73% to 4.92%. That this coincides with another surge in teracap stock prices may not be an accident.

      Reading between the lines even more liberally, I think Powell thinks he effed up leading that 2020-2021 moneypalooza on so long and wants to atone. He’s actually admitted extrapolating from the prior decade, in which no amount of monetary ease appeared to ignite consumer inflation (It went into asset prices!) and being taken aback when it did so spectacularly. That political discord and civil unrest ramped up contemporaneously is also likely no mere coincidence. The Fed provided the tinder, George Floyd the spark.

      So hazardous as it is trying to get into policymakers’ heads, I think the hawkish rhetoric suggests they’re patiently waiting for something to “break” and take another bite (~20%?) out of stock prices, at which point they hope to declare victory over inflation and deal with whatever fallout there is as it occurs. The “policy mistake” so much of the Wall Street media fret over will have been on purpose.