There has been much talk about inequality over the last several years. However, most people fail to identify the real roots of the problem. In this post, we analyze how central banks have created an interest rate apartheid that has led to massive inequality and a stagnant economy.
Content
- Introduction
- Interest Rates since the 2008 Financial Crisis
- Why Loose Monetary Policy led to Wealth Inequality
- Interest Rate Apartheid
- Conclusion
Introduction
The focus of this post is to address how the monetary policy of central banks, especially since the financial crisis of 2008, has led to an interest rate apartheid that has caused massive wealth inequality.
This is because two of the main drivers of interest rates have been mostly abolished. On the one hand, interest rates in general have been set by central banks and market forces have been put aside. On the other hand, credit risk has been ignored for certain borrowers and that has led to distortions in the economy.
First, interest rates should be mostly determined by market forces. We have both savers and borrowers. If individuals want to save or borrowers do not have much appetite for borrowing, interest rates would go down. But if there are not enough savers and demand for borrowing is high, interest rates would have to go up.
At the same time, interest rates are lower for those who are more creditworthy. If we lend money to a company with very little debt and many assets, the probability of that company going bankrupt is very low and we will be fine charging a small rate of interest.
Conversely, if we were to lend money to a highly indebted company, we would charge a high rate of interest to make up for the high risk of bankruptcy. If we are not compensated for the risk, we are simply not going to lend that money.
All these things (availability of savings, appetite for borrowing, and creditworthiness) help self-regulate the market. Interest rates are nothing other than the price of money. Low prices (low interest rates) lead to high demand (more borrowing) and low supply (less savings). High prices (high interest rates) lead to low demand (less borrowing) and more supply (more savings).
While central banks have long intervened in the interest rate market, the monetary policies that have been in place in most Western economies since 2008 have been a lot more extreme and led to catastrophic results.
Interest Rates since the 2008 Financial Crisis
The 2008 financial crisis was caused by excessive borrowing and a bubble in the price of assets. Too much money had been lent to households and corporations who were unable to pay that money back. That led to a wave of bankruptcies and a harsh economic recession.
The problem is that deflating an asset bubble is slow and painful. It is necessary to purge the excesses and imbalances of the system. That goes hand in hand with rising unemployment, losses for investors and corporations, lower tax revenues for governments, and the need to cut public spending.
For this reason, after the aftermath of the 2008 crisis, governments and central banks decided that it would be best not to go through that process. The problem is that the only way to avoid that outcome was to reinflate the asset bubble again. And that required more extreme measures.
With this objective in mind, governments and central banks decided to start printing money, increase public spending, bail out the banking sector, lower interest rates to all-time lows, encourage more borrowing from households and corporations, reinflate the real estate bubble, and cause an overvaluation in the stock market.
As a result of all those policies, unemployment did go down and economic growth improved slightly. Nonetheless, the job market and the performance of the economy never fully recovered. Officials had tried to engineer a recovery, but it had been an artificial recovery.
At the same time, the standard of living for a large portion of the population continue to drop. Wealth inequality hit an all-time high. Governments, households and corporations went further into debt. The financial system became even more unstable. Therefore, we should ask our officials if those measure were worth it.
Why Loose Monetary Policy led to Wealth Inequality
Massive monetary expansion causes money to lose value. If there is more money in the economy chasing the same amounts of goods, services and assets, price have to adjust upward.
At the same time, lowering interest rates also acts a devaluation tool. Interest rates are the price of money. If interest rates are lower, it becomes cheaper to borrow money. Since money is lent into existence, an increase in borrowing leads to an increase in the amount of money in the economy. That ultimately leads to more devaluation and inflation.
Because money is worth less, asset prices go up. This is true for higher housing prices, the stock market, gold, other commodities, and even collectibles such as classic cars. People try to get rid of their money and accumulate assets instead.
The biggest beneficiaries of that process are those who have a lot of debt and see the value of that debt decrease. We must emphasize that Western governments are the most indebted institutions in human history.
Leaving governments aside, who are the instigators and major beneficiaries, these measures affect socio-economic groups in different ways:
Those who rely on a modest income and own no assets end up worse off. Their standard of living drops dramatically, and life gets more difficult. This specific group has been known as the working poor. They may work very hard but the monetary system is stack against them.
By contrast, the rich are in a much better position. Most rich people know that money loses value over time, so they prefer to own assets: real estate, companies, stocks, gold, commodities, etc. If as a result of loose monetary policy asset prices go up, the rich will see their nominal wealth increase.
In fact, the rich have access to financing. They can leverage their assets to borrow money cheaply and acquire even more assets. Since the value of that money is likely to go down and asset prices are likely to continue to go up, they end up better off.
The middle classes will be somewhere in the middle. While they rely on an income to live, they also own some assets. Therefore, they are partially shielded against the negative effects of loose monetary policy.
As you can see, all these measures taken since 2008 have led to a massive increase in the wealth gap between the poor and the rich. Instead of blaming the rich and successful, we should look at governments and central banks for having created an unfair monetary system and an interest rate apartheid.
Interest Rate Apartheid
In order to illustrate why governments and central banks have create an interest rate apartheid, we will see how different groups and institutions in society are affected by such monetary policies:
1) Governments
Governments are the great beneficiaries of this monetary system. It is only logical since they are the ones who have created it. Governments are nowadays able to increase public spending as much as they want. There is no longer a need or appetite to keep the deficit under control. In fact, the more debt they accumulate, the lower interest rates will be, thanks to central banks, and the more they will be able to borrow.
The United States, with its gigantic debt pile, pays interest rates that are much lower to the inflation rate. The same can be said of the United Kingdom, Japan and Germany. And many countries in the Eurozone, such as Italy, Spain and Greece, despite being effectively bankrupt, can continue to increase their debt level without being penalized with higher borrowing costs.
This means politicians’ power to buy votes is now greater than ever. It is no longer necessary to spend money well and carefully. As a result, there are ever larger groups of people who are dependent on government money. This has led to a stagnant economy and dangerous circumstances for the long-term stability of those countries.
2) Large Corporations
Large corporations have access to capital markets. Consequently, they are able to issue debt at very low interest rates. Because investors are unable to make a decent return on government bonds, they end up buying corporate bonds. In fact, even central banks have been buying corporate debt. The official goal was to stimulate the economy. The real outcome was more inequality.
In 2019, LVMH (the parent entity of Louis Vuitton), whose largest shareholder is France’s richest person, issued debt at a negative interest rate to buy Tiffany’s of the United States. One of the institutions that bought that debt was the very own European Central Bank.
Cheap debt allows large companies to borrow and expand their businesses at the expense of smaller companies without access to capital markets. This leads to a less efficient economy, more concentration, more corporate debt, and a less stable financial system.
3) Households with Good Incomes
Households with decent income levels earn enough to qualify for a mortgage. As you can imagine, mortgage rates were very low as a result of those monetary policies, and these people were able to borrow cheaply.
Although we may think that the people in this group are lucky, nothing could be further from the truth. Low mortgage rates led to much higher home prices. This means it is more difficult for younger generations to get to the same socioeconomic level as would have been the case in the past.
This stifles social mobility and increases wealth inequality in terms of age groups. This has the potential to lead to inter-generational conflicts in the future.
4) Working Poor
Low-income workers, also referred to as the working poor, are the biggest victims of the current monetary system. They are the ones who will never be able to own their own home as they do not earn enough to either qualify for a mortgage or save in a significant manner. Thus, they are forced to be perpetual renters.
If these people want to borrow to finance a purchase, they will have to pay very high interest rates. One example would be car loans with interest rates hovering and sometimes exceeding 10%.
Social mobility is extremely difficult of this group of people. In fact, one of the big threats in this regard is that low-income workers do not live much better than those who live permanently at the expense of the state, thanks to generous social programs. These social programs are in part financed by the very same loose monetary policy.
Such situation discourages poor people from working, further reinforcing their dependence on the state. This leads to more public spending, less tax revenue, more power for the state and politicians, less economic growth, less innovation, less social mobility, etc.
Conclusion
As you can see, governments and central banks have created a true interest rate apartheid. While most people are unable to see it, they can feel its consequences.
The saddest thing is to see how politicians are able to convince citizens who are affected by those policies that such policies are good for them.
In fact, many of those affected by this interest rate apartheid often blame capitalism for their situation. However, a corrupt monetary system that only serves the interests of governments at the expense of most of the population has nothing to do with capitalism. Americans have a word to describe this: cronyism.
As citizens, we must demand a real capitalist system. A system that incentives things that are positive for both the individual and society, where good decisions are rewarded and bad ones have their consequences.
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