In the mid-late 1930s, Americans were in the throes of the greatest depression ever experienced in this country and might be forgiven for focusing on issues closest to home. Nevertheless, this was also the time that Ernest Hemingway wrote his highly acclaimed book, For whom the bell tolls, about the seemingly distant issue of the Spanish Civil War. His message, according to wikipedia [here], was that the war is "not of importance only to Spaniards; it matters to everyone."
The same message is also an appropriate one for investors today. While the issue of increasing inequality may seem to many people like a distant one, such as an abstract ethical concept or a concern for some unfortunate "other" people, it is not. Inequality manifests itself in ways that affect all of us and therefore "matters to everyone".
The issue of growing inequality is not one of conjecture; the evidence abounds. Some of the most compelling evidence is captured by the comparison of US household wealth between the bottom 90% and the top 0.1% which John Mauldin and Marc Faber discuss [here]. Faber presents a chart, Figure 2, which shows the distribution of wealth among US households. It shows the bottom 90% of households have been losing share of the total since the mid-late 1980s while the top 0.1% have been steadily gaining share since the late 1970s. Currently, the shares of the bottom 90% and the top 0.1% are just about equal.
In addition, Robert Gordon adds a number of examples in his book, The Rise and Fall of American Growth, which illustrate how inequality manifests itself in everyday life. For starters, he notes, "The Caterpillar Corporation has become a poster child for rising inequality. It has broken strikes in order to enforce a two-tier wage system in which new hires are paid half of existing workers, even though both groups are members of the same labor union."
Gordon also highlights some other striking examples: "In Scranton, 41.3 percent of those older than 18 have withdrawn from the workforce." In addition, "The number of children born outside of marriage is drawing equal with the number of children born within marriage." Finally, he mentions, "Fully two-thirds of black male high school dropouts experience at least one spell in prison by the time they reach 40 years old."
Despite this compelling evidence, many are not moved to see inequality as a problem. John Mauldin provides some useful insight as to why this is the case [here]: "In the US we have a cultural imprint that I think traces back to our Puritan origins. It tells us that everyone gets what they deserve. If you're wealthy, you must be smart and hardworking. Conversely, they poor are poor because they're lazy and make bad choices."
In addition to this cultural blind spot, conventional economic theories also fall short of addressing inequality in a rigorous way. Since inequality doesn't fit neatly into economic models, the issue is normally treated more as an abstract curiosity or a conundrum than an important practical problem. Indeed, while most economists are facile with numbers, they can be also almost pathologically insensitive to issues that affect other dimensions of society. A natural, yet potentially dangerous, consequence of this insensitivity is that it leaves many of today's investment "experts" poorly equipped to deal with current conditions.
A major challenge for investors is that the lack of an adequate understanding of inequality makes an already "noisy" investment environment even more so. After all, it's not that the notion of meritocracy is completely wrong or that economic theories are completely useless. The problem is that those perspectives alone are not sufficient to understand many of today's crosscurrents.
As a result, there is a nagging excess of unusual circumstances that lack adequate explanation. Economic growth, for example, seems to be decent but a key driver, productivity growth, has been inexplicably weak. "Soft" data has been going in one direction while "hard" data has been going the other. Further, the constant drone of sensational political headlines often overshadows fundamental data altogether and exacerbates a growing sense of uneasiness. What is going on?
The good news is that a better understanding of inequality goes a long way in reconciling these inconsistencies. David Brooks begins to connect the dots in one of his recent commentaries [here]. He observes, "Slow growth strains everything else — meaning less opportunity, less optimism ..." and with it, more "zero-sum thinking". Brooks describes a more widespread phenomenon that can't be analyzed within the realm of economics alone: "In different ways [Nicholas] Eberstadt and [Tyler] Cowen are describing a country that is decelerating, detaching, losing hope, getting sadder. Economic slowdown, social disaffection and risk aversion reinforce one another."
Rana Foroohar picks up on a similar thread in the Financial Times [here]. Foroohar notes that the recognition of Bernie Sanders as "the most popular politician in US" in a recent poll "says quite a lot about what Americans really care about politically - things such as economic inequality, wage stagnation, student debt, and the divide between Wall Street and the real economy."
Both pieces address the notion that economic life is not a discrete function that is completely insulated from other dimensions of life, but rather happens in the context of financial, social, and political life and is tightly interwoven with each. This is especially so with the issue of inequality which largely explains why it often flies under the radar of many observers. This insight was clearly articulated by Francis Fukuyama in his book, The Idea of Trust: The Improbable Power of Culture in the Making of Economic Society. Fukuyama argued, "Economic activity represents a crucial part of social life and is knit together by a wide variety of norms, rules, moral obligations, and other habits that together shape the society."
Fukuyama also provides some terrific insights into why inequality has continued to rise. He describes, "Americans are so used to celebrating their own individualism and diversity, however, that they sometimes forget that there can be too much of a good thing. Both American democracy and American business have been successful because they partook of individualism and community simultaneously." In other words, Americans have gradually become more individualistic over the years and this has eroded the country's social fabric in important ways.
According to Fukuyama, "The causes of the growth of American individualism at the expense of community are numerous. A primary one is capitalism itself." He goes on to describe, "Today's continuing capitalist revolution undermines local communities as jobs are moved overseas or to wherever else capital can earn its highest return; families are uprooted; and loyal workers are laid off in the name of downsizing."
But there are also social reasons for the growth of individualism. Fukuyama cites the "liberal reforms of the 1960s and 1970s" as having a number of unintended consequences. For example, "Slum clearance uprooted and destroyed many of the social networks that existed in poor neighborhoods ..." In addition, the expansion of the welfare state, beginning with FDR's New Deal, "tended to make federal, state, and local governments responsible for many social welfare functions that had previously been under the purview of civil society." The aggregate effect of all of these changes was captured by John Kasich in the Economist [here] when he noted that Americans have "fallen out of the habit of caring for one another".
The rise of individualism and the reinforcement of "economic slowdown, social disaffection and risk aversion" go a long way in explaining the pernicious nature of inequality. But it is Gordon that delivers the bottom line by specifically associating its effect on economic growth. While recognizing that a number of factors are at work, he makes clear that, "Steadily rising inequality over the past four decades is ... one of the headwinds blowing at gale force to slow the growth rate of the American standard of living." In fact, Gordon explicitly quantifies the magnitude of the inequality effect on productivity growth: "We ... assume that median real income per person will grow at 0.4 percent per year slower than average real income per person."
One key takeaway from all of this is that investors should not be so cavalier in dismissing inequality as a serious issue. For one, evidence suggests that inequality serves as a real and significant constraint on economic growth, as substantiated by Gordon's decision to explicitly incorporate it as a factor in his estimates for productivity growth. Inequality affects productivity growth; productivity growth affects economic growth, and economic growth affects us all.
Inequality is also a serious issue because it is a social and political issue in addition to an economic issue. All of these affect one another in a grinding feedback loop. As a result, it is an issue that does not lend itself well to isolated study. Nor does it lend itself to corrective policy solutions: "Political reforms are mostly ineffectual, in part because they are often aimed at the balance of power between the straightforwardly wealthy and the politically powerful, rather than the lot of the have-nots," according to an Economist review of The Great Leveller: Violence and the History of Inequality from the Stone Age to the Twenty-First Century, by Walter Scheidel [here]. Scheidel's dire conclusion, as summarized by the Economist, is that, "only catastrophic events really reduce inequality."
Consistent with the potential for serious consequences from inequality, Marc Faber shares an outlook that includes a special warning for investors: "I am discussing them [these issues] because I believe that an unstable system in which the majority of people lose out to the privileged few is simply not sustainable and will end either with a Bernie Sanders-type socialist gaining power or with the establishment of a dictatorship. Democracies promised a level playing field in society, but that certainly does not seem to be in place nowadays ... I feel that we are reaching a tipping point where something is likely to give, and I am afraid that this 'something' could be the inflated asset markets."
So how can investors move forward? Janan Ganesh does a good job of diagnosing the political problem, albeit in relation to British politics, in a story entitled, "Our apathy makes politics vulnerable to capture" [here]. He wrote, "The problem is not with them [politicians]. The problem is us. Our apathy has inescapable consequences. The smaller politics becomes, the riper it is for capture by ideologues and second-raters (and ideological second-raters)." He noted further, "More and more, the dysfunction in politics stems from public indifference to politics." This reality was also captured by Kasich who complained about citizens "living with their heads down and expecting far-off government leaders to solve such problems as the opiate addiction ravaging Middle America."
It is here that Fukuyama provides a ray of hope. He writes: "One of the most important lessons we can learn from an examination of economic life is that a nation's well-being, as well as its ability to compete, is conditioned by a single, pervasive cultural characteristic: the level of trust inherent in the society." When inequality goes up, trust tends to go down. As a result, increasing the level of trust in society can simultaneously serve as a public policy objective, an individual mandate, and a gauge by which to measure risk levels.
While it may be easy for some investors to dismiss the problem of inequality as irrelevant to them, this way of thinking not only overlooks significant risks, but also exacerbates them. As Ganesh notes, "But do not the feign surprise when this sect of obsessives [political extremists] has a material effect on your lives. You left them to it." So Hemingway's message is also relevant to the issue of inequality: For whom the bell tolls; it tolls for thee.