What's The Primary Cause of Wealth Inequality? Financialization

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Financialization results when leverage and information asymmetry replace innovation and productive investment as the source of wealth creation.

Emmanuel Saez and Thomas Piketty are leading lights in the exploration of rising wealth inequality. Both are academic economists who have devoted considerable time and effort to assembling data that deepens our understanding of the issues.

For example, Saez's recent essay Striking it Richer: The Evolution of Top Incomes in the United States, provides an in-depth look at the widening gulf between the top 1% and the bottom 90% from 2009 to 2012.

Here is a chart of the top 10% share of income, based on their research: (the note in red marking the beginning of financialization in 1982 is my own)


What is the primary driver of this era's widening wealth inequality? Thomas Piketty's new book Capital in the Twenty-First Century provides an answer: financialization. While definitions vary, mine is:

Financialization is the mass commodification of debt and debt-based financial instruments collaterized by previously low-risk assets, a pyramiding of risk and speculative gains that is only possible in a massive expansion of low-cost credit and leverage.

Another way to describe the same dynamics is: financialization results when leverage and information asymmetry replace innovation and productive investment as the source of wealth creation.

When the profits from financializing collateral and leveraging those bets to the hilt far exceed generating wealth by creating products and services, the economy is soon hollowed out as the perverse incentives of financialization start driving every business decision and strategy.

Author David Cay Johnston recently wrote an insightful review of Piketty's book,Trickle-Up economics:
 

Coming out of the Great Recession in 2009, inequality increased dramatically, the opposite of what happened when the Great Depression ended nearly eight decades earlier. Why?

The short answer: When investment returns exceed economic growth, the rich get richer, increasing inequality.

When an economy grows at 1 percent annually but investment returns are 5 percent, the already wealthy need to reinvest only a fifth of their gains for their fortunes to grow at the same rate as the overall economy. The rest can be spent on a sumptuous lifestyle.

Since by definition the very rich do not need to consume 80 percent of their incomes — the portion by which investment returns exceed the growth of the economy in Piketty’s model — they can reinvest most of their annual gains in the market. Over time this accumulating capital will snowball.

The official American income numbers, crunched by Piketty and his sometime colleague Emmanuel Saez, show that in the 21st century wealth and income increases are almost all taking place among the tiniest sliver of the wealthiest and highest-earning.

The top 1 percent of Americans raked in 95 cents out of every dollar of increased income from 2009, when the Great Recession officially ended, through 2012. Almost a third of the entire national increase went to just 16,000 households, the top 1 percent of the top 1 percent, Piketty and Saez’s analysis of IRS data shows.

The income changes for the vast majority are just as revealing. The bottom 90 percent saw their average incomes rise 8.8 percent in 1934 over the prior year, while in 2012 the same statistical group had to get by on 15.7 percent less than in 2009.

Piketty shows that whether capital is taxed or not, inequality will grow under current policies because savings from current wages and salaries cannot grow as much as returns to existing riches.

The process of accumulating “becomes more rapid and inegalitarian as the return on capital rises and the [overall economic] growth rate falls,” Piketty writes.

It's important to note that capital is not monolithic, nor is all capital qualitatively equal. Capital that is invested in rigged financier games funded by the Federal Reserve (for example, carry trades and high-frequency trading) is entirely different from capital that is placed at risk in a start-up company.

Capital invested in building a house is quite different from capital invested in pyramiding the mortgage into mortgage-backed securities (MBS) and exotic financial instruments based on the MBS.

Productively invested capital is at risk and generates additional production of goods and services. Financialized capital skims profits from leveraging debt: nothing of any real-world value is produced, it's just a giant skimming operation based on information asymmetry (or outright fraud and misrepresentation) and leverage.

Fed-funded financialization creates a perverse set of incentives: talent and capital flow to unproductive skimming operations because that's what generates the outsized profits, effectively starving the real economy of talent and capital.

The Fed makes essentially limitless funds available to banks and financiers at near-zero interest rates. Try borrowing $100,000 from the Fed at 0.1% interest; you can't. That privilege is reserved for financial predators and parasites.

Financier skimming operations stripmine productive assets and labor. With the Fed providing free money to financiers and no limits on debt, leverage, information asymmetry and sleight-of-hand accounting, the only result possible is widening wealth inequality.

You want to fix wealth inequality? Abolish the Fed, eliminate the too-big-to-fail banks, tax speculative profits from high-frequency trading and other skimming operations at 90% and lower the corporate tax rate on productively invested capital to 5%. The only way to reduce wealth inequality is to change the incentives and disincentives to favor productive investments and innovation rather than financialization.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Hippocratic Oaf's picture

And don't forget there are NO JOBS.

We make and build NOTHING.

Just paper pushers..........all.

ghostfaceinvestah's picture

Nothing new, people have known this for centuries, but of course this isn't taught in public schools:

One of the evils of paper money is that it turns the whole country into stock jobbers. The precariousness of its value and the uncertainty of its fate continually operate, night and day, to produce this destructive effect. Having no real value in itself it depends for support upon accident, caprice, and party; and as it is the interest of some to depreciate and of others to raise its value, there is a continual invention going on that destroys the morals of the country.

Thomas Paine - 1786

wintermute's picture

Financialization is exactly what cryptocurrencies like Bitcoin will kill off.

 

A crypto-based economic system will be far more equitable.

 

NoDebt's picture

What the hell would we want to kill it off for?  Everything's finally working exactly right.

Ivan K's picture

@NoDebt Love the new avatar.

Eeyores Enigma's picture

"Both are academic economists who have devoted considerable time and effort to assembling data that deepens our understanding of the issues."

Let me fix that for you Chuckles;


Both are academic economists who have devoted considerable time, MONEY, and effort to assembling data that reiterates, goes into unnecessary detail and complexity on a simple concept, and over all muddles our understanding of the issues without really coming to the core issue of no money = you die and proposing and solution that changes this insane system we have structured ourselves around which brings out the worst in humanity. Hello....eloooo...eloooooo. 

adr's picture

Financialization may be the vehicle but it still needs a driver. The real cause of wealth inequality is that we haven't killed those that wish to generate wealth without working for it.

American Hustle is a great movie to show the lengths some people will go to make money without working for it.

A Nanny Moose's picture

I was going to call horseshit on this arcticle, and say that money printing is the root cause of wealth inequality however, you are correct; the printing of money is the action of a few human doings, who purport to know what is best for everybody.

Are we getting what we deserve, or were we all "educated" in government run schools, for the benefit of those same people?

trader1's picture

nothing fundamentally wrong with "government run".

what you're seeing in america is a lack of competence administrating public services for the common good, in addition to a selfish, etertainment-addicted, ADHD-afflicted, and schizophrenic populace.  

cynicalskeptic's picture

.........the lengths some people will go to make money without working for it.

 

The 7 Walton family heirs (WalMart) are worht more than 40% of ALL AMERICANS COMBINED - all INHERITED wealth

The 2 Koch Brothers are woirht how much?  - INHERITED WEALTH

 

The US is developing a rentier class - those who make money ONLY from their money - INHERITED MONEY

This class has perfected the generation of wealth without working for it.  

Without limits on inherited wealth you end up with more and more wealth concentrated in fewer and fewer hands.

Ivan K's picture

That video is fan-fucking-tastic.

Kirk2NCC1701's picture

I thought it was "Birthright"

kellycriterion's picture

I think you'll find that politicians, bureaucrats, and their kickbackiest friends have done rather well.

It should also be noted that much of this financialization has been directly and indirectly gone to the political class and funding their operations.

Ya know the government borrowing that isn't borrowing. Inflation and leverage that keeps taxes on an upward trajectory. The leverage ramp RRE has gone on for decades with government leading the charge.

But the important thing is to protect the political class. And when you're drowning in an ocean of corruption, the blame game is easy.

gjp's picture

I thought it was due to unequal access to education and technology.  That's what establishment whore the Economist told me.  Then I cancelled my subsription.

q99x2's picture

Let me guess. It has something to do with the genetic make-up of the FED members.

fijisailor's picture

unproductive skimming operations=HFT

TruthInSunshine's picture

This is why members of CONgress are exempt from the legal ban on insider trading.

Just ask Nancy Pelosi (who has a hedge fund husband).

Debugas's picture

two major primary causes - capital inheritance, lending at interest

Flakmeister's picture

Do not be confused by the difference between cause and means....

Dollar Bill Hiccup's picture

And it's only going to get worse, so lever up friends.

When it blows, well, who knows.

Dollar Bill Hiccup's picture

One cannot serve both the Lord and Mamon ...

Anyone remember that one? Anyone? Bueler?

kurt's picture

The quantitative easing of your money into Richie Rich's pocket. Oh, and F.U. he don't care!

How long are you going to take this?

SofaPapa's picture

This is it exactly.  When banking, which produces zero tangible wealth by definition, becomes the dominant industry, the economy becomes stagnant and destructive.  We have been there since 2000.  The scary thing is that the second "dream job" for the elites these days is "information technology", i.e. the cloud.  Also produces no tangible goods.  These are just ways to move goods around in new ways, not create them.  Education?  Useful when it leads to productive pursuits, but as has been pointed out on here ad nauseum, the vast majority of our graduates these days are unable to find productive work.  As such, education is producing a vastly oversupplied product of "information experts" when there is not remotely enough market to absorb them.  The only remaining relatively large growing industry in this country that has a tangible benefit to society is medicine.  And that industry is also now dying a nasty death because of financialization through the insurance process.  Full circle.  

This country is creating less and less while continuing to consume at a high (though diminishing) rate.  That is the very simple reason why most of us on here have been waiting for it to collapse.  I don't know how TPTB have kept it moving this long.  

Inertia is the closest explanation I can come up with.

cynicalskeptic's picture

The financial industry SHOULD exist to allocate capital to productive endeavors.  Fifty years ago the financial sector was well under 10% of the GNP.  

Today the financial sector is over 40% of the GDP but all it does is EXTRACT wealth from the productive economy.  Banks own warehouses that make money by DELAYING deliveries of aluminum to users. Banks write mortgages guaranteed to default, sell them off as packaged securities and then make money off the fees they charge to deal with the foreclosed properties.   Wall Street firms drive up the prices of commodities with all the free cash they get from Gov.  One JPM exec said 'we own tankers full of oil, warehouses full of metal, all kinds of things a bank should not be involved in.......'  Today the financial sector is a leech draining the blood from the few productive endeavors left in the US.

moneybots's picture

"Coming out of the Great Recession in 2009, inequality increased dramatically, the opposite of what happened when the Great Depression ended nearly eight decades earlier. Why?"

 

Because nothing has been fixed.  The massive fianancial fraud continues unabated.

gwar5's picture

Primary cause is criminal banksters and corrupt politicians. 

Cursive's picture

@CHS

You can can it "financialization," but I prefer "rent-seeking."

csmith's picture

"...financializing collateral and leveraging those bets to the hilt..."

Nothing a good market collapse (we tried in 08 but the Fed short circuited it) wouldn't fix. The solution to wealth and income inequality is simple:  Let rich people fail once in a while.

Tsar Pointless's picture

Financialization and Reaganomics. Which one is the chicken, and which the egg?

Which came first: The chicken or the egg?

Trick question. Answer: The rooster.

The Econ Ideal's picture

Leverage on inflating asset bases is rewarded at an outsized measure -- but who makes the rules? Producers and innovators need to garner more "leverage" of their own.

Pairadimes's picture

Just so we are clear, financialization is the 'proximal' cause of wealth inequality. The 'primary' cause is excess government interference in the regulation of free enterprise, to the point where wealthy interests can co-opt the process of government and rig the game.

NihilistZero's picture

No, the primary cause is government's existence itself.  Government arbitrarily draws the borders, creates the currencies, enforces the patents, and above all else, creates the laws that WILL ALWAYS DISTORT THE MARKETS AND FREEDOM OF EVERYONE!

If your not a classical anarchist, you're merely playing the shell game.  Any system that requires unescapable submission to authority will b erigged sooner or later.

Questan1913's picture

the problem seen from a slightly different perspective perhaps?

malek's picture

 The short answer: When investment returns exceed economic growth, the rich get richer, increasing inequality.

Excellent finding!
However in the end such is not caused by financialization itself, but by manipulating money and interest rates.

New American Revolution's picture

END HFT's along with most derivatives.  Close the FED, replace it with a classical gold standard regulated by a Suffolk Bank type solvency enforcement regulation administered by accountants, not economists.   The insolvent 2B2Fails will go bankrupt, HFT's will be in jail along with the banksters of the 2B2Fails, and then we can fiddle with the tax code.   www.electanewcongress.com

Notsobadwlad's picture

Financialization is the last act of value destroying incompetents and parasites.  Using clever and obscure financialization processes does not make one valuable.

Ayn Rand would most likely agree.

falak pema's picture

In ONE WORD : financialization was in essence the wealth skimming process initiated by Reaganomics and Thatcherism AS A POLITICAL CONSTRUCT. To privilege the capitalist class of elites at the expense of the labour and white collar middle class in the developed world-- and as collateral-- to export, using "outsourcing", the world factory model to third world based on slave labour arbitrage. (Thank you WTO surrogate of Pax Americana elites and IMF imposed reserve money hegemony)

The catholic kings of financialization killed wealth distribution and initiated the pyramidal construct that has led to the ponzi of bubbleonomics. 

ALL GREAT SCHEMES HAVE A GREAT VISION BEHIND IT.  A MINDSET and the means to execute the plan.

Just like Mein Kampf.

chinoslims's picture

Financialization gives rich people the first crack at credit in the form of loans and leverage.  By the time all the wealth gets trickled down, prices of goods and services have risen.  In conclusion, QE can only help the rich.