Friday, March 16, 2007

The Long View: Spectre of income inequality haunts investment bankers

Financial Times analytical article:

Sometimes the stuff of populist politicians, or even revolutionary theorists, can look a lot like investment strategy. Look at a pressing subject for investors – inequality.

Who, for example, said this? “Society as a whole is more and more splitting up into two great hostile camps, into two great classes directly facing each other.”

And who said this? “The world is dividing into two blocs – the plutonomy and the rest. The US, UK and Canada are the key plutonomies – economies powered by the wealthy. Continental Europe . . . and Japan are in the egalitarian bloc.”

The first is from Karl Marx and Friedrich Engels’ Communist Manifesto, the second from a strategy note by Ajay Kapur, until recently the chief global equity strategist for Citigroup, the world’s biggest bank.

Here is another thesis on the same lines. “There are two Americas, not one: one America that does the work, another that reaps the reward.” That is from the stump speech of John Edwards, a candidate for the Democratic presidential nomination.

Meanwhile, “we find that low-income Americans have been in a recession all this century”. That is from a research paper by UBS, the biggest Swiss bank. UBS also asserts that from 1997 to 2001, the top 0.1 per cent of Americans saw their incomes increase almost as much as the cumulative rise received by the bottom 50 per cent.

The investment bankers do not use the same language as revolutionaries and politicians, but their version of the facts seems identical.

It is their job to make money for their clients, not to change society. But inequality matters to investors, deeply. In the very long term, it could lead to the dialectical reaction that Marx predicted.

For the moment, a key implication of Kapur’s “plutonomy” thesis is that global imbalances – the huge indebtedness of the US combined with the apparently excessive reserves held by Asian central banks – is easier to explain than first appears. As he put it: “In plutonomies, the rich absorb a disproportionate chunk of the economy. Their decision to lower their savings rate has a massive negative impact on reported aggregate numbers.”

The balance sheets of the rich are in great shape, according to Kapur, and their behaviour overwhelms that of the hypothetical – and indeed, non-existent – “average” consumer.

So he contends that a minus 10 per cent savings rate for the wealthy – in which they spend 10 per cent more than they earn for the year – would have a trivial impact on the growth in their net worth. Thus global imbalances are more stable than first appears, and the saving rate in the main “plutonomous” countries can continue to fall while equities do well.

But there are also more negative implications. Aggregate economic data for the most “unequal” economies is virtually useless.

Remembering that it really is true that there are in effect two different economies in the US, the contradictions that have churned world markets this month are easier to explain. Aggregate data shows the US economy in decent shape with growth in gross domestic product slowing but positive, running at more than 2 per cent.

But inequality is such that it is possible for benign aggregate conditions to co-exist with a recession for a significant chunk of the population. And the crisis for “subprime” mortgage lenders, who lend to those with bad credit histories, is a symptom of this.

UBS points out that the effective inflation rate for the poor is higher than that for the wealthy. The poor need to buy a basket of staples which is inflating faster than the norm, while many of the goods purchased by the wealthy are decreasing in price thanks to technological advances. So inequality is greater than the widening gap in incomes implies.

This has critical implications for debt. Put simply, UBS says “higher interest rates are more likely to hurt low-income consumers”. Debt levels for the poor are increasing, even though their real incomes, given the inflation they are facing, have been falling. The real interest rates they pay, higher in any case because they represent a bad risk, are higher than they appear because their nominal income is growing slowly.

Add to this that low-income groups tended to enjoy less home price appreciation during the good times, and you have all the ingredients for a terrible crisis in subprime lending while the economy as a whole appears to prosper. Note that the overlap between subprime and low-income borrowers is not perfect – subprime loans were concentrated in areas where home prices rose the most – but the link is there.

Last week brought news from the US Mortgage Bankers Association that subprime delinquency rates were rising fast. That sparked a renewed sell-off in world stocks.

“Prime” mortgages did not suffer anything like as much. Several Wall Street banks used their quarterly results to deny they had significant subprime exposures, although many traders remain unconvinced.

But the risk is plain. If subprime losses eventually lead to losses by big banks, and for the investors who hold securities ultimately backed by subprime loans, the troubles of “poor America” could yet have a dire effect on the finances of the wealthy. Karl Marx’s theories will not be necessary – if it happens this way, capitalism will have done the job.

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