The never-end­ing de­bate over wealth and in­come

The Pak Banker - - OPINION - An­to­nio Foglia

EV­ERY­ONE seems to be talk­ing about - and con­demn­ing - to­day's ris­ing level of eco­nomic in­equal­ity. Fu­eled by jar­ring sta­tis­tics like Ox­fam's re­cent rev­e­la­tion that the world's rich­est 62 peo­ple own as much wealth as the poor­est 3.6 bil­lion, pop­u­lar sup­port for left-wing fig­ures like Amer­ica's Bernie San­ders and Bri­tain's Jeremy Cor­byn is ris­ing.But to­day's ide­ol­o­gy­driven de­bates over­sim­plify an is­sue that is ex­ceed­ingly com­plex - and af­fected by pro­cesses that we do not fully un­der­stand.Many of those en­gaged in the de­bate on in­equal­ity nowa­days cite the French econ­o­mist Thomas Piketty's 2014 book Cap­i­tal in the Twenty-First Cen­tury, which makes three key points.

First, over the past 30 years, the ra­tio of wealth to in­come has steadily in­creased. Se­cond, if the to­tal re­turn on wealth is higher than the growth in in­comes, wealth is nec­es­sar­ily be­com­ing in­creas­ingly con­cen­trated.

Third, this ris­ing in­equal­ity must be re­versed through con­fis­ca­tory tax­a­tion be­fore it de­stroys so­ci­ety.The points might seem con­vinc­ing at first glance. But the first state­ment is lit­tle more than a tru­ism, and the se­cond is fal­si­fied by Piketty's own data, mak­ing the third ir­rel­e­vant.Piketty ob­serves a ris­ing wealth-to-in­come ra­tio from 1970 to 2010 - a pe­riod di­vided by a sig­nif­i­cant change in the mon­e­tary en­vi­ron­ment. From 1970 to 1980, the Western economies ex­pe­ri­enced ris­ing in­fla­tion, ac­com­pa­nied by in­ter­est-rate hikes.

Dur­ing that pe­riod, the wealth-to-in­come ra­tio in­creased only mod­estly, if at all, in th­ese coun­tries. From 1980 on, nom­i­nal in­ter­est rates fell dra­mat­i­cally. Not sur­pris­ingly, the value of wealth rose much faster than that of in­come dur­ing this pe­riod, be­cause the value of the as­sets that com­prise wealth amounts es­sen­tially to the net present value of their ex­pected fu­ture cash­flows, dis­counted at the cur­rent in­ter­est rate.The most straight­for­ward ex­am­ple is a govern­ment bond. But the value of a house is de­ter­mined in a sim­i­lar man­ner: ac­cord­ing to the rent it is ex­pected to gen­er­ate, cap­i­talised at the cur­rent nom­i­nal in­ter­est rate. Eq­ui­ties, too, are val­ued at a higher mul­ti­ple of earn­ings when in­ter­est rates fall.

In de­ter­min­ing the value of to­tal wealth, Piketty in­cluded both the in­come gen­er­ated by as­sets and their ap­pre­ci­a­tion. Mean­while, in­comes were cap­i­talised at de­clin­ing in­ter­est rates for more than a gen­er­a­tion. By this ap­proach, his find­ing that wealth grew faster than in­comes makes per­fect sense - it is a di­rect con­se­quence of fall­ing in­ter­est rates.

What im­pact do lower in­ter­est rates have on mea­sured in­equal­ity? If I own one house and my neigh­bor owns two, and fall­ing in­ter­est rates cause the value of those houses to dou­ble, the mon­e­tary in­equal­ity be­tween us also dou­bles, af­fect­ing a va­ri­ety of sta­tis­ti­cal in­di­ca­tors and trig­ger­ing much well-in­tended con­cern.But the re­al­ity is that I still own one house and my neigh­bor still owns two. Even the rel­a­tive af­ford­abil­ity of houses doesn't change much, be­cause lower in­ter­est rates make larger mort­gages pos­si­ble. For fur­ther ev­i­dence of this phe­nom­e­non, con­sider Piketty's own data. In Europe, Piketty sin­gles out Italy as the coun­try where the wealth-to-in­come ra­tio rose the most, to about 680 per cent in 2010, com­pared to 230 per cent in 1970. Ger­many ap­pears to be a more "vir­tu­ous" coun­try, with a wealth-to-in­come ra­tio of 400 per cent, up from 210 per cent in 1970. What Piketty fails to high­light is that, over this pe­riod, in­ter­est rates fell much more in Italy (from 20 per cent to 4 per cent) than in Ger­many (from 10 per cent to 2 per cent).The real-world im­pact of this dy­namic on in­equal­ity is pre­cisely the op­po­site of what Piketty would ex­pect. In­deed, not only are Ital­ians, on av­er­age, much richer than Ger­mans; Italy's over­all wealth dis­tri­bu­tion is much more bal­anced.

A 2013 study of house­hold fi­nances in the eu­ro­zone, con­ducted by the Euro­pean Cen­tral Bank, showed that in 2010 - the last year in Piketty's re­search - the av­er­age Ital­ian house­hold was 41 per cent richer than the av­er­age Ger­man house­hold. More­over, whereas the dif­fer­ence be­tween mean and me­dian house­hold wealth is 59 per cent in Italy, it is a whop­ping 282 per cent in Ger­many.This dif­fer­ence can be ex­plained largely by the fact that 59 per cent of house­holds in Italy own homes, com­pared to only 26 per cent in Ger­many. A larger share of Ital­ians has thus ben­e­fited more from a larger drop in in­ter­est rates.This ex­am­ple high­lights how house­hold in­vest­ment de­ci­sions shape wealth out­comes. Com­pli­cat­ing wealth mea­sure­ments fur­ther is the fact that, as Martin Feld­stein re­cently pointed out, for the vast ma­jor­ity of house­holds, a large pro­por­tion of wealth is in the form of un­ac­counted fu­ture so­cial ben­e­fits.

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