Why The Gap Widens, According to the FedThe Federal Reserve’s latest Survey of Consumer Finances, according to Federal Reserve Governor Brainard, shows that the share of income held by the top 1 percent of households has risen from 17 percent in 1988 to 24 percent in 2015, and that the wealth held by that same group rose from 30 percent in 1989 to 39 percent in 2016.
There are many explanations of why the gap between the rich and the poor widens. Governor Brainard attributes some of it to labor market disparities relating to geography and to race and ethnicity. She and Robert Frank say it results from the wealthiest households being much more likely to invest additional money received than those in other income groups. Vincent Del Giudice and Wei Lu blame automation and robotics. John Tamny says it is a consequence of the explosion in entrepreneurship that has benefited us all. A Tax Policy Center report concludes that it will widen even more if the president’s income tax overhaul is enacted.
The Brookings Institute held a conference to explore whether monetary policy widens the wealth gap. Mainstream economists support expansionary monetary policy because the income gap closes after mortgage payments are lowered when homes are refinanced at lower interest rates. However, a conference panelist and former Federal Reserve (Fed) board member Kevin Warsh referred to the Fed’s monetary policy during the financial crisis as being “reverse Robin Hood.” This view has merit because the Fed’s purchases of securities push interest rates down and expand the money supply. The expansion of money then inflates the prices of financial assets, which are disproportionately owned by the rich.
The Brookings Debate
In a previous article for Mises Wire, I discussed data that seems to support both sides of the Brookings debate. In it, I conducted a thought experiment using aggregated data from Edward Wolff’s recent NBER paper and total household debt from the Federal Reserve Bank of New York. The experiment uses these data to calculate windfalls (or reductions in interest payments) that accrue to households when central banks lower interest rates. It assumes the interest rate that would have prevailed in the absence of central banking starts at 5 percent. To meet its annual inflation target of 2 percent, the Fed expands the money supply through time. This has lowered the interest rate on reserves to around 1 percent. The experiment assumes this is the interest that prevails in the presence of the Fed.
In aggregate, the experiment suggests that a reduction in interest rates from 5 percent to 1 percent benefited the bottom 90 percent. That group received the larger aggregated windfall from the Fed’s too-low interest rates. The total interest that this group paid declined by $332 billion. For the richest 1 percent, the total interest they paid declined by only $24 billion.
The above result supports the mainstream view that expansionary monetary policy disproportionally benefits the Americans populating the bottom 90 percent. Aggregation, however, is the fatal conceit of this view. As I pointed out, 98.9 percent more people are in the bottom 90 percent than in the top 1 percent. When the aggregate windfalls are disaggregated to the household level, the annual windfall for the richest 1 percent was $20,852, but only $3,154 for the bottom 90 percent. So, in any given year, setting too-low interest rates widens the income gap between rich and poor.
More Income for the Top 1 Percent
Over a long period of time, investment compounding of these windfalls widens the wealth gap. This results from the richest households being much more likely to invest windfalls than people in the lower income group, who mostly live paycheck to paycheck. Investing annual windfalls of $20,852 at 5.91 percent increases the wealth of those in the top 1 percent by $273,687 in 10 years or $1,622,639 in 30 years. This is not the case for those in the bottom 90 percent. If they spend most of their annual windfalls on consumer goods and invest the rest, say $1000, at 3.27 percent, their wealth increases by $11,607.45 in 10 years or $49,711.94 in 30 years.
Although the Federal Reserve was created to provide the US with a flexible and stable monetary and financial system, it has not. Its policies have caused economic booms and busts, reduced the value of the dollar to about a penny in just over 100 years, and may be causing substantial income and wealth inequality.
Republished with permission by Mses Institute