It would be nice to think that, with Brexit being concluded early next year and President Trump leaving office, investors will be free to worry less about politics and focus instead upon what we are more comfortable with, such as valuations, earnings and the near-term economic weather. Sadly, though, this is not the case. There is increasing evidence that one of the most important issues in politics – inequality – also matters for investors. And this evidence comes not from radical economists but from the heart of the financial establishment.
A simple fact gives us a clue here. The Bank of England’s Michael Kumhoff points out that the two greatest financial crises in recent western history – those of 1929-31 and 2008-09 – both followed big rises in inequality. By contrast, the egalitarian post-war period was notable for a lack of crises in the west. Is this really a coincidence?
Maybe not. “Higher inequality is associated with greater financial risks” conclude a team of International Monetary Fund (IMF) economists in a recent paper. And Pascal Paul at the San Francisco Fed has found that inequality along with weak productivity growth are “robust predictors of crises.”
This, they say, is because inequality causes banks to lend more to the poor who (by definition) are worse credit risks. And this creates the danger – and in 2008 the reality – of a wave of defaults and hence a crisis. This happened partly because low-income earners borrowed more to maintain their spending in the face of a squeeze on their incomes. But governments were also happy to tolerate sub-prime lending as a way of keeping alive the dream of wider home ownership. Raghuram Rajan, a former chief economist at the IMF, has described such lending as a “political response to rising inequality.”
You might object here that a correlation between inequality and subsequent financial crises doesn’t prove causality. Perhaps instead the financial deregulation of the 1980s led to both. Inequality, however, is not merely a matter of wealth and income. Inequalities of power also matter. And that deregulation was the result of a political process that favoured the interests of the rich.
There are, however, other channels through which inequality matters for financial markets. One has been pointed out by Dominique Mielle, a former hedge fund manager. In unequal societies decision-makers are likely to be isolated by their wealth (and in many cases their background) from the wider society. This generates groupthink which leads to bubbles and busts – as we saw with herding into assets such as tech stocks and mortgage derivatives. It also causes them to misread political trends: Brexit and the election of Donald Trump were both surprises to markets.
Worse still, inequality can be bad for growth. IMF economists have found a “strong negative relation” between the level of inequality in a country and its economic growth in the following years. Increased inequality in the UK and US since the 1980s and the emergence of what former US Treasury Secretary Larry Summers calls “secular stagnation” might be related.
There are several mechanisms whereby this happens. Princeton University’s Roland Benabou has shown that inequality causes the rich to fear crime or future redistributive policies and therefore to invest less in productive assets and more into what The University of Massachusetts Sam Bowles calls guard labour. The Nobel laureate Jean Tirole has shown that the big bonuses that contribute to inequality can incentivise short-termism and excessive risk-taking rather than prudent long-term stewardship. And inequality encourages company bosses to seek to entrench their power by lobbying governments for regulations that protect them from competition, thereby weakening the creative destruction that is essential for economic expansion: The Captured Economy by Brink Lindsay and Steven Teles and The Great Reversal by Thomas Philippon both document this process.
Weaker economic growth does more damage to investors than merely reducing growth in corporate earnings. It also increases financial fragility. Central banks have responded to lower trend growth by cutting interest rates. But this, says Mr Summers, is “likely to encourage financial risk, unsound lending and asset bubbles.”
It also increases political risk. IMF economists say inequality “can fuel populism and political upheaval”, a fact corroborated by Harvard University’s Ben Friedman, who has shown how economic stagnation leads to increased intolerance and hostility to democracy. This matters for investors, as political uncertainty is strongly correlated with lower share prices.
So, we have strong evidence that high inequality is bad for equities as it raises financial fragility and political uncertainty and reduces economic growth.
But this is only part of the story. New York University’s Sydney Ludvigson and colleagues have shown that the rising share of profits in US national income since the 1980s has been the biggest reason for the massive rise in equity prices since then. Capital’s increased power over labour can be good for equities, even though it causes increased inequality.
High inequality, then, is a mixed blessing for equities. Which poses the question: is it possible to get the benefits of it without the costs? This is a tricky question, made even tougher by the fact that so few people want to answer it.