Economic Surplus: Christmas 2021/22 Edition 3
Economic Surplus by The Marshall Society
3 January 2022
"Economics is not about goods and services; it is about human choice and action." ― Ludwig von Mises
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Marshall's Thoughts - Inflation & Monetary Policy
This week’s Marshall’s Thoughts are written by Edward Hilditch.
Historically, monetary policymakers, especially in Western developed economies, have been most concerned with low and stable inflation and supporting economic growth. However, central banks have recently woken up to the fact that, in affecting inflation and aggregate demand, monetary policy also has sometimes unintended, significant impacts on a variety of other macroeconomic measures. For example, many Western central banks have now released statements and action plans (such as the ECB in July 2021) not only recognising how climate change can impact financial stability but also what central banks can actively do to mitigate this, including how their policies contribute to potentially environmentally damaging consumption patterns. In this article, though, I am more interested in looking at what unintended consequences monetary policy (in particular historically low base rates and QE) may have had on another, often ignored, macroeconomic objective: inequality.
It is undeniable that monetary policy has been easy over the last decade. For example, since 2008, the fed funds rate has spent more than 8 years at its lowest ever level of 0.25% and has only been above 2% for 18 months between June 2018 and September 2019. By contrast, between 1970 and 2008 the fed funds rate never once dropped below 2% and, indeed, at points, was as high as 20%. Likewise, the Fed’s balance sheet in 2016 had, at $4.4 trillion, more than 7x the amount of assets on it than in 2000. This was equivalent to 23.4% of nominal GDP in 2016; over the preceding century, the previous highest value for Fed assets as a percentage of GDP was, post the Great Depression, in 1939 when it measured 23%. Similar trends can be seen across other major Western economies which suffered greatly in the 2008 financial crisis. This historically easy monetary policy has coincided with rising levels of inequality across these same economies. Between 2007 and 2020, the US’ Gini coefficient for income rose from 0.46 to 0.49. The increases in wealth inequality have been even more staggering: in 2005 the share of UK wealth held by the top 1% was just over 15%; by 2020, that figure was 25%. It is natural, then, to ask whether monetary policy may have played any part in these trends in income and/ or wealth inequality.
It is particularly natural to ask such a question given the clear potential theoretical links between easy monetary policy and, especially, wealth inequality. The theory would go something like this. Lower base rates and higher levels of quantitative easing lead to lower interest rates across the economy. This tends to lead to rising asset prices: lower treasury bond yields cause higher bond prices due to the inverse relationship between yields and prices (in addition to the artificially higher demand for bonds from QE); lower bond yields lead to a lower opportunity cost of holding equities and lower discount rates on future cash flows which then leads to higher demand for equities and so rising share prices. Also, lower long term mortgage rates lead to rising demand for houses. Since assets are disproportionately owned by the richest percentiles, any significant asset price appreciation will disproportionately benefit the wealthy. At the same time, the poorest percentiles are hit the hardest by lower rates because they are less likely to own a house (in the UK, 37% of households are not homeowners for example) and instead most of their wealth is held in savings accounts, or cash, which will not only compound at a slower rate if base rates are falling, but will also decline in real terms in a higher inflation economy promoted by easier monetary policy.
Indeed, this theory, concerning the link between easy monetary policy and wealth inequality, is broadly supported by data. The Bank of International Settlements found that, following an increase in QE by the Fed, US stocks grew 10x more than US GDP. Considering this, combined with the fact that 54% of US stocks are owned by the wealthiest 1, it is not a surprise that the richest 1% in America are holding a higher share of total wealth than at any other point since records began in 1989.
Although the impact on wealth inequality is clear, the impact of such policy on other forms of inequality, particularly income inequality, is much more tenuous and ambiguous. Indeed, it can even be argued that easy monetary policy may, when it comes to income inequality, be progressive rather than regressive. By boosting consumer spending and business confidence and investment, easier monetary policy impact tends to have a positive impact on unemployment and the number of hours of work the lowest income earners can find. Beyond government policies such as higher welfare payments or a higher minimum wage, the biggest drivers of the incomes of the lowest percentiles of earners are employment levels and hours worked, rather than wage growth.
At the very least, it should be clear that easier monetary policy impacts different groups of people and inequality in various complex ways. The same households who will get lower interest incomes from their large savings accounts will often also see large appreciations in the value of their houses and stock portfolios. While lower interest rates tend to make debtors worse off and creditors better off, there is no clear division of debtors and creditors in an economy and certainly it is difficult to make an immediate connection to inequality, especially easy monetary policy seems to have differing effects on different kinds of inequality (wealth vs income). It is important, also, to note that, in any case, there are many much larger drivers of the increases in income and wealth inequality we have seen over the last 30 years, such as globalisation, technological change and the decline of unions.
Indeed, one interesting perspective, on which I will end this article, is that, rather than easy monetary policy leading to higher inequality, the causality is reversed: rising inequality forces interest rates down. This is because the rich tend to have a higher propensity to save than the poorer and so, if the rich control a higher share of income and wealth (ie a rise in inequality), then there will, on average across the economy, be a rise in the level of saving and reduction in the level of spending. As a result, with a higher propensity to save independent of the interest rate level, the natural rate of interest of the economy would fall and so the levels at which central bankers would have to set base rates to maintain full employment and stable inflation would also systemically decline. This, at least, is the view of a recent paper by Atif Mian, Ludwig Straub and Amir Sufi which blames inequality, more than other factors such as changing demography, for the savings glut across advanced economies since 2008. So, maybe, we are posing the question the wrong way around: we shouldn’t be asking what effect monetary policy has on inequality, but, instead, how does inequality affect monetary policy.
In Case You Missed It:
This piece in the FT investigates the harmful impact of Erdogan’s repeated refusal to raise interest rates. While Erdogan believes this policy will produce a competitive currency bolstering exports and investment, the current situation is one of a volatile and collapsing currency and runaway inflation.
This article discusses the Bank of England’s recent decision to raise base rates from 0.1% to 0.25%. With inflation running at 5.1%, the highest in a decade, and expected to rise further, the article reveals how the BoE felt it was necessary to raise rates to temper this somewhat. However, the article does question whether this move was sensible, with consumer confidence beginning to show signs of weakness in the face of omicron.
This article describes how, thanks to senator Joe Manchin’s vote against and the slim Democrat majority in the Senate, Biden was unable to get his Build Back Better Act through Senate, even though the spending promised by the bill had already been trimmed from $3.5trn to $1.7trn by the House. The article then goes on to question where this setback, on Biden’s signature legislation, leaves his overall agenda.
That's it from us for now!
The Marshall Society