Is the Fed blowing bubbles to cover up growing inequality.... …again?


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Is the Fed blowing bubbles to cover up growing inequality.... …again?

  1. 1. Macro Commodities Forex Rates Equity Credit Derivatives Please see important disclaimer and disclosures at the end of the document 27 September 2013 Global Strategy Alternative view Global Strategy Weekly Is the Fed blowing bubbles to cover up growing inequality…again? Albert Edwards (44) 20 7762 5890 Global asset allocation % Index Index neutral SG Weight Equities 30-80 60 30 Bonds 20-50 35 50 Cash 0-30 5 20 Source: SG Cross Asset Research Global Strategy Team Albert Edwards (44) 20 7762 5890 They’re at it again! US inequality is surging and the Fed has created another house price boom. Does this matter? Well I think so. But who cares what I think. Warren Buffet, Bill Gross and Stanley Druckenmiller think it matters. Clients marvel at how the US profits’ share of GDP remains so high and that labour remains so weak. Marc Faber said recently that in postponing the QE taper, we have merely climbed to a higher diving board. I go further. I see growing inequality draining the swimming pool dry. The crunch, when it comes, will be ugly.  We know Quantitative Easing has mainly helped the rich. The Bank of England admitted as much a year ago. Specifically it said that its QE programme had boosted the value of stocks and bonds by 25%, or about $970 billion. It then calculated that about 40 percent of those gains went to the richest 5 percent of British households – link.  Profits and capital have benefited from QE at the expense of labour. Dividends and share buybacks have benefited at the expense of wages. Andrew Lapthorne describes a mechanism where QE washes through the system and ends up enriching management via share buybacks. Unsurprisingly, inequality has continued to grow - link.  I was starting to update some charts on the US house price boom. The Case-Shiller 20 Cities Index rose a frothy 12½% in the year to July, led by fizzing San Francisco prices which rose 25% yoy. Then I remembered I had meant to highlight to readers the updated measures of US inequality which have reached new grotesque heights (see chart below). The correlation between another US house price surge and still soaring inequality took me back to thinking about my original note on the topic “Theft! Were the US & UK central banks complicit in robbing the middle classes?”- link. I wanted to update my thoughts.  Does this level of extreme inequality matter and, if so, can anything be done? Yes and yes. I believe the 99% who have missed out on the fruits of recovery will demand change and will not be bought off with another housing bubble designed, as before, to divert their attention from the continued appropriation of the fruits of their labour by the 1%. I expect that ultimately, US capital gains (and dividend) tax rates will be brought into line with income tax. And the 99% will hail former UK Chancellor, Nigel Lawson, for the visionary he was. US inequality reaching new extremes (Top decile income share) Source: Emmanuel Saez of Berkeley University, Striking it Richer: The Evolution of Top Incomes in the United States This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  2. 2. Global Strategy Weekly 27 September 20132 When I saw the latest US Case-Shiller data showing house prices surging at a double-digit national pace, I recalled one of the key reasons we had previously identified for why the US Fed may have been so keen to get a house price bubble inflating. US S&P Case-Shiller house prices (Level, seasonally adj, Jan 2000=100) Source: Datastream We noted back in early 2010 that the Fed was in some economic sense ‘required’ to offset the impact of rising inequality on the economy by generating a house price boom. We wrote: “Our US economists make the very interesting point that peaks of income skewness – 1929 and 2007 – tell us there is something fundamentally unsustainable about excessively uneven income distribution. With a relatively low marginal propensity to consume among the rich, when they receive the vast bulk of income growth, as they have, then the country will face an under-consumption problem. (Marc Faber also cites John Hobson’s work on this same topic from the 1930s).” Hence, while governments preside over economic policies that make the very rich even richer, national consumption needs to be boosted in some way to avoid under- consumption ending in outright deflation. In addition, the middle classes also need to be thrown a sop to disguise the fact they are not benefiting at all from economic growth. This is where central banks have played their pernicious part. I recall seeing an article from John Plender on this topic back in April 2008. His explanation for why there had been so little backlash from the stagnation of ordinary people’s income at a time when the rich did so well was simple: “Rising asset prices, especially in the housing market, created a sense of increasing wealth regardless of income. Remortgaging homes over a long period of declining interest rates provided a convenient source of funds via equity withdrawal to finance increased consumption” – link. Now some argue that central banks had no choice in the face of under-consumption, while conspiracy theorists might even conclude there has been some sort of unspoken collusion among policymakers to ‘rob’ the middle classes of their rightful share of income growth by throwing them illusionary spending power based on asset price inflation. We will never know. But now it all makes more sense! Let’s look at what has happened since the Great Recession in more detail. Emmanuel Saez of Berkeley University has just updated his analysis and we show his key chart of how the top income tiers have done (see front cover chart). “Based on IRS data, incomes of the top 1% grew by 31.4% while bottom 99% incomes grew only by 0.4% from 2009 to 2012. Hence, the top 1% captured 95% of the income gains in the first three years of the recovery. 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 60 80 100 120 140 160 180 200 220 240 60 80 100 120 140 160 180 200 220 240 NY 20 cities San Francisco This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  3. 3. Global Strategy Weekly 27 September 2013 3 Overall, these results suggest that the Great Recession only depressed top income shares temporarily and will not undo any of the dramatic increase in top income shares seen since the 1970s. Indeed, the top decile income share in 2012 is equal to 50.4%, the highest since 1917 when the series start (see front cover chart). Saez considers some of the surge, including capital gains, may be due to retiming of income due to impending 2013 tax changes, but he thinks that tax re-timing is unlikely to explain the surge in income inequality once capital gains are excluded – see link). Saez looks ahead and concludes; “based on the US historical record, falls in income concentration due to economic downturns are temporary unless drastic regulation and tax policy changes are implemented and prevent income concentration from bouncing back. Such policy changes took place after the Great Depression during the New Deal and permanently reduced income concentration until the 1970s. In contrast, recent downturns, such as the 2001 and 2008 recession, led to only very temporary drops in income concentration." So, what does this mean? In an excellent article entitled Income Inequality Sheds Its Taboo Status, Chrystia Freeland of Reuters notes that while it has long been almost taboo to talk about inequality in the US, there have been some high quality discussions recently. In the article she discusses a recent Brookings panel she attended, discussing income inequality, including the research collected in a new book published by Brookings titled “Inequality in America.” - link. The panel “offered three important takeaways about the causes and consequences of rising income inequality. One was that government matters. Like most students of the subject, the assembled economists agreed that rising inequality was driven partly by economic forces like the technology revolution and globalization." But the state can choose to mute the impact of the invisible hand. Paradoxically, in much of the Western world, and particularly in the United States, even as the power of these economic shifts has become more profound, government efforts to mitigate them have become weaker. As Mr. Buffett pointed out, the effective tax rate paid by the 400 top earners in 1992 was 26.4 percent. By 2009, it had fallen to 19.9 percent — even as the pretax gap between the plutocrats and everyone else had widened. (I will return to the theme of taxation policy later.) A second theme of the Brookings discussion helps to explain why the top earners’ tax rate has fallen — effectively the economy has gone global, but nation-states have not. Higher taxes on the rich may be a logical response to rising income inequality, but actually levying those taxes is getting harder in an age of global capital flows. Mr. Buffett said it was “sickening” that rich people and companies use the Cayman Islands to lower their tax bills, but moral outrage is a weak weapon against international tax arbitrage. If you are still not convinced that all this matters, consider the third, and most striking, possibility raised at the Brookings panel. Set aside any moral or political concerns you may have about rising income inequality — worries about poverty, justice, undue political influence or even social mobility. According to Mr. Dervis, co-author of the book, the research collected in “Inequality in America,” shows that a growing number of economists suspect that once inequality passes a certain point it may jeopardize economic stability and economic growth. As the book argues, “rebalancing of the distribution of income may play a role in unlocking the U.S. economy’s growth potential in a sustainable way.” That is exactly the point Warren Buffet, Bill Gross and Stanley Druckenmiller make. You don’t have to be a communist to conclude that high levels of inequality not only adversely affects long-term growth, but also increases the economy’s vulnerability to recession. This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  4. 4. Global Strategy Weekly 27 September 20134 Joseph Stiglitz makes the most simple point in a NY Times op-ed “Our skyrocketing inequality — so contrary to our meritocratic ideal of America as a place where anyone with hard work and talent can make it — means that those who are born to parents of limited means are likely never to live up to their potential. Children in other rich countries like Canada, France, Germany and Sweden have a better chance of doing better than their parents did than American kids have.” He is right. There is growing body of evidence that the largest determinant of your income is increasingly your starting point. When I was studying economics I think this was part of the lecture on the Edgeworth box: how well you do depends on your initial endowments and how far you move along the contract curve. Or to put it another way, it is economically inefficient for Tim (nice but-dim)’s parents to buy education at his private school while the highly intelligent Tracy sinks like a stone at a local sink school (no disrespect to any Tim’s or Tracy’s out there). It’s not about equality of outcomes, it’s about equality of opportunity. I think all of us, especially economists, can identify with that…until it comes to our own children, that is. On that topic it is shocking that the reading scores for the US high school graduation class of 2012 reveal a four-decade low, The Washington Post reports one explanation may be a sharp increase in students of low-income backgrounds: “There are many factors that can affect how well a student rates on the SAT scores, but few correlate as strongly as family income” –link. Average SAT reading/verbal scores for US High School Graduates hits a 40 year low Source: Zero Hedge So let’s quickly run through some of the excellent charts that we should keep in mind given the disturbing news that inequality in the US is still surging (front cover chart). I will then give my view on one way this might play out. Now we all know that income inequality in the US is among the worst in the OECD and the most unequal in the developed world (see chart below). Source: OECD, (S90/S10 is top deciles income share relative to the bottom decile) This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  5. 5. Global Strategy Weekly 27 September 2013 5 But much more controversial is measuring the impact, if any, of high levels of US inequality on economic and social outcomes. A paper published earlier this year by the World Bank entitled “Inequality of Opportunity, Income Inequality and Economic Mobility: Some International Comparisons” goes to the heart of these matters and tries to strip away much of the party political dogma associated with each side of this controversial debate. One key subject the authors tackle is whether there is any observable relationship between inequality of opportunity and income inequality. It all gets a bit technical as these things do, but they say that “it is not obvious that there should be any mechanical reason to expect a correlation between income inequality levels and the relative extent of inequality of opportunity (IOR). (Yet) the figure below shows the clear association (I’ve circled the US in red as it gets a bit lost underneath Spain – ‘ESP’). Inequality of opportunity and income inequality Source: World Bank, Inequality of Opportunity, Income Inequality and Economic Mobility: Some International Comparisons Having established an international link between income inequality and inequality of opportunity (IOR), they then go on to draw a further association with intergenerational mobility. The authors show that their measure of inequality of opportunity (IOR) is strongly positively correlated with two different measures of intergenerational persistence (the converse of mobility): the intergenerational elasticity of income, and shown below, the correlation coefficient of parental and child schooling attainment. Inequality of opportunity and intergenerational mobility – i.e. the American dream Source: World Bank, Inequality of Opportunity, Income Inequality and Economic Mobility: Some International Comparisons This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  6. 6. Global Strategy Weekly 27 September 20136 The authors conclude that “inequality of opportunity (IOR) is the missing link between the concepts of income inequality and social mobility: if higher inequality makes intergenerational mobility more difficult, it is likely because opportunities for economic advancement are more unequally distributed among children. Conversely, the way lower mobility may contribute to the persistence of income inequality is through making opportunity sets very different among the children of the rich and the children of the poor.” To me that is all complicated academic speak for explaining why Tim (nice but dim) does so well in terms of eventual earnings power compare to Tracy. But I am doing this excellent piece of research an injustice and invite you to peruse it yourselves at your leisure - link. Let’s now quickly view some other charts on inequality and social outcomes I found pretty compelling. The first thing that surprised me was to find income inequality was more extreme in Singapore than in the US (see left-hand chart below). But certainly Singapore’s income distribution does not seem to be affecting key social measures such as infant mortality, whereas it clearly does in the US and elsewhere (see chart below). I was surprised to see Singapore topped OECD inequality… ..and also surprised that the US infant mortality was so bad Source: The Equality Trust, citing U.N. Development Program Human Development Indicators, 2003-6.and OECD data Even more compelling is when we put these two variables on one chart (see below). Spurious correlation? Ignoring Singapore (!) it does seem pretty compelling Source: The Institute of Policy Studies and The Equality Trust This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  7. 7. Global Strategy Weekly 27 September 2013 7 The Institute of Policy Studies in their excellent paper (link) push this correlation between income inequality and social wellbeing even further by building a composite measure of Health and Social Problems comprising:  Life expectancy  Maths proficiency and literacy  Infant mortality  Homicides  Imprisonment  Teenage births  Trust  Obesity  Mental illness, including drug and alcohol addiction  Social mobility And then we get the chart below which is even more compelling (although Singapore has now disappeared). The US is clearly in a world of its own! Spurious correlation? I don’t think so personally. But what about causality? Source: The Institute of Policy Studies and The Equality Trust The Institute of Policy Studies go on to cite some work done here in the UK “A 2009 study in the British Medical Journal attempted to quantify the number of deaths that could be attributed to economic inequality among the 30 rich countries that make up the OECD - link. The researchers found an association between greater inequality and a higher overall death rate in countries where inequality runs “relatively high”. What constitutes “relatively high” inequality? To answer this question, the researchers ranked the 30 OECD countries in order of their ‘Gini index’, a standard metric that economists use to describe the level of inequality in a population. The United States ranks as the fourth-most unequal country, with a Gini of 0.357. The median Gini among OECD nations, 0.3, became the reference point against which researchers compared countries and their death rates. The British Medical Council study concluded that almost 884,000 excess deaths per year in the United States could be attributed to the high level of income inequality. In other words, if the Gini in the United States were 0.3 instead of 0.357, we would see nearly 884,000 fewer deaths per year. Wow! But what can be done quickly NOW to help arrest this trend towards ever increasing inequality and social and economic problems in the US? Nigel Lawson is our man. This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  8. 8. Global Strategy Weekly 27 September 20138 Now being a bear of very little brain I thought I needed to remind myself how things worked in the US tax system for income, dividends and capital gains - The situation for dividends before 2013 was this: “The U.S. tax code gives similar treatment to dividends and capital gains. Ordinary dividends and short-term capital gains are subject to the same rate as one's income tax rate.” But this higher rate is easily avoided. ‘Qualified’ dividends and long-term capital gains benefit from a lower rate. Qualified dividends are those paid by domestic or qualifying foreign companies that have been held for at least 61 days out of 121 days. “Long-term” for US capital gains tax purposes is over a year. Neither of these seem a particular long holding period to me to qualify for favourable tax relief! Prior to this year, with qualified dividends and long-term capital gains, individuals in the 25% or higher tax bracket paid a 15% tax, whereas those in lower brackets were exempt from any tax (i.e. way lower than income tax). What an incredible distortion to the US tax system! No wonder it has been so easy for the 1% to get richer and richer in the US. While some might explain higher inequality as the inevitable consequence of technological innovation and globalisation, for me distortions in the tax system are key to explaining the extreme levels of income inequality in the US. Now in the murky parts of my brain I seemed to remember that 2013 was going to see a major reform of the US dividend tax system. Indeed, upon double-checking it had indeed been planned that from the beginning of this year the preferential treatment given to qualified dividends was set to disappear completely. It HAD been planned that as of this year individuals would have to pay the appropriate rate of income tax rate on all dividend income they receive. That would have been an important victory for the 99% and an important step, in my humble view, in arresting the inexorable upward march of inequality in the US. Unfortunately as the tables below show, the Administration had to back down amid howls of anguish from congress and the 1%. Qualified dividends remain aligned to far lower Capital Gains tax rates and the only step forward to convergence with income tax was to introduce a higher 20% rate of capital gains (and qualified dividend tax) for those in the 39.6% income tax bracket (which, for a single person kicks in at taxable income over a lively $400,000). Capital Gains tax rates in the US Dividend taxation rate in the US Source: I’m lazy and copied these out of Wikipedia Instead of backing off, things should have gone even further in my opinion to arrest the upward march of US inequality. In my opinion one of the greatest tax distortions and biggest incentives for tax avoidance would be eliminated by completely aligning all taxes on capital gains and dividend income with income tax. This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
  9. 9. Global Strategy Weekly 27 September 2013 9 I can hear the calls from the economic libertarian bloggers to hang, draw and quarter me (incidentally I used to drink at a pub of the same name just next to the Tower of London so I am fully acquainted with the practice). But before I am strung up as a heretic, consider the words of one of the most tax-reforming, right-wing UK Chancellors of the Exchequer of the 20th century. Nigel Lawson said in 1988: “In principle there is little economic difference between income and capital gains, and many people effectively have the option of choosing, to a significant extent, which they receive. Insofar as there is a difference, it is by no means clear why one should be taxed more heavily than the other.” And separately "I have long felt it is highly undesirable that Capital Gains Tax should have given rise to a substantial tax avoidance industry dedicated solely to converting income into capital gain, which is taxed very much more lightly." It was Lawson who in 1988 brought capital gains taxation into line with income taxes to stamp out any incentives for the rich to even bother trying to use this time-honoured method for to avoid income tax. And he did what no Labour government had done before him. We are talking about Nigel Lawson, the former UK Chancellor’s of the Exchequer in Margaret Thatcher’s extremely ‘conservative’ Conservative administration. Nigel Lawson was no lily- livered leftie liberal. He was so far right he makes Ron Paul look like a pinko-socialist – ok, maybe not quite that far right. Yet despite his right wing, free market credentials Nigel Lawson should be THE pin-up poster boy for the 99% movement. Unfortunately Lawson’s far-sighted tax reforms were undermined by the subsequent Labour government with disastrous consequences. In an interview with the BBC in 2010 Nigel Lawson blamed former Prime Minister Gordon Brown’s cutting of Capital Gains Tax in 1997 for the subsequent boom in buy-to-let housing bubble that proved a major factor in the boom and bust of the UK economy in the Great Recession – link. But let us return to the problems in the US here and now. What society needs to grow in an economically optimal fashion is not equality of outcomes, but equality of opportunity. But with the grotesque distortions of income now prevailing, one’s lifetime opportunities are so increasingly dominated by what one’s parents income is that the American dream has increasingly become just that –a dream, and an increasingly distant one at that. We do not feel we are alone in our call. Notable investors such as Bill Gross, Warren Buffet and more recently Stanley Druckenmiller have voiced similar concern about the current grotesque levels of inequality in the US. Many investors I meet continue to marvel at US labour’s inability to rebuild its wage share of GDP and how dominant capital and profits have become. I believe society will ultimately demand and implement a change. We have already seen a potent grass-roots backlash against cross-border tax arbitrage and tax-havens, which has forced the politicians to react here in the UK. Yet inequality in the US continues to grow. Investors should make no mistake. The anger of the 99% will ultimately not be bought off by yet another central bank inspired housing bubble, engineered to pacify them and divert their attention as their real incomes fall and inequality continues to grow. The current bubble will burst, despite the Fed postponing the event by climbing to ever higher diving boards. All the time rising inequality is draining the swimming pool dry and the crunch when it comes will be ugly. Then the long overdue reforms in the tax system discussed above could be forced by a raging public onto the 1% despite their brays of indignation. And when dividends and capital gains tax rates are properly aligned with income tax and inequality begins to decline, let the 99% hold former UK Chancellor Nigel Lawson aloft on their shoulders and fete him for being well ahead of his time. This document is being provided for the exclusive use of YANNICK NAUD (GLENDEVON KING LTD)
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