Rise of the Western Banana Republics?

These are dark times for developed economies such as the United States and parts of Europe. Income inequality has been rising steadily for the last 40 years, but the 2008 financial crisis, the ensuing global recession and subsequent stimulus by the global central banks have only  exacerbated the divide between the rich and poor.

According to a recent study on income inequality by the National Bureau of Economic Research, the US now has the highest income inequality and lowest upward mobility of any country in the developed world. Accordingly, the study found that while the picture grows increasingly bleak for America’s middle class, “the share of total annual income received by the top 1 percent has more than doubled from 9 percent in 1976 to 20 percent in 2011.”

Earlier this year, a report by the Organization for Economic Co-operation and Development (OECD) also found that the US now leads the developed industrialized world in income inequality. Finally, a recent study from the University of California, Berkeley, found that 95 percent of income gains from 2009 to 2012 went to the top 1 percent of the earners, a trend largely attributed to the Federal Reserve’s asset purchases, since the rich hold a much larger proportion of financial assets than other income brackets.

Percent Change in Real Income Since 1948


Source: IRS data compiled by economist Emmanuel Saez

“Lost in the angst over inequality is the critical role that central banks have played in exacerbating the problem,” wrote Stephen Roach, former top economist at Morgan Stanley and lecturer at Yale. In an article, entitled Occupy QE, he wrote, “All of this means that the wealthiest 10 percent of the US income distribution benefit the most from the Fed’s liquidity in! jections into risky asset markets. And yet, despite the significant increases in asset values traceable to QE over the past several years – residential property as well as financial assets – there has been little to show for it in terms of a wealth-generated recovery in the US economy.”

The problem, Roach argues, continues to be the crisis-battered American consumer. “In the 22 quarters since early 2008, real personal-consumption expenditure, which accounts for about 70 percent of US GDP, has grown at an average annual rate of just 1.1 percent, easily the weakest period of consumer demand in the post-World War II era. That is the main reason why the post-2008 recovery in GDP and employment has been the most anemic on record.”

Clearly, the struggles of the middle class are alarming, since its well-being is a necessary component of a successful democracy. Further, history shows a disappearing middle class has disturbing implications for the future growth prospects of the economy. Some have voiced concern that the United States and some European countries are in danger of becoming banana republics plagued by growing inequality, huge debts, political paralysis and subpar growth.

A banana republic – the term was first applied to the shaky regimes of Central America and the Caribbean – is a politically unstable country stratified into a large, impoverished working class and a ruling plutocracy that comprises the elites of business, politics, and the military. This politico-economic oligarchy controls the productive assets and uses its privileges to exploits the country’s economy. Growth in such an imbalanced economy tends to be limited, and its benefits accrue largely to the elites.

While there are certainly policies that can be implemented to arrest the decline of America’s middle class, and it’s our sincerest hope our political and business leaders act to stop potential social and economic stagnation, engaging in a polic! y debate ! is outside the narrow scope of this newsletter. Rather, we aim to show how income inequality in developed economies is rising, and how past economic research shows unequivocally the correlation between income inequality and inflation, and the need for investors to protect their portfolios.

Inflation Doves Are Strange

Surprisingly, some economists have recently argued that moderate inflation may be a good thing. According to an October story in The New York Times, “The Fed has worked for decades to suppress inflation, but economists, including Janet Yellen, President Obama’s nominee to lead the Fed starting next year, have long argued that a little inflation is particularly valuable when the economy is weak.”

These economists argue, “Rising prices help companies increase profits; rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly,” according to the article, headlined “In Fed and Out, Many Now Think Inflation Helps.”

The push for “modest” inflation has been advocated by such prominent economists as Paul Krugman and Kenneth Rogoff. Of course, these arguments presuppose that incomes would keep up with inflation, companies would spend, and that the central banks can be precise in controlling inflation.

Such views apparently ignore the recent phenomenon of globalization and the weakness of unions as well as new market dynamics and technologies, all of which will likely stifle efforts to renegotiate most wages upward, further increasing income inequality. And record Fed stimulus has yet to incentivize companies (which have trillions on their balance sheets) to spend and hire sufficiently to boost economic growth above the current sluggish levels.

In an inflationary environment, many companies may not be able to pass through costs – which may mean less hiring or even layoffs. Finally, central banks have a terrible record of timing s! timulus p! rograms, nearly always leading to higher inflation than intended, which is what we believe will happen.

In sum, what all this means is that not only is higher inflation very likely given the dovish bent of many central bankers and economists, but so is greater income inequality, which not only predicts but can potentially exacerbate the length and impact of future inflationary periods.

Tears of Tomorrow

In analyzing the inequality-inflation relationships for 53 countries between 1981 and 2000, a researcher at the London School of Economics’ Center for Economic Performance, finds a positive relationship between inequality and inflation holds even when controlling for other factors such as the overall level of development. According to the 2005 study by Chris Crowe, politicians in high-inequality countries may have incentives to choose higher inflation, a process he divides into two stages.

“To demonstrate the first stage, note that inflation is a tax. Printing money raises revenue for the government, in the process expropriating a proportion of any wealth held in nominal assets such as cash. But not all people face the same inflation tax rate. Inflation is regressive, a tax that hits the poor and middle class hardest because they hold more nominal assets, as a fraction of total income, than the wealthy. This means that the wealthy – who can mostly avoid the inflation tax – might well prefer it to more progressive taxes such as income tax,” Crowe wrote.

And the political and economic preferences of the rich carry ever more weight as they grow richer. “To put it simply, money talks. But if political voice depends on income, then greater inequality means greater inequality in political participation. In turn, this increases the adoption of policies – such as inflation – more favorable to the wealthy,” Crowe argues.

Of course, this provides only partial explanation for inflation. Some policy-makers are simply inco! mpetent, ! according to Crowe. Inflation worldwide has clearly waned since its heyday in the 1970s, while inequality has not. Still, the positive correlation Crowe found between inequality and inflation cannot be ignored.

Given the negative trends in income inequality that are happening in Europe and the U.S., and suggestions by economists and policymakers that they indeed hope to generate higher levels of inflation in the future, we reiterate to investors our recommendation to invest in companies that have pricing power; commodities, real estate and diversified international portfolios that would take advantage of better growth dynamics in other countries, all of which offer protection from inflation.