Income inequality in a low-interest rate world
A topical discussion in economics is a trend of rising Income inequality, with some calling it the most disturbing social and economic issue of our time.[1] One way to measure this inequality is to compare the income earned by the top 1% as a share of national income. Plotted in the graph bellow we can see that the top ‘1%’s earnings are becoming a larger share of national income around the globe.
The Reserve Bank of Australia (RBA) has now turned its attention to the role monetary policy has in this trend. Recently, senior researcher at the RBA, Dr. Gianni La Cava, gave a lecture at the University of Melbourne about the distributional effects of monetary policy, synthesising his observations from Australia. He introduced monetary policy as a new element to the inequality debate, which differs from prevalent analysis of structural policies, or the role of economic capital – as popularised by the French economist Thomas Piketty – that contribute to the income gap. Unlike the politicised debate around globalism, unionisation, inherited wealth and changing demographics, monetary policy remains relatively apolitical. The merits of expansionist policy and the role of the RBA are generally supported across political parties.
However, if there was evidence that monetary policy was furthering inequality, this may draw scrutiny on the RBA and its ability to operate in accordance with its mandate to contribute to “the economic prosperity and welfare of the people of Australia.” The apolitical sentiments around monetary policy, however, may disappear if policy can be seen to favour one income class more than another. The RBA would therefore have to consider whether its policy mechanisms provide equitable solutions which support the mandated common economic prosperity.
The correlation
Since the 1980s we observe two phenomena: a gradual increase in the share of national income earned by the top 1%, and a decrease in the cash rate. These two trends have a negative correlation, since lower interest rates are associated with higher inequality, as measured by the top 1% of income earners share of national income. While our data focuses on Australia, similar trends can be observed across developed countries.
It’s important to stipulate, as La Cava does, that this is a relationship of correlation and does not imply causation as there are not established control variables which would prove the effect.[3] However, as he detailed next, there are observable economic movements that support the case that a low interest rate environment furthers the income gap.
A good time for asset holders
Potentially the most obvious driver of this gap is that low interest rates are linked to favourable stock and property market conditions.[4] Given that higher net-worth individuals have a propensity to own more of these assets, the consequence of increasing asset values would disproportionately increase the wealth of the ‘1%’ compared to those who primarily derive their wealth from their labour incomes. However, unlike the unison effect lowering of the interest rate has on stock valuation (lowering of discount rate) property markets operate differently. In soon to be released research, La Cava illustrates greater elasticity amongst wealthier suburbs in response to interest rate changes compared to poorer suburbs.[5] This effect would imply that a given interest rate cut would disproportionately increase the value of property in wealthier suburbs compared to the poorer suburbs, and a rate hike would disproportionately lower values respectively. Given this difference in volatility of property, we can see how an environment of declining interest rates, as observed in Australia over the past decades, benefits owners of property in wealthy suburbs far more than poorer. If we also consider the predisposition of wealthier individuals to diversify their assets into equities as well, we have two asset classes which gain significant value in low interest rate environments, further contributing to the wealth gap.
The price of company credit
The income of individuals is not the only inequality we can note, as firms are also subject to disproportionate benefit when considering their financing cost. As La Cava illustrates through his research with colleague Jonathan Hambur, the decline in interest rates impacts the price firms pay for credit differently depending on their size.[6] Through pulling the finance cost paid by ASX listed companies, La Cava and Hambur show this trend.
What can be seen is that the costs of finance for larger businesses moves downward, as the cash rate has since 2005, but the cost of finance amongst the smaller companies sees largely no change. This is explained through the “mixed bag” of finance sources which is prevalent in smaller companies but not larger. Smaller companies have more variety in finance sources, which can include loans from individuals such as directors or investors which contributes to the “mixed bag”, while larger companies generally turn to credit markets and institutional lenders. The divergence in lending rate trends for small and large companies suggests lowering the cash rate largely decreases the lending cost for large companies but does little for smaller.
If we consider the previous point, that lowering interest rates creates favourable market conditions for risk assets (stocks), then it should follow that the credit of these companies experiences similar favourable market conditions. In theory, lowering the cash rate lowers the risk-free rate of return; if investor want higher returns, they must turn to risker opportunities, such as lending to smaller companies. The increased supply of credit for these firms should therefore lower the cost of finance, which is not what is seen in the graph. A possible explanation for why larger companies are able to gain cheaper finance while smaller companies see no change, is due to the undiversifiable risk more prevalent amongst smaller companies. For larger companies, debt instruments and diversification can be used to minimize the risk of lending, which along with lower interest rates contributes to this low cost of borrowing. However, for smaller companies these instruments are unavailable, and the risk of default is unchanged, all of which contributes to the disparity seen in the chart. The trend shows an inequality in cost of credit which supports a notion that decreasing interest rates benefits large companies more than smaller.
The conditions of decreasing interest rates do not benefit everyone equally, as we can observe higher price rises for property in expensive suburbs, stock markets and cheaper lending for the ASX’s largest companies. With this in mind, we must consider that we have not observed the impact of an increase in interest rates so we cannot infer how much of these trends are structural economic changes or the result of lower rates. Should the trends be reverted in an environment of rising rates then an argument can be made that inequality is a part of expansionist policy but not an ongoing trend so long as monetary policy reverts to contractionary. There is not evidence yet to suggest this yet, but the points made in this article imply monetary policy is playing some role in inequality. Given the trend for rates appears to be decreasing (at best remaining flat) in the foreseeable future, it is possible that the cause of the wealth inequality trend is less important than our response. With a monetary policy environment that favours our largest companies and the wealthy as opposed to meritocratic wealth generation, it is easier to justify a tax and transfer response to narrow the gap between disposable incomes. However, this encourages a wider debate about equity, whose principles are often not derived from the same considerations as monetary policy. Hopefully, however, this could strengthen the inescapable roots of economics as a social science.
F. Scott Fitzgerald: “The rich are different from us”
Ernest Hemingway: “Yes, they have more money”
[1] Berman, Y., Ben-Jacob E., & Shapira Y. (2016). The Dynamics of Wealth Inequality and the Effect of Income Distribution. PLoS ONE, 11(4), 1-19.
[2] Dollman, R., Kaplan G., La Cava, G., Stone, T. (2015). Household Economic Inequality in Australia. Retrieved from https://www.rba.gov.au/publications/rdp/2015/pdf/rdp2015-15.pdf
[3] La Cava, G. (2019). The distributional effects of monetary policy: Insights from Australia. The University of Melbourne.
[4] Hall, M. (2019). How Do Interest Rates Affect the Stock Market?. Retrieved from https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/
[5] La Cava, G. (2019). The distributional effects of monetary policy: Insights from Australia. The University of Melbourne.
[6] La Cava, G., Hambur, J. (2018). Do Interest Rate Affect Business Investment? Evidence from Australian Company-level Data. Retrieved from https://www.rba.gov.au/publications/rdp/2018/pdf/rdp2018-05.pdf
[7] Ibid.