The premise in Albert Edwards' latest letter "Is the Fed blowing bubbles to cover up growing inequality... again" is simple: the unprecedented social inequality in the US (and the rest of the world - as pointed out here), and what it will ultimately lead to. Regarding what it will lead to, Edwards believes, is that "growing inequality drains the swimming pool dry. The crunch, when it comes, will be ugly." Simple enough.
Digging a little deeper.
It is ironic that nearly five years ago, we first posited that the only result QE would achieve as a result of reflating asset prices to astronomical levels, while transferring (in)finite wealth from the middle class to the 0.1%, would be an inevitable tear in the social fabric resulting, eventually, in outright conflict and/or war (and, ultimately, hyperinflation because the Fed will stop at nothing to reflate the debt, especially in a rising rate environment - even paradropping money from helicopters, something even Deutsche Bank agrees with now). Back then everyone called this (as so often happens) a naive conspiracy theory. Now, even respected strategists are starting to see things our way. From Edwards:
Some argue that central banks had no choice in the face of under-consumption, while conspiracy theorists might even conclude there has been some sort of unspoken collusion among policymakers to "rob" the middle classes of their rightful share of income growth by throwing them illusionary spending power based on asset price inflation. We will never know. But now it all makes more sense!
Naturally, economists being the last to voice concerns about the status quo (and their sanctity of their tenures of course), are even more muted. But even they are starting to admit the underlying threat.
Set aside any moral or political concerns you may have about rising income inequality - worries about poverty, justice, undue political influence or even social mobility. According to Mr. Dervis, co-author of the book, the research collected in “Inequality in America,” shows that a growing number of economists suspect that once inequality passes a certain point it may jeopardize economic stability and economic growth. As the book argues, "rebalancing of the distribution of income may play a role in unlocking the U.S. economy's growth potential in a sustainable way."
That is exactly the point Warren Buffet, Bill Gross and Stanley Druckenmiller make. You don’t have to be a communist to conclude that high levels of inequality not only adversely affects long-term growth, but also increases the economy’s vulnerability to recession.
Edwards then goes on to observe if in a world of record income inequality, all that matters is one's "starting point", i.e., being born with a silver spoon in the mouth. His conclusion: why certainly.
Joseph Stiglitz makes the most simple point in a NY Times op-ed "Our skyrocketing inequality - so contrary to our meritocratic ideal of America as a place where anyone with hard work and talent can make it - means that those who are born to parents of limited means are likely never to live up to their potential. Children in other rich countries like Canada, France, Germany and Sweden have a better chance of doing better than their parents did than American kids have." He is right. There is growing body of evidence that the largest determinant of your income is increasingly your starting point.
When I was studying economics I think this was part of the lecture on the Edgeworth box: how well you do depends on your initial endowments and how far you move along the contract curve. Or to put it another way, it is economically inefficient for Tim (nice but-dim)'s parents to buy education at his private school while the highly intelligent Tracy sinks like a stone at a local sink school (no disrespect to any Tim's or Tracy's out there). It’s not about equality of outcomes, it’s about equality of opportunity. I think all of us, especially economists, can identify with that…until it comes to our own children, that is.
Here Albert shows our annual SAT chart which shows year after year that US kids are, sadly, getting progressively dumber. Unfortunatly, more than anything, it shows that equality of opportunity is indeed a major issue for a society in which the classes have never been more apart.
Where things get entertaining is when Albert Edwards looks at the US tax system, and particularly its capital gains and dividend taxation components, and concludes "No wonder it has been so easy for the 1% to get richer and richer in the US. While some might explain higher inequality as the inevitable consequence of technological innovation and globalisation, for me distortions in the tax system are key to explaining the extreme levels of income inequality in the US." He continues: "Instead of backing off, things should have gone even further in my opinion to arrest the upward march of US inequality. In my opinion one of the greatest tax distortions and biggest incentives for tax avoidance would be eliminated by completely aligning all taxes on capital gains and dividend income with income tax."
Where it gets downright amusing is that Edwards believes that his assessment regarding the reasons for US social inequality would engender a very violent reaction from "economic libertarian bloggers." To wit:
I can hear the calls from the economic libertarian bloggers to hang, draw and quarter me (incidentally I used to drink at a pub of the same name just next to the Tower of London so I am fully acquainted with the practice). But before I am strung up as a heretic, consider the words of one of the most tax-reforming, right-wing UK Chancellors of the Exchequer of the 20th century.
Nigel Lawson said in 1988: "In principle there is little economic difference between income and capital gains, and many people effectively have the option of choosing, to a significant extent, which they receive. Insofar as there is a difference, it is by no means clear why one should be taxed more heavily than the other."
And separately "I have long felt it is highly undesirable that Capital Gains Tax should have given rise to a substantial tax avoidance industry dedicated solely to converting income into capital gain, which is taxed very much more lightly."
It was Lawson who in 1988 brought capital gains taxation into line with income taxes to stamp out any incentives for the rich to even bother trying to use this time-honoured method for to avoid income tax. And he did what no Labour government had done before him.
We are talking about Nigel Lawson, the former UK Chancellor's of the Exchequer in Margaret Thatcher's extremely "conservative" Conservative administration. Nigel Lawson was no lilylivered leftie liberal. He was so far right he makes Ron Paul look like a pinko-socialist - ok, maybe not quite that far right. Yet despite his right wing, free market credentials Nigel Lawson should be THE pin-up poster boy for the 99% movement.
We are not sure why Edwards is so convinced about the fury this statement would generate: after all "economic libertarian bloggers" have never said that capital gains and dividend taxation is equitable (even if soaring income taxes will merely force enterprenuerial individuals - those who seek to build up capital - to more hospitable tax jurisdictions). After all, the pathetic "Patriotic Millionaires" movement made it a point to highlight that they are wiling to see their income taxes hiked to 100% or more just to prove their "patrotism." How convenient, especially considering that the bulk of their wealth is not in the form of current income (and certainly not through labor), but from returns on assets, dividends, capital gains of course, and generally mortgaging existing assets at the lowest interest rates possible.
After all, we have yet to hear just how much wealth Buffett's secretary has in the form of invested assets and how much her annual dividend payment is.
So Albert: sleep well - your observations are once again accurate.
Which brings us to Albert's conclusion: ignoring for a second where the inequality came from, it is time to focus on where it will lead us. To Edwards, the light at the end of the tunnel (with a toll keeping all but the richest out) is the Hyperloop.
Many investors I meet continue to marvel at US labour's inability to rebuild its wage share of GDP and how dominant capital and profits have become. I believe society will ultimately demand and implement a change. We have already seen a potent grass-roots backlash against cross-border tax arbitrage and tax-havens, which has forced the politicians to react here in the UK. Yet inequality in the US continues to grow.
Investors should make no mistake. The anger of the 99% will ultimately not be bought off by yet another central bank inspired housing bubble, engineered to pacify them and divert their attention as their real incomes fall and inequality continues to grow.
The current bubble will burst, despite the Fed postponing the event by climbing to ever higher diving boards. All the time rising inequality is draining the swimming pool dry and the crunch when it comes will be ugly. Then the long overdue reforms in the tax system discussed above could be forced by a raging public onto the 1% despite their brays of indignation. And when dividends and capital gains tax rates are properly aligned with income tax and inequality begins to decline, let the 99% hold former UK Chancellor Nigel Lawson aloft on their shoulders and fete him for being well ahead of his time.
We would go further: when the fury of the 99% boils over, the 1% (and their bought and paid for politicians) better hope that the army is on their side. Because the reverse wealth redistribution when (not if) it comes, will be swift, militarized, and very brutal.