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Rising Wealth Inequality Is Bad, But Liberal 'Solutions' Are Much Worse

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(Image credit: AFP/Getty Images via @daylife)

Is rising inequality of income and wealth a bad thing?  Yes, in the sense that the monetary chaos that is causing it is a bad thing.  Everyone, including “the one percent,” would be better off today if America had had stable money for the past 45 years*.

However, if we assume that we must, for some reason, stick with our undefined, discretionary, fiat dollar, then rising inequality is actually a good thing—or, at least, a necessary thing.  The increased concentration of income and wealth simply reflects the economy’s effort to adapt to bad monetary policy.

Rising inequality is being driven by five factors:

  • Monetary instability raises the cost of capital.  This drives up the required return on capital, which (with a lag) increases the share of GDP accruing to capital.  Don’t be fooled by the current low interest rates currently being enjoyed by governments and big corporations.  Capital for new ventures is scarce and expensive.
  • A larger share of GDP going to capital means a lower share of GDP going to labor.  In the 1950s and 1960s, a period of stable money, wages commanded an average of 51% of GDP.  By 2012, labor’s share had fallen to 44% of GDP.  In today’s economy, this difference is equivalent to almost $1.2 trillion.  As counterpoint, corporate profits as a percent of GDP rose from an average of about 6% in the 1950s and 1960s to almost 11% in 2012.
  • Management is the steward of capital.  As the cost of capital has risen, the pay of those whose job it is to manage society’s capital has risen.  This has caused a higher percentage of the (already shrunken) total wage pie to go to executives (especially CEOs).  This phenomenon has added to the squeeze on middle class wage incomes.
  • One way that the real economy has adapted to monetary instability is to develop mechanisms to allow companies to insure against risks created by chaotic, improvised monetary policy.  While necessary, these mechanisms are costly.

    Since 1970, the percent of GDP accruing to “finance and insurance” (also known as “Wall Street”) has risen from about 4% to 8% (or more).  Much of this additional revenue (4 percentage points of current GDP amounts to almost $0.7 trillion) accrues to “the one percent.”

  • Monetary instability leads to inflation.  The interaction between inflation and our income tax system has resulted in negative real after-tax returns on the kinds of investments favored by ordinary people.  These negative returns have persisted long enough that middle class people have become less willing to save (i.e., participate in the ownership of the nation’s capital).

Because of the mechanism that is causing the greater inequality, any attempt to reduce it via forced redistribution of income and/or wealth would just make things worse for everyone.  Here’s why.

First, imagine the income that you could generate by gathering food in the wild with your bare hands (hint: it would not even be the $500/year required to avoid starvation).  Now, consider that U.S. GDP per worker is currently $115,703/year.  The difference between these two numbers is the result of having capital (tools of various kinds) to work with.

GDP is determined by the quantity of fixed assets (i.e., the capital stock).  Each year, GDP tends to be about 0.07 times residential assets plus 0.48 times nonresidential assets.  It takes about $200,000 of nonresidential assets to support one average job.  So, both GDP and total employment are a function of capital accumulation.

Every asset has to be owned by someone, and that someone has control of that asset.  “The rich” are, well, rich.  They can’t consume very much of their earnings.  So, on the margin, “the rich” save and invest 100% of their income.  They also do not need to liquidate assets to finance current consumption.

If, as some progressives advocate, America were to introduce a wealth tax, this would have the effect of transferring assets from “the rich,” who would preserve the assets, to the poor and the middle class, which would liquidate them.  If you have any doubt that this would be the case, just look at the studies on ordinary people that win the lottery.

The slower build-up of fixed assets that would result from higher taxes on “the rich” would very quickly cost the struggling middle class more in terms of lost jobs and wage income than they would get from the wealth redistribution programs.  And, of course, higher taxes on capital would just increase the cost of capital even more, driving profits up, and wages down, even further.

So, if we must have unstable money and all of its deleterious effects on savings and investment, the economy will try to adapt by concentrating assets in the hands of “the rich,” who will preserve and add to them, rather than liquidate them.  Doing this will minimize the damage to middle class jobs and wage incomes.

But wait—there’s more!

Unstable money interferes with capital accumulation, both by adding a discouraging new risk element to capital investment, and by encouraging “malinvestment.”

Malinvestment occurs when investors are misled by price signals that have been distorted by monetary machinations.  Investments get made that subsequently must be written down or written off when the true value relationships become clear.

The recent American housing bubble and bust was the biggest example of malinvestment in human history.  However, excess inventories of commodities (e.g., gold, oil, copper) that are held as inflation hedges also represent malinvestment.

The hundreds of billions of dollars of capital that went toward building unneeded houses and accumulating inflation hedges would have been better allocated to building up America’s stock of job-creating nonresidential assets.

Since President Nixon abrogated the Bretton Woods gold standard system in the early 1970s, America has become less efficient at converting fixed investment into increases in the nation’s stock of fixed assets.  This is largely because of an increased incidence of malinvestment.

During the first 178 years of American economic history, U.S. real GDP (RGDP) grew at an average annual rate of 3.98%.  Since 1968, when the gold standard first began to break down, RGDP growth has averaged only 2.81%.  And, during the hyperkinetic monetary improvisation of the Bush 43/Obama years, RGDP expansion slowed to only 1.75%.

Because, as Einstein said, compound interest is the most powerful force in the universe, America’s RGDP growth rate makes an enormous difference over time.  If U.S. RGDP had grown as fast from 1968 to 2012 as it did from 1790 to 1968, our economy would be about 60% larger today.  Imagine the impact that 60% more GDP would have on, well, everything and everybody.

The unstable fiat dollar under which we have now suffered for 45 years is the root cause of both feeble GDP growth and rising inequality.  The only real way out of this mess is to stabilize the dollar.  Progressive schemes to redistribute income and wealth would only make things worse for everyone.

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*The free market price of gold first moved above the official gold price of $35.00/oz in 1968.