Cash News
For those of you who don’t remember the Global Financial Crisis of 2008 (it even has its own acronym, GFC), it was no walk in the park. From late-2007 to mid-2009, a downturn in the US housing market catalyzed a panic that spread from the United States to the rest of the world through linkages in the global financial system. Notable finance company failures included household names at the time, like Lehman Brothers and Merrill Lynch. Many other firms around the world incurred large losses and relied on government support to avoid bankruptcy. Millions of people lost their jobs as the major advanced economies experienced their deepest recessions since the Great Depression in the 1930s.
It was a scary period for investors, too. The S&P 500 declined 57 percent from its October 9, 2007 peak, to the trough on March 9, 2009. No one wishes to endure those financial stresses again. Yet one of the driving forces of the GFC is still with us, and its associated indicators are flashing yellow: the culprit is economic inequality.
Economists are united in attributing the GFC to an asset price bubble in the U.S. housing market. But as they tried to determine the causes of this bubble, scholars began to zero in on the nation’s severe and rising level of economic inequality. In what became known as the “Rajan hypothesis,” Raghuram Rajan, a former International Monetary Fund economist (and current University of Chicago faculty member) posited that financial deregulation, coupled with political pressure to assist increasingly desperate lower and middle-income households to boost their consumption, were major contributing factors to the GFC. Since that time, a large body of research has accumulated to connect the GFC with rising inequality. Its focus has shifted from the actions of government to the actions of the rich and the poor, but whether the GFC was caused by the behavior of our institutions, or the wealthiest among us, or our most deprived, inequality-related economic signals of another financial crisis are currently going in the wrong direction. In the name of prevention, we would do well as a society, and as a capitalist economy, to reduce income and wealth inequality before another financial crisis crushes the stock market once again.
Relative Deprivation, Trickle-down Consumption, and Debt Bubbles
One way that inequality precipitates debt bubbles begins with “relative deprivation.” This concept concerns the discontent people feel when they compare their socio-economic status, measured by income, wealth, consumption, or other indicators of perceived economic welfare, with that of their richer counterparts. Economists have suggested several ways that this discontent may translate into indebtedness. One theory holds that people of a given income level may try to increase spending to match the higher consumption of those just above them. This in turn leads others just below the group in question to spend more, and so on, in what has been termed an “expenditure cascade.” Another theory focuses on the increased supply of high-status goods and services that flow into the economy as the rich grow richer. Such increases might induce everyday people to demand and consume more of these status items. If the non-rich wish to maintain their usual consumption of other, non-status items, they might then end up spending more out of current income. Marianne Bertrand and Adair Morse, the authors of “Trickle-Down Consumption,” found some support for both of these theories, which explained their finding that middle income households consume a larger share of their current income when they learn about the rising consumption of upper income households. When everyday people consume more out of current income, they save less, and borrow more.
Not only might inequality induce the non-rich to consume and borrow more, but it may also influence them to make more risky investments. Another recent paper, by Aron Gottesman and Matthew Morey, found a positive relationship between income inequality and financial overconfidence and risk taking. This study also showed that as inequality increases, poor individuals increase their willingness to take risk.
How the Rich Contribute to Financial Instability: The “Saving Glut”
Compared with low-income households, high-income households spend a lower share of their income, and save a higher share. They also allocate a higher fraction of their savings toward riskier assets. This may be another way that higher inequality drives inflated valuations of risky assets like stocks.
Moreover, the manner in which the rich save can serve to finance the debt bubbles of the poor and middle class. Since the 1980’s in the U.S., the rise in savings by the top 1% of the income or wealth distribution has been substantial, and has been associated with dissaving, in other words borrowing, by the rest of the household sector as well as the government. In their paper, “The Saving Glut of the Rich,” authors Mian, et al. determine that businesses owned by the rich have increased their holdings of money market funds and time deposits substantially since the mid 1990s, injecting excess liquidity into the banking system, which in part induced the banks to lessen lending standards. As households sought to expand their borrowing to bolster their eroding socio-economic status, the banks, in essence financed by rising inequality, were happy to oblige. The combination of demand for debt by the non-rich, and the excess of funds supplied by the rich, caused the ratio of household debt to disposable income to rise from 77 percent in 1983 to 177 percent in 2007 for the bottom 95% income group of U.S. households. In contrast, the top 5% group maintained a trendless ratio in the range of 50-100% during the entire period.
What Are the Indicators Saying Now?
The United States is now more unequal than it was at the beginning of the GFC. The share of total disposable income of the top 10% of working age adults is higher compared to 2007. When measured by wealth, the share of the top 10% (and top 1%, 0.1% and 0.01%) is also higher than it was in 2007.
Asset prices are also flashing yellow. The inflation-adjusted median home price is higher than before the GFC. The valuation of the equity market is also elevated in comparison to 2007.
While the consumer is not yet overburdened by debt, the direction is concerning. As the U.S. Financial Stability Oversight Council notes, “household debt servicing ratios and overall consumer delinquencies remain relatively low. However, savings are falling, overall nominal consumer debt balances are at an all-time high, and credit card and auto loan delinquencies are on the rise.” In fact, credit card and auto loan delinquencies are approaching or exceeding the levels witnessed in 2006/2007. The ingredients are in place for another inequality-based financial crisis.
Public and Private Approaches to Reduce Inequality
Investors who fear the carnage that another financial crisis will wreak on their portfolios will understandably wonder whether there is anything that they can do to mitigate this inequality-induced systemic risk. Solutions to rising inequality have been discussed for years, including some that investors can implement. Our paper, “The Investor Case for Fighting Inequality: How Inequality Harms Investors and What Investors Should Do About It,” outlines a number of arguments that investors should use when pushing companies to be more transparent about the wages they pay, the taxes they avoid, and how they lobby to maintain the status quo. We point out that some inequality-inducing practices that may benefit the bottom line in the short-term, such as keeping worker compensation low while heaping riches upon top management, could have an adverse effect in the long run when customer satisfaction with products or service declines. Other company policies will help to ameliorate inequality while boosting overall financial performance, such as granting employees equity stakes.
While clever social media, or even a hand-written note will always garner some attention, you probably don’t have the time or resources to engage directly with companies in your portfolio that contribute to inequality. But if you have a retirement plan, or own mutual funds or exchange-traded funds, you have someone to turn to for help: your retirement fund or mutual fund trustee, in other words your fiduciary. Your fiduciary owes you an obligation to reasonably diminish your investment risk, such as that driven by inequality, and some large pension funds have already begun this effort.
For example, in 2020 New York City Comptroller Scott Stringer and the New York City Retirement Systems negotiated Board and CEO diversity search policies with 14 companies, including 13 in response to shareholder proposals. Other shareholder proposals calling for reduction in inequality within corporations have received substantial support. Earlier this year, the White House convened some of the largest pension funds in the U.S. to promote worker rights. Last year even witnessed an attempt to elect labor-friendly directors at Starbucks, led by a union-affiliated pension plan, resulting in a more open approach to the company’s bargaining.
In a recent post I have outlined the ways that anyone with a retirement account or mutual fund/ETF can activate their financial power with their fiduciary. Inequality has increased the chances of a financial crisis, and the harm that it will do to your portfolio. It may be time for you to communicate your concerns to those with a duty to protect your financial health.