the plan for the future
11 November 2021 (latest revision: 20 December 2022)
During the last decade, the wealth of the poorest relative to billionaires shrank dramatically, Oxfam research demonstrates. In 2009, the combined wealth of the world's richest 380 people equalled the wealth of the bottom half. By 2018, that number had shrunk to 26. So, 26 billionaires own as much wealth as the bottom half of the world! At the same time, interest rates went to zero. And it may not be a coincidence. There could be a link between interest and wealth inequality. Money printing by central banks and lower interest rates could promote wealth inequality.
The relation between wealth inequality and interest rates operates in two directions. Capital grows because of interest, and interest makes the rich richer. Capital produces the things we need. And interest makes this capital available by promising rewards in the future for those who save and invest. Interest in the broadest sense consists of all payments made to owners of capital. Owners of capital usually are the rich. On balance, the bottom 90% poorest pay interest to the top 10% wealthiest. So, if interest rates can be lower, then it should benefit the bottom 90%. So why does it appear not to work out that way?
Central bankers fear a 1930s-style depression and hope that inflation will pick up so that debts will become less of a burden. To forestall disaster, central banks have flooded the financial markets with money. When interest rates go down, the value of capital assets like real estate and corporations can rise because of discounting. By discounting the future income of capital assets against the interest rate, you can calculate their present value. That is explained in Shadows grow taller until the sun sets. Rising asset values may have contributed to wealth inequality.
Usually, depression, war or hyperinflation reduce wealth inequality. And central banks try to prevent these things from happening. In doing so, they proverbially walk on a tightrope, and increasingly so, because economies become more indebted. So far, asset values have risen. To see how that benefits the rich, we introduce three imaginary people: a poor person, a middle-class individual, and a wealthy person. Assume further that these individuals represent the average of their class and that there are 1,000,000 poor, 1,000,000 middle class, and 200,000 rich people.
Assume that in 2009, the poor person had no assets except € 1,000 in cash. The middle-class individual owned a home worth € 200,000 with a € 150,000 mortgage and € 25,000 in a savings account. The wealthy individual owned a € 500,000 home with a € 400,000 mortgage, € 500,000 in investments in the stock market, and € 50,000 in a savings account. Their net worths were € 1,000, € 75,000, and € 650,000, respectively. Of total assets, the poor owned 1 billion (0.5%), the middle class 75 billion (36.4%), and the wealthy 130 billion (63.1%).
Assume that in the following decade, home values have doubled, and stock markets have tripled. After ten years, the poor person still has € 1,000. The middle-class individual saw the value of the home increase by € 200,000 and took up another mortgage of € 100,000 to keep up with expenses. The savings are now gone. The wealthy individual now has a € 1,000,000 home with a € 400,000 mortgage, € 50,000 in savings and € 1,500,000 in investments. Their net worths are now € 1,000, € 150,000, and € 2,150,000 respectively. Of total assets, the poor now have 1 billion (0.2%), the middle class 150 billion (25.8%), and the wealthy 430 billion (74.0%).
The poor saw their slice of total wealth fall from 0.5% to 0.2%, a 60% decline. The middle class saw its portion of wealth sink from 36.4% to 25.8%, a decline of 29%. The rich benefited. Their portion of wealth went up from 63.1% to 74.0%, an increase of 12%. Insofar lower interest rates and money printing cause rising asset values, they contribute to wealth inequality. But it is not clear whether this is the case and to what extent. Home prices also increase due to inflation. And the valuations in the stock markets may be high, but they are not exceptional.
If you owned a house during this period, you likely have profited. You probably pay less for your mortgage than ten years ago while your home has risen in value. People who pay rent often pay more now than they did a decade ago, and they do not own a home that has increased in value. In the Netherlands, the average net worth of homeowners in 2021 is € 36,000. That of tenants is only € 2,600. And that does not include the home itself. People who own homes are wealthier in the first place, but higher home values and lower interest rates have greatly benefited homeowners while tenants had no such windfall.
Interest rates are, in the first place, the result of market conditions. At an interest rate near zero, the supply of money and capital can exceed demand. An alternative to money printing would be to allow interest rates to go negative, and once they are negative, to cap interest rates to zero. Negative interest rates can provide stimulus, while the interest rate cap can deliver financial discipline. That is explained in Financial Stability Hypothesis.
Significantly higher real interest rates appear not to be in the cards in the foreseeable future. With the current state of wealth inequality, that may be impossible. Interest consists of all payments to capital owners. Furthermore, risen asset values, insofar they are the result of discounting, are not real gains. They are future gains brought to the present. Low interest rates may even tell us that the long term perspective for yields on capital is dismal. Another example can illustrate this.
Assume that you buy a 10-year government bond yielding 4% when the interest rate is 4%. The bond is worth € 1,000, yields € 40 in interest each year, and after ten years, the € 1,000 is returned. Over the 10-year period, you will receive € 1,400 in total. If the interest rate is 4%, then the present value of the bond is € 1,000. Now suppose that immediately after you buy the bond, the interest rate drops to 0%. The present value of the bond suddenly rises to € 1,400, a gain of € 400. That is the result of discounting. But if you keep the bond until the end, you still receive € 1,400 in total over the 10-year period.
If you reinvest this money, the interest rate matters. If the interest rate is still 0% after ten years, and you buy another 10-year bond, you will still have € 1,400 after twenty years. But if the interest rate never had dropped to zero and had remained 4% all the time, you could have reinvested the proceeds of the bond at 4% interest, and you would have ended up with € 2119 after 20 years. In the short term, lower interest rates may make the rich richer, but in the long run, the opposite is true. That is because interest is capital income, and the rich own most capital.
With bonds, the situation is clear. The relationship between interest rates on the one hand and business profits, rents, stock market values, and home values on the other hand, however, is not so clear. It makes sense that an excess supply of capital or a lack of demand for goods and services cause interest rates to decline so that asset values rise and capital on aggregate yields less in the long run. To prove it may not be possible. In the real world, other factors interfere with this presumed relationship. It is plausible that such a relationship exists. That is often the best you can get in economics.