Rising Inequality and the Fed's QE2

Sebastien Buttet and Panos Mourdoukoutas - 831 words. (this article was published in the op-ed section of the Plain Dealer on 12/15/10)


If one judges from the recent sales reports of upper-end retailers like Tiffany’s and the crowds that lined up outside low-end retailers like Wal-Mart on Black Friday, the Fed’s Quantitative Easing Program Part II (QE2) is already working! It got American consumers spending again. 


On a closer examination, the simultaneous rise of upper- and
lower-end stores underlines and highlights an unintended consequence of QE2 that has yet to be recognized: the rising of income inequality that boosts demand for both high-end and low-end goods. 


When the Fed prints money, it is like a helicopter dropping
money over the economy-to use Milton Friedman’s metaphor. The
problem with QE2, however, is that the helicopter doesn’t fly across the US, distributing dollars evenly to all citizens. It flies over Wall Street, distributing dollars unevenly, raising the income gap between Wall Street and Main Street, and diminishing, if not nullifying the effectiveness of monetary policy in lowering unemployment. 


Quantitative Easing Part II (a similar program was initiated at the height of the financial crisis after the collapse of Lehman Brothers a couple years ago) was announced at the Fed’s last meeting in November and consists of two separate and complimentary policies. First, the Fed will buy $600 billion worth of long-term government bonds at a rate of roughly $85 billion per month. Second, the Fed will roll over but not expand its $300 billion mortgage-backed securities portfolio.

Quantitative easing is not without risks to the economy, however, and the list of skeptics and doubters has grown larger. Many economists and elected officials worry that the inherent risks of an unprecedented increase in the money supply (which include a run on the dollar, the collapse of the U.S. Treasury markets and the ensuing inevitable rise in nominal interest rates, rising commodity prices - in particular oil and grains- and out-of-control hyper-inflation) outweigh its uncertain benefits.
    
Ultimately, only time and history will tell how successful the
Fed’s program was at soothing the U.S. labor markets and the economy at large. However, because it provides support to equity markets, QE2 means that income inequality, already at historically high levels unseen since the Great Depression, will rise irrespective of the program’s rate of success. 
    
To support this argument, let us consider the impact of the Fed’s program under two very different scenarios. First, let us assume that critics are correct: The economy plunges into a double-dip recession; QE2 easing fails to create jobs, does not stimulate real demand and only affects the “monetary” side of the economy. The unemployment rate will remain at elevated levels and perhaps will increase even further. Income inequality under this catastrophic scenario will unambiguously rise as the fraction of unemployed and poor household goes up dramatically. As the dollar weakens to unprecedented levels, inflation and commodity prices will creep up and poorer households who spend relatively more on food and energy compared to more affluent ones will feel the pinch the most. Finally, higher nominal interest rates will put a brake on the economy, reducing the chances for the unemployed of finding a job even further. 
    
Now let us examine the more optimistic scenario where QE2 succeeds in bringing down the unemployment rate and bolstering the US economy. None of the previous gloom and doom applies and middle class families will see their economic situation improve. Under this scenario, it is likely that banks will resume lending to small firms and households, companies will expand their operations and stock market valuations will move to higher levels. Richer households at the upper end of the income distribution will reap most of the gains of QE2, however, because they hold a disproportionately higher fraction of stocks, either directly, with investment accounts, or indirectly through pension funds; and the simultaneous gain in high- and low-end sales may confirm this trend. 
    
Rising income inequality, in turn, may eventually depress consumer spending, diminishing or even nullifying whatever early gains occur in spending.


Buttet is a professor of economics at Cleveland State University. Mourdoukooutas is a professor and the chair of the economics
department on the C.W. Post Campus of Long Island University. 
    

How Prolonged Low Interest Rates Hurt the Real Economy

by Sebastien Buttet and Panos Mourdoukoutas - 734 words.

The recent rise in the 10-year Treasury rate following the Fed announcement of a second round of quantitative easing in November has created sharp divisions among Wall Street bankers and Washington politicians alike. Those who early on cautioned against the risks of an unprecedented increase in the money supply now argue that higher interest rates are a sign of negative things to come: increased (anticipated) inflation, higher commodity prices, and the beginning of the end for the two decade long bull market in U.S. Treasury. On the other hand, those who supported the Fed’s program since its inception view the rise in interest rate as a positive sign that the economy is healing, investors are willing to take on more risks by allocating money away from bonds to the stock market, and the unemployment rate will ultimately revert to its historical (lower) mean.

In our opinion, the economy will benefit from a modest and orderly increase in nominal interest rates whoever ends up being right (bears or bulls) because higher nominal rates will close the excess capacity gap. Low interest rates are normally good for the real world economy. They stimulate consumer and investment spending, foster innovation, and help the economy and employment grow, especially when low rates follow a period of high rates. However, prolonged low interest rates aren’t good for the world economy. They lead to excess capacity on the supply side, market saturation on the demand side, and eventually fuel cycles of speculative bubbles that hurt the real economy.

Real interest rates, that is, nominal interest rates adjusted for inflation or deflation, are equal to the long-term return to capital invested in different sectors of the economy. A positive real interest rate is the necessary condition for the functioning and survival of capitalism. Economic theorists from Adam Smith to David Ricardo, Karl Marx and Joseph Schumpeter argued that fluctuations in the return of capital are at the root cause of capitalisms periodic crises. Rising real interest rates fuel economic booms, as capitalists rush to take advantage of higher capital returns. Declining real interest rates are at the root of economic busts, as capitalists rush to withdraw capital from unprofitable sectors.

In some cases, low interest rates release the “creative destruction of capitalism,” the animal spirits of entrepreneurs for wealth creation, foster investments in R&D that lead to the invention and innovation of new high profit margin products and processes that replace lower margin ones - rejuvenating capitalism - as was the case with investments in the PC and biotechnology industries in the mid-1980s, and the internet in the mid-1990s. In other cases, low real interest rates fuel a shift of capital to areas of the world with untapped labor reserves and to “financial engineering,” the development of products that accommodate investments in what was once considered high risk sectors of the economy, which often end in financial bubbles followed by crises when those risks materialize - as has been the case in the subprime crisis of 2008, the sovereign debt crisis in Europe, or the Japanese real estate market collapse of the 1990s, and the looming Chinese bubble.

What makes the difference? Why lower real interest rates spark innovation and growth in the one case and financial bubbles in the other? The level from which real interest rates begin to fall and the duration of that fall. When falling from high levels, real interest rates have a stimulative effect, because real interest rates are also the cost of acquiring something now (e.g., a business acquiring a piece of equipment, a consumer buying a new car, new home appliances, or remodeling her house) versus sometimes in the future. However, if interest rates stay too low for too long, too much firms’ business and consumer purchases are being “stolen” from the future and this inter-temporal transfer eventually has to run its course. On the supply side, investors undertake projects whose profitability solely rests upon low interest rates (e.g., landowners entering commercial or residential ventures). On the demand side, consumers rush to buy durable goods just because of “zero financing,” but this sort of demand will eventually taper off, as the interest elasticity of durable goods is low; the market becomes saturated and eventually spending falls if rates stay low for too long—aggravating the problem of excess capacity.

The FED should welcome the current rise in interest rates, as it brings capacity in line with consumption.

Sebastien Buttet is professor of Economics at Cleveland State University. Panos Mourdoukoutas is professor and chair of the Economics Department at Long Island University, CW-Post Campus.

What Makes America Immune to Food Rioting Contagion

by Veronika Dolar and Panos Mourdoukoutas - January 23, 2011

America seems to be immune to the food rioting contagion, and for a good reason, obesity. As evidenced by the size of their waist, Americans are better positioned to withstand rising food prices than the people of countries like Tunisia where the contagion started. According to World Heath Organization (WHO), 22.03 percent of American are overweight and 1.35 percent underweight that is starvation is virtually non-exist. By contrast, 8.69 percent of Tunisians are overweight and 7.59 percent underweight that is starvation is an existing problem that leaves people little choice but to take the streets.

Obesity further makes America immune to public that is usually associated with rising income inequalities that support and re-enforce social unrest. Economists have been pointing out for some time now that income and wealth inequality, by many measures (e.g. wages, jobs, taxes), is now greater than it has been since the 1920s. However, American people seem to be oblivious of this situation. A recent survey shows that on average Americans grossly underestimate how unequal the distribution of wealth in this country and want the distribution to be "even more" equal than their gross underestimate (see Building a Better America One Wealth Quintile at a Time by Michael I. Norton and Dan Ariely).

In addition, in the recent elections the American voters opted for more republican and tea party candidates, whose policies are obviously against redistribution and more egalitarian policies. Historically, high income and wealth inequality have been associated with poor and starving masses that were driven by their desperation to take to the streets and overthrow the regime. The hunger has historically been an instigator of revolutions and civil wars. In fact “Bread and Games” became the solution in Rome between 200 BC and 300 AD when it was becoming increasingly difficult to keep the people happy and keeping them from starting the revolution against the system, against repression and exploitation.

Fortunately, this hasn’t been the case in the advanced capitalist world, as technological advances have lowered the cost of food, especially the cost of fats and sweeteners used in high calorie prepackaged snacks and drinks. Today, the average American spends significantly less income on food as compared to 50 years ago. Food is cheaper, especially government subsidized packaged food (syrup used in snacks comes from heavily subsidized corn) that is purchased in bulk and stored in large garages and basements. This isn’t the case in less developed countries, where people still spend a large proportion of their income on food, and high-calorie prepackaged food is still expensive, especially for those in the bottom of the pyramid, who lack the credit and the storage space to purchase food in bulk.

Low price high-calorie food has been the main cause for the recent obesity epidemic. And it is due to the expanding waist that Americans are not more outraged by the income inequality in this country. As long as our bellies are full, and our direct survival is not threatened, there is no need to revolt against the status quo.

Americans are not only full; they are stuffed. How can we complain about income inequality and unfairness when at the same time our bellies are getting bigger by the minute? How can we complain that we don't have enough, when it is obvious, that we have more than enough money to buy food, way too much food?

Recent studies have also linked obesity to the depression and lethargy.  Our full bellies and food induced stupor can very easily spill over to apathy in politics where we no longer care who is winning the local and national elections and what policies they pursue.  As long as the average American waist grows, our politicians do not have to worry about riots and revolutions. American capitalism is safe.

Veronika Dolar and Panos Mourdoukoutas are Professors at the Economics Department of the C.W.Post Campus of Long Island University. They are currently working on a book, The Six Rules of Intelligent Dieting: Wisdom from Economists on Living the Healthy and Fit Life