How the Other Half Goes Broke

By Karen Shaw Petrou and Matthew Shaw

In our last blog post, we laid out the most telling inequality-data points from an important new study from the Federal Reserve Bank of Minneapolis which for the first time runs from 1949 to 2016 and adds many critical equality measures.  These data show more decisively than ever not only that wealth inequality in 2016 is the worst since at least the Second World War, but also that this is due to who holds the assets that have gained the most.  Since which assets return how much is due now in large part to post-crisis monetary and regulatory policy rather than to market forces and broader macroeconomic trends, it’s post-crisis policy – not forces from beyond – that increasingly dictates U.S. economic equality.

We have addressed these issues in prior work posted on this blog and elsewhere.  In response, some have said that ownership of wealth-generating assets such as stocks and bonds is more equal than we suggest due to 401(k) plans, widespread investment in mutual funds, and other “democratizing” financial instruments.  We have also been challenged by assertions that house-price appreciation since 2012 advantaged the middle class.  Our prior work shows how unevenly these gains are in fact distributed, but none does so as well in so up-to-date a way as this new FRB-Minneapolis study.

To recap:  economic inequality derives from changes to both post-tax income and net wealth.  Income and wealth are inextricably intertwined because, the more wealth (i.e., the more stocks and bonds, the higher the net value of a home), the more “capital income” (i.e., interest income, dividends, the proceeds of a sold home) that factors into wages, pensions, and other “labor income.”  Economic advancement thus derives not just from wages, but also and increasingly far more importantly from the realized, “capital income” from assets.  If all assets appreciated in lock step or paid the same returns, then income and wealth equality might not be better, but it would at least be far less bad.  But, when the value of the assets held by the rich appreciate and return more than the assets lower-income households are able to accumulate without crippling debt, lower-income households are doubly disadvantaged – their wealth not only plummets, but also does so even as others do just fine.  This means less economic resilience, uncertain retirement security, reduced educational opportunity, and even greater mortality risk.  And, of course, the less wealth, the less to bequeath – no wonder inter-generational economic mobility has reversed to the point at which most households expect children to do worse than their parents. 

Thus, which assets are held by whom and with how much debt at what rate of return is a critical equality force.  According to the FRB-Minneapolis study:

• The bottom 50% has very little net wealth, derived mostly from automobiles not from durable or financial assets. One reason for this is a sharp increase in debt burdens, with educational debt now replacing mortgage debt as the top obligation of the bottom 50%.  Stunningly, the wealth of those below the 50% dividing line dropped by 52% from just 2007 to 2016. 
• What the paper defines as the middle class – from 50% to 90% of the wealth distribution – holds about two-thirds of its wealth in housing and other non-financial assets. Stock holdings are usually less than 5%, with remaining assets largely derived from savings and defined-contribution plans.  Household leverage is high (mostly due to mortgage debt), with assets exceeding wealth by 10 to 30 percent.  In this category, wealth dropped 17% from 2007 to 2016.    
• The top 10% holds the bulk of its wealth in financial assets (stock, business equity). Housing-asset prices have risen but reflect a smaller portion of total assets, with the top ten percent far less leveraged than the rest of the wealth distribution.  Here, the sum of assets is approximately equal to wealth – i.e., no net debt.

The following chart expands on the historical distribution of wealth we showed in our past post to add asset-distribution disparities:

The data above and much more in this study show that Americans below the top ten percent derive most of their wealth from housing and are far more highly leveraged to get it.  This makes wealth for all but the richest households elastic in response to house-price appreciation.  Although there has been sharp house-price appreciation for higher-cost homes in hot coastal markets, overall U.S. house prices in real terms are still 10% below 2007 according to this study.  The Fed’s own stress test projects house-price depreciation of as much as 30% under stress from what it sees as a highly-appreciated sector.  The thought of what this would do to wealth equality makes us pale.

In contrast, the principal stock indices were up about 30% in real terms from 2007 to 2016.   For the wealthiest Americans, especially those who realized significant amounts of capital income from their financial-asset holdings, even a 65% drop in equity prices – the Fed’s severely-adverse scenario – could be more of a painful correction than a meaningful reduction in wealth, let alone wealth share.  The 2008-2010 equity-market drop – considerably less severe than the Fed’s nightmare – was short-lived from an inequality perspective, despite the otherwise-toxic macreconomic impact of the great financial crisis. 

The overall conclusion from all of these data is that American wealth equality is a race between house prices and the stock market.  When house prices rise in real terms, Americans may be more income unequal (the case following 1971), but wealth equality can stay the same or even get a bit better (as it did until 2007).  But, when stock and other financial-asset prices rise, the top ten percent (and especially the upper reaches within it) put everyone else in what most wish weren’t their place. 

Further, two percentage points in wealth share equals fourteen percentage points of total annual household income.  Thus, even if labor wages start to rise – one of the Fed’s long-awaited defenses for post-crisis policy – it will take years, if not decades, to compensate for all this lost wealth and the hopes many have for their children and grandchildren. 

Importantly, the FRB-Minneapolis study does not go on to blame the Fed.  We do. 

As we noted in the first post on this blog, the Fed has no clue whether QE worked even as it frequently alludes to its own handiwork as the architect of the post-crisis recovery.  The Bank of England and European Central Bank more overtly assess their inequality impact than the Fed, but similarly absolve themselves.  With about $20.1 trillion of assets on central-bank books never before removed from the market, it’s hard on its face to fathom the “zero-market impact” conclusion.  The structural, significant, and clear changes above show just how dramatic this impact has been.

The basic rationale of all of these central-bank defenses, and likely also the Fed’s were it pushed to offer one, is that asset-price bubbles have disproportionately enriched the wealthiest but that reduced unemployment reduces income inequality, starting first at the low-wage, low-skilled end of the distribution.  The central bank of central banks, the Bank for International Settlements, has assessed all of these rationales and found them wanting.  In perhaps its most important result, this BIS staff paper finds that QE’s peak impact – that is, its impact across the years and all of its trillions – in the U.S. had ten times more effect on stock prices than on maximum output.  The Fed’s first, desperate, and sudden QE program in 2009 (QE1) did had very significant impact on near-term GDP growth because the market did not expect QE1 and thus behaved largely as the Fed anticipated.  However, QE’s overall impact fades to favor only the equity markets – not the macroeconomy – as subsequent programs (QE2 and QE3) wended their amply-signaled way through financial markets increasingly inured to large Fed positions and hungry for the yield required to salvage damaged business models.

But, is the inequality effect just an unfortunate correlation or could central banks really stoke equity-price hikes that advantage only the wealthy?  This BIS study also concludes that, over time, QE’s net impact fades to zero even though higher equity prices persist.  One could of course argue that exogenous factors (e.g., regulatory or tax policy) affect equity prices.  However, while the BIS paper finds a weaker link between QE and equity prices over time, it still concludes that the most significant underlying force behind resilient, higher equity prices is the yield-chasing spawned by both QE and ultra-low interest rates.

In short, own stock, get richer.  Own a high-price house, amass wealth absent undue leverage.  Try to get by on wages and a home with a mortgage, student debt, and other loans that make ends meet each week?  Put money in the bank to build a nest egg when interest rates on low-balance accounts are negative in real terms?  Even if you have a job in concert with others in your household and even if wages are rising – which mostly they aren’t – and the benefit of more than one wager-earner per household isn’t costing you almost as much in child care, and even if you can afford health care, you face insuperable odds of improving your family’s economic destiny without a significant change in the return you can expect from the little you can own or save.