Winners And Losers: The New Economy
This article originally appeared in the Daily Capitalist.
There was a wonderful article in the Wall Street Journal this weekend on the ultra (über, hyper, 1%) rich. The article ("The Wild Ride of the 1%") discusses the volatility of wealth of the top 1% income earners in America. The author, Robert Frank, reveals that these people's income and wealth have become much more unstable than the wealthy class of the past. He makes an important point about today's economy. I urge you to read the article. If you are not a subscriber, you may find it here.
First look at some of the article's data highlights:
The super-high earners have the biggest crashes. The number of Americans making $1 million or more fell 40% between 2007 and 2009, to 236,883, while their combined incomes fell by nearly 50%—far greater than the less than 2% drop in total incomes of those making $50,000 or less, according to Internal Revenue Service figures.
As of 2009, the richest 20% of Americans showed the largest decline in mean wealth of any other group.
Only 27% of America's 400 top earners have made the list more than one year since 1994, one study shows.
Suddenly, in 1982, the wealthiest broke away from the rest of the economy and formed their own virtual country. Their incomes began soaring higher during good times. The top 1% of earners more than doubled their share of national income, to 20% as of 2008. Looking at another measure, the richest 1% increased their share of wealth from just over 20% to more than 33%.
Between 1947 and 1982, the beta of the top 1% was a modest 0.72, meaning that their incomes moved relatively in line with the rest of America. Between 1982 and 2007, their beta soared more than three-fold. ["Beta" is an investment term that tries to measure market risk of a stock in terms of volatility.]
Interviews with more than 100 people with net worths (or former net worths) of $10 million or more, and a wave of new studies on the rich, suggest a different cause: the "financialization" of wealth. Simply put, more wealth today is tied to the stock market than to broader economic growth. A larger share of today's rich make their fortunes from stock-based pay, shares in publicly traded companies, selling a business or working in finance.
The household debt of the top 1% surged more than three-fold between 1989 and 2007, to $600 billion, and grew faster than their net worth.
As the wealthy gain a greater share of wealth and income, they account for a growing share of spending, taxes and investments. The top 5% of earners now account for 37% of consumer outlays,according to Moody's Analytics. The top 1% of earners pay 38% of federal income taxes. The richest 1% of Americans own more than half of the country's individually held stocks, according to the Federal Reserve.
Luxury is now the most volatile segment of the consumer economy.
The spending volatility of the top 10% of earners is now more than 10 times the spending volatility of the bottom 80%, according to one study.
The article illustrates two important concepts of Austrian theory economics:
- The impact of the boom-bust business cycle (Mises); and
- The dynamics of creative destruction (Schumpeter).
The result of these two forces is that we are increasingly being turned into a society of winners and losers as the economy becomes less robust, more volatile, and less dynamic. This has important investment consequences and lessons for the protection of wealth.
The Boom and Bust
The article's author, Robert Frank, sees wealth volatility as a cause of economic instability. In fact it is a result of Federal Reserve policies that create these boom-bust cycles and destroy real capital.
Back in 2009, Bill Gross of PIMCO made the observation (in a very depressing post):
We were getting richer by making things [in the two decades after 1956], not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. ...
The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them.
For once I would agree with Mr. Gross. His blind spot is that he doesn't understand why all this happened. He justifies the Fed's and Treasury's interventions to prop up asset prices, regardless of the negative consequences of ZIRP, etc. That's why he has made our Crony Capitalist of the Month list.
Perhaps Mr. Gross should look at money supply. It is not a coincidence that monetary growth since the 1980s has been rather exponential—this chart measures the Fed's broadest measure of money stock:
What Mr. Gross and Mr. Frank and many others don't see is that it is the creation of fiat money that destroys wealth and misdirects the investment of capital into less productive assets. That is, monetary inflation destroys capital (wealth). The reason why the production of goods and services do not bear higher yields than financial assets is that the production of goods and services suffers from a lack of real capital. Remember that real capitalcomes only from the saved profits of production and from the savings of workers from wages earned in production.
You obviously cannot print wealth, but if you try that fiat money distorts the entire economy by directing investment to things which appear to appreciate but what is really happening is that the dollar is depreciating. As a result, fiat money and real capital are invested in financial assets because they appear to have greater yields than returns from the production of goods. Prices rise (price inflation) and it creates the inevitable boom which always busts. The fall out is that we are stuck with things people don't want (in the present re/depression it is housing). And we fall for it every time.
This has led to the phenomenon that Messrs. Frank and Gross describe: the financialization of the economy.
Creative Destruction
If you look at the Forbes 400 richest Americans you will see that the industry that has the most rich people is "investments" (96 people, or 24%). The next category is technology which has 48 people. So investments have generated twice as many billionaires as America's powerful and dynamic technology sector. By the way, manufacturing has only 17 people on the list.
The result of these boom-bust business cycles is not only the financialization of the economy, but a change in the attitude of investors about how money is made. My thesis is that (i) investors go where the money is and (ii) people believe that making money is easy. Wall Street is an example of (i) and Main Street is an example of (ii).
I've discussed the easy money syndrome before: people see other people making money as a result of the boom phase of the cycle and jump in. It looks easy when your neighbor just refinanced their home and bought a new truck and trailer with a boat on it. If they were left out in the last cycle, they will get into the next one. This, as we have seen, replaced a society of savers with a society of spenders. They were fooled by the cycle and ended up bust or holding on to houses that are underwater. We know how that impacted the economy (Crash, Bust, Depression).
It is (ii) that results in the One Percenters and instability of their wealth. It's not an earth shaking conclusion: investors always go where the money is. But in this case the Fed has caused them to go to the wrong place and when the bust inevitably happens many a fortune is lost, as the above statistics reveal.
This is the Schumpeterian aspect of capitalism but it is not a result of dynamic, competitive capitalism. Businesses are not wiped because someone invented a better product, but rather fortunes are lost through speculation, which is another way of saying betting.
Look at investor John Paulson. He is No. 17 on the Forbes 400 list at $15.5 billion (the only investors ahead of him are Buffet and Soros). In 2006 he wasn't on the list (he was worth only a measly $300 million in early 2007). How did he get so rich? His fund bet heavily against subprime debt and he personally scored $3.5 billion in 2007. Investors flocked to his funds and in 2008 he was up another 20% betting mostly against subprime. In 2009 he started buying gold and his personal wealth went up 50%. In 2010 he doubled his wealth again (his take-home pay was $4.9 billion, a record for the hedge fund industry). This year his fund is down 30% but his personal wealth is up 25% because of his own investments in gold.
But let's be clear about the foundation of Mr. Paulson's wealth: he bets. Granted he made mostly smart bets and he is to be congratulated for that but he is no Warren Buffet (my criticism of him aside, Buffet is a great investor). But others made the same bets and turned around and lost it all (see my article on Peloton Partners-also see Nassim Taleb's comment there).
Financial speculation has always existed throughout history, and usually for the same reasons (fiat money), but financial speculation is now a fixture of our economy as a result of the relentless boom-bust policies of the Federal Reserve. And we now see that these cycles are causing greater economic dislocation each time they occur. This is the valid point of Mr. Frank's article: the new speculative wealth is less stable than early industrial fortunes because it isn't real and when that fact is discovered (bust) it can go away. And it ripples through the economy. Recall his point:
The top 5% of earners now account for 37% of consumer outlays, according to Moody's Analytics. The top 1% of earners pay 38% of federal income taxes. The richest 1% of Americans own more than half of the country's individually held stocks, according to the Federal Reserve.
This is what we have been calling the bifurcated economy, an economy that benefits the wealthiest among us, but hasn't "trickled down" to most of us because real capital isn't being invested in things that would benefit us for the long term.
As long as the Fed pursues these policies which continue to destroy real capital we will be plagued by booms and busts and our economy will be more volatile and less productive. Instead of wealth being distributed widely throughout the economy as capitalism has done historically, we are now becoming an economy of winners and losers.
*Mr. Frank is coming out with a book on this topic, The High-Beta Rich: How the Manic Wealthy Will Take Us to the Next Boom, Bubble, and Bust, to be published Nov. 1 by Crown Business.
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