The Rising Gap between Rich and Poor - April 2023 Update
The philosophy of the rich and the poor is this: the rich invest their money and spend what is left. The poor spend their money and invest what is left.
Robert Kiyosaki, American entrepreneur
Why the rising gap is problematic
The gap between rich and poor can be expressed in a couple of ways – either through income statistics or through household wealth statistics. The two measures paint largely the same picture, even if they are not identical. In the following, I will provide data on both, and I will assume that the correlation between wealth and income statistics is so high that the two measures can be used interchangeably.
Maybe I should start this update by explaining why the gap continues to rise, and why it should worry you. Provided the poorest in society are still doing reasonably well, a rising gap is, in itself, not a significant issue, apart from the envy factor it may evoke. The problem is, in most developed countries, increasing numbers of individuals are struggling to make both ends meet. The rising gap has coincided with a spike in inflation, which has led to declining living standards amongst all but the wealthiest. When living standards amongst ordinary people decline, there is a growing sense of discontent within society..
Growing discontent typically leads to a rise in populism. As I documented in the 2020 paper, populism is now at the highest level since the 1930s. You may recall the end-result of that stint of extreme populism – World War II. Could the war in Ukraine lead to World War III? I certainly hope not. Nor do I think it is a likely outcome, but it would be foolish to completely disregard such a possibility.
One of the (many) consequences of a rise in populism is that more and more public capital is misallocated, i.e. deployed unproductively. Populist politicians prefer to spend public money on things voters want rather than need. Deploying public capital unproductively leads to slowing productivity growth which, when combined with negative workforce growth, can only lead to slowing, perhaps even negative, GDP growth. That is a problem when the world is as indebted as it currently is. We need as much economic growth as possible to stand a reasonable chance of being able to service all the debt we have built in recent years.
The latest statistics on inequality
In December 2021, World Economic Forum (WEF) published an update on the rising inequality between the world’s richest and poorest (see here). As the author behind the paper pointed out, although the COVID-19 pandemic has exacerbated many existing inequalities, the rising gap is nothing new. In fact, it has been with us since the early 1980s. According to WEF, the wealthiest 10% now account for no less than 76% of total household wealth worldwide (Exhibit 1).
In fact, wealth is even more concentrated than suggested in Exhibit 1 – at least in some countries. Take the US, which has seen a burst in wealth amongst the country’s super-rich as a result of the tech boom. As you can see in Exhibit 2 below, the wealthiest 1% of all Americans now control over 40% of total wealth in that country. No other country (in the survey) is close to such concentration of household wealth.
It will probably come as no surprise to most of our readers that some of the wealthiest people worldwide are to be found in the US, but are you aware of how extreme inequality is over there? That can be measured if you instead look at median wealth. As you can see in Exhibit 3 below, when measured this way, the average American is suddenly the least wealthy in the group of countries in the survey.
We have enjoyed an extraordinary bull market in risk assets since the mid-1980s, following Volcker’s fight with inflation. Interest rates have collapsed (I am conveniently ignoring the recent rise), equity markets have done phenomenally well, and so have property markets. Following the war against inflation back then, it took approximately ten years before wealth began to rise markedly, hence why the rise in wealth in Exhibit 4 is measured from 1995.
As you can see, the bottom 50% of the population worldwide, has only captured 2% of the wealth created since 1995. Meanwhile, the top 1% has captured no less than 38%. The implication of that is obvious. Since 1995, the rich have gotten much richer; therefore the gap between rich and poor has widened significantly and continues to do so.
Why the difference in wealth dynamics between Europe and the US?
Last year, researchers at Imperial College of Business School in London did a study on the determinants of wealth inequality in Europe and the US (you can find the study here). Their findings were not hugely surprising. Whilst interest rates and property markets have performed similarly on either side of the Atlantic during the period in question, equity markets have not. As Clara Martinez-Toledano (one of the authors of the study) points out, “from the 1980s we see a wealth gap start to emerge, where there’s a more dramatic change in the United States. The wealth that the top one percent richest people own in the States has undergone a significantly larger increase than the top one percent richest in Europe – in other words, the gap between rich and poor in the US became much more pronounced as wealthy Americans became even richer.”
Martínez-Toledano continues: “Differences in the composition of these assets across wealth groups is key. The richest people tend to own financial assets such as stocks and bonds, while the middle wealth groups tend to have a house as their major asset. But even with a big growth in house prices in both regions, stock market prices were the standout distinguishing factor, with a huge jump in value of US stocks during those decades“. The problem, according to Martinez-Toledano, is that “high levels of economic inequality can lead to economic and political instability. This is why action needs to be taken before societies become polarised”.
The impact on life expectancy
Declining living standards affect many things in life, none more important that mortality rates. As you can see in Exhibit 5 below, the latest longevity statistics coming out of the US indicate that life expectancy over there is now the lowest it has been since 1996 (you can read more about that here). I am not arguing that the rising gap between rich and poor is the only reason behind declining life expectancy – not at all. The pandemic has certainly had an effect. So has the ongoing opioid crisis. Having said that, when the money is tight, you don’t always go to the doctor at the first sign of problems. If you don’t think the rising gap between rich and poor has had an effect on mortality rates, I suggest you read this article in New York Times.
What will happen if the gap continues to widen?
Unless political action is taken, the inequality gap will most likely continue to widen. As the gap grows, more and more problems will materialise. Not only is extreme wealth and inequality politically corrosive. It is also socially divisive. Society is undermined, not necessarily in the short term but definitely over the longer term. Take for example positions of power whether in politics or elsewhere. Those from the elite are much more likely to end up in those positions, further entrenching inequality. And children of the elite will likely follow their parents into positions of power.
Extreme wealth is also economically inefficient. Wealthier people spend a smaller proportion of their disposable income on consumer goods than poorer people do. Therefore, a concentration of wealth on fewer hands leads to a drop in consumer spending when measured as a proportion of overall economic activity. Having said that, a concentration of wealth on fewer hands has proven good for risk assets, as wealthy people invest more; hence why financial markets have done so well since the 1990s.
One of the (many) problems we face at the moment is that ordinary people are forced to make sacrifices every day. The British media call it a cost-of-living crisis, and that is hardly an exaggeration. Meanwhile, the super-rich continue to get wealthier and wealthier. According to Gabriela Bucher, Executive Director of Oxfam International, “taxing the super-rich and big corporations is the door out of today’s overlapping crises. It’s time we demolish the convenient myth that tax cuts for the richest result in their wealth somehow ‘trickling down’ to everyone else. Forty years of tax cuts for the super-rich have shown that a rising tide doesn’t lift all ships – just the superyachts.”
Unfortunately, it is not as simple as that. Unless such a tax programme is global in nature, the super-rich – most of whom may have a pretty good track record in terms of finding loopholes in the tax laws – could possibly relocate to various tax havens. And, quite frankly, I would be stunned if the entire world were to agree to a programme like Ms. Bucher suggests. The problem facing the rest of us is that the chain will come off at some point. It could take another 10 years, perhaps even another 100 years, but come off it will, if the gap continues to rise. How do you think the French Revolution in 1799 came about? The problem must be addressed before it is too late.
In the original 2020 paper, I argued that, for as long as the gap between rich and poor continues to widen, risk assets will probably continue to do well. That is still my opinion; however, there are two noteworthy caveats. First and foremost, as long-term readers of my work will be aware, I am of the opinion that, at some point, household wealth will begin to mean-revert when measured as a percentage of GDP. In many countries, particularly in the US, wealth-to-GDP is so much above its long-term mean value that it is unsustainable. Risk assets won’t do well in an environment where wealth-to-GDP is falling.
The problem I have with this argument is that a significant drop in wealth, which shall be required to restore the long-term mean value, could still be decades away. The underlying theory provides zero guidance on timing, but I am inclined to think that mean reversion will truly begin when the mob decide that enough is enough. A civil war, or a revolution, may never happen, but less can get the mean reversion process underway. An extreme left-swing in parliament could give the far left sufficient powers to make earth-shaking changes. Here in Europe, we tend to smile when Americans call Bernie Sanders “an extreme left-wing”. At least by our standards, he is far from extreme, but he could be the canary in the coalmine.
The other issue you need to take into consideration is inflation. Although I think the worst is probably behind us now, the journey back to 2% will be long and arduous. The issue at heart is the strength of the US labour market. Unless it weakens meaningfully from here, the Fed could be forced to raise its policy rate well above current expectations. The market-implied terminal rate is currently hovering around 5.7%, which is about 1% above the present Fed Funds rate. If the Fed needs to go much higher to get inflation under control, risk assets will most likely suffer.
Niels C. Jensen
11 April 2023