Contractionary monetary policy increases inequality and burdens workers. Expansionary monetary policy is good, actually.
Contrary to the right-leaning fear-mongering (usually in the media) about the Federal Reserve reducing interest rates and rounds of QE ‘’distorting the market,’’ ‘’debasing the currency,’’ and ‘’inflation as a tax,’’ as well as misguided left-leaning populism that claims that expansionary monetary policy is bad because it increases stock prices or ‘’gives money to rich people,’’ I assert that, ‘’expansionary monetary policy is good, actually.’’ This is a data and theoretical response to the left-leaning populist, as well as a criticism of the right-leaning position as essentially class warfare from the top down.
I also show that expansionary monetary policy has economic benefits, aside from being the more egalitarian of the two policy options.
Distribution of liabilities, composition of incomes and power structures
The distributive consequences of this issue is sometimes hard to visualize and there is much back-and-forth. Some critical thinking can help us understand the distributive nature of monetary policy.
Think about the composition of incomes, liabilities, assets and inflation.
Lower-income earners earn labor income, save less and have more debts.
Higher-income earners earn capital income, save more and have fewer debts.
Lower-incomes benefit from lower interest rates and higher inflation.
Higher-incomes benefit from higher interest rates and lower inflation.
Contractionary policy and anti-inflation policy disadvantages lower incomes by reducing demand for labor, reducing wages and increasing interest payments on debt.
Contractionary policy and anti-inflation policy advantages higher incomes by reducing demand for labor (stifling the bargaining power of workers) while increasing interest payments on savings and bonds and preserving the real value of capital and savings.
In short, the poor pay interest whereas the rich are paid interest.
This would mean that high interest rates would increase inequality. The following paper seems to demonstrate my basic proposition.
The abstract of the paper reads:
‘’…Finally, the evidence indicates that wealth holders are helped by contractionary monetary policy as interest rates increase and inflation declines.’’
The main paper continues this thought.
‘’While disinflationary monetary policy will initially harm (or fail to benefit) most sectors, as interest rates rise and prices decline certain groups should gain. The clearest winners are wealth holders. Since the holding of interest-bearing assets are concentrated among the wealthiest, higher interest rates that shift the functional distribution of income toward interest payments will shift the personal distribution of income toward the wealthiest.’’
The study (see here) continues and finds a concrete number:
‘’Moore (1989) and Niggle (1989) have investigated the distributional effects of disinflationary policy by household type poor, middle income, and rich. The distribution of asset holdings is very different across these groups. Whereas poor households tend to be net debtors, the top 10 percent of wealth holders tend to be net lenders. Following the Volcker deflation this top 10 percent held 94.4 percent of all bonds and trusts and 50.8 percent of all other interest-bearing assets. As Moore and Niggle discuss, high interest rates due to the Volcker deflation caused the share of interest in personal income to increase almost 5 percent between 1979 and the end of 1982. Since the ownership of interest bearing assets is so heavily concentrated among the wealthiest, this shift in the functional distribution of income produced a shift in the personal distribution of income towards greater inequality. Niggle estimated that the higher interest rates due to contractionary monetary policy increased the share of total income going to the wealthiest 10 percent of households by 3.5 percent.’’
The study also found a simultaneous decrease in employment by 2.4 percent when interest rates were raised by 300 basis points in 1994. The inequality effects directly as a result of increased unemployment, in turn as a result of rate increases, are as such:
‘’Blinder and Esaki (1978) investigated the effects of negative macroeconomic shocks on the distribution of income. Writing shortly before the Volcker deflation, they found that each one percentage point rise in unemployment takes about 0.28% of national income away from the lowest 40% of the income distribution and gives it to the richest 20%’’
There is also by comparison little reduced demand for capital, in contrast to labor. Owners cannot be ‘’unemployed’’ unless in the relatively rare case that a business fails or the even rarer case that state defaults on its debts and does not pay interest on bonds. Even at that point, owners likely own diversified assets or can easily acquire new ones. Owners are anchored in their position because they control capital (business enterprises, land etc.) and are often the creditors of the state through ownership of bonds; therefore their incomes would be by definition less responsive (negatively) to contractionary monetary policy. Workers by contrast are at the mercy of a boss or firm and can be unemployed at any time.
This is reflected in the data, from Innocent bystanders? Monetary policy and inequality in the US:
The data shows significant declines in labor income and total income for the lowest percentiles (P10), (P25) more or less neutral or slightly negative effect (P50) and significant positive effects for the highest percentiles (P75) and (P90). It is also important to note that labor income declines more than total income, which would indicate that lowered demand for labor is a critical factor.
Disregarding percentiles and breaking down the effects into high income / net worth and low income / net worth, we see the same effect:
Another study found similar results.
‘’We find that contractionary monetary policy shocks lead to an increase in earnings, income and consumption inequality and contribute to their fluctuation. The response of income and consumption at different quantiles suggests that contractionary policy has a larger negative effect on low income households and those that consume the least when compared to those at the top of the distribution.’’
This was because it decreased wages, which mostly affects lower-incomes than richer people who receive their money by owning. The direct decrease in incomes at the lower end as a result of contraction seems to lead to a similar, essentially mirrored increase, in incomes at the top!
‘’Results from this exercise suggest that the contractionary monetary policy shock decreases wages and income for households at the low end of the distribution while households at the upper end are less affected. This is consistent with richer households deriving a larger proportion of their income from investments.’’
‘’The top two panels of the Ögure show that a monetary contraction has a large negative impact on the wages and income within the lowest percentile. Wages in P1 decline by about 0.1% at the 2–3 year horizon, while the fall in P2 is estimated to be about 0.05%. In contrast, the wages within the middle and higher percentiles display an initial increase before returning to base. The response of income at higher percentiles shows a similar pattern with the income in P5 rising by 0.1%’’
Concerning interest payments only: those who borrow money and thus stand to win from low interest rates are at the low end of the income distribution. Those who lend money and own interest-bearing assets and thus stand to lose from low interest rates are at the top end of the income distribution.
There is also the question of lower inflation benefiting wage-earners. Would that not lead to higher real wages? My initial thesis on who benefits from inflation did not take wage labor into account, so let’s do that! The problem is that if higher interest rates and a constricted money supply lead to lower inflation, that would mean that real interest rates would also rise alongside real wages. The question is which rises more: real wages or real interest rates? From what I can deduce, the result would be that the additional interest payments used to fight inflation would also cut into wages just as much or more than inflation. Wage-earners would be worse off. For example, the average American family spends $4,499 on mortgage interest with an average interest rate of 3.8%. The median income is about $59,000 if this article is to be interpreted. If a 1% rise in interest rates decreases inflation 0.4% from 3%, this means $5,682 in total interest expenses in a 4.8% rate environment. This is an additional $1,183 in interest payments and simply $236 in savings from lower inflation. The net loss is $947 per year. Keep in mind, this doesn’t include the other loans!
Even that 0.4% increase in real wages / income is generous, because it assumes increases in interest rates only decrease inflation and not wages. As the study above suggested, even though inflation falls, the wage as it is paid to the worker also falls at least 0.1%! The policy intended to increase real wages by controlling inflation inflicts collateral damage. Thus, the revised net loss may be higher!
In conclusion, we have falling inflation, but also decreasing wages and increasing household interest payments.
Ron Paul is sort of right (at least with regards to wages) when he says inflation is a tax. But the policies to fight the inflation are an even worse tax.
Some may also ask, ‘’but don’t businesses pay fewer of their potential profits in interest when rates are low? Does this not increase inequality, because the business owners are wealthy?’’ This is a sort of fallacy, because it implicitly assumes that banks they are borrowing from are not also corporations with owners. If anything, it is the opposite.
Banks of all industries, are probably both the least labor and capital intensive, or at least less likely to be intensive in these areas than their borrowers. This means a higher rate of return. Shifting revenues to those industries with less labor and capital intensity would mean higher inequality. This is because revenue is translated into profit to a greater extent because there are fewer costs. This contrasts with industries such as restaurants which are more labor intensive because they employ large workforces and industries such as oil extraction and refining which would be more capital intensive because they need large amounts of property and equipment to operate.
The argument that higher interest payments are essentially a progressive tax on corporations, of which the burden falls on rich owners, is wrong. This is relevant because it is common to see expansionary policy (such as the bond purchases the the Federal Reserve made recently) described as ‘’corporate handouts.’’ As Matthew Bruenig points out, the correct analysis (and fully consistent with left-wing egalitarianism, Bruenig is a socialist) also includes the lender, not just criticism of the borrower because they happen to be a corporation.
Studies on interest rates
Once all the effects are accounted for, researchers find that a 1 increase in the Federal Funds Rate increases inequality as measured by GINI by 0.7%.
They find statistically and economically significant effects of surprise monetary policy changes on inequality. Specifically, they estimate that a surprise increase in the fed funds rate of one percentage point would increase pre-tax income inequality, as measured by the Gini coefficient, by roughly 0.007, but only after three to five years
To be clear, the GINI coefficient is measured in percentages from 0–100 and usually written as a number from 0–1, so the seemingly insignificant 7 thousands increase in GINI is actually 0.7%. 0.7% x 1.0 = 0.007.
Another study by the International Monetary Fund finds that a 100-basis points (or 1%) decrease in interest rates reduces inequality as measured by the GINI Index by 1.25% in the immediate and 2.25% over the long-term. The labor share of income increases, whereas the top 1% share of income and capital share all decrease. On the other hand, contractionary monetary policy shocks such as a 100-basis points increase in interest rates also reduces output about 0.8%, increases unemployment about 0.5% while inflation decreases about 0.4%. Inequality also increases about 2%. The increase in the unemployed also confirms the previous point on reduced demand for labor.
The previously linked study (Innocent Bystanders?) found that overall contractionary monetary policy between 1980 and 2008 has increased inequality. While it is true that interest rates have declined from nearly 20% in 1980 to nearly 0% by 2009 and inequality has increased over this period, this study suggests the inequality problem would have been worse otherwise.
While there are several conflicting channels through which monetary policy may affect the allocation of wealth, income, and consumption, our results suggest that, at least in the US between 1980 and 2008, contractionary monetary policy actions tended to raise economic inequality or, equivalently, expansionary monetary policy lowered economic inequality.
Sometimes it is asserted that expansionary policy is a negative because it increases stock prices, with unconventional monetary policies that make use of tools besides interest rates being the worst offender. These are likely nominal stock prices, however. As shown in the IMF study, contractionary policy of just a 1% increased rate reduced inflation 0.4%. Stock prices increasing would be a function of companies having to pay fewer of their profits into interest payments.
What this overlooks is that higher interest rates also can increase profits over the long term by reducing labor demand and worker bargaining power, as well as reducing the inflation rate. A combination of lower wages and lower inflation ultimately means that contractionary policy could *increase,* or at least not severely damage, the rate-of-return and stock prices.
This assertion is backed by evidence from the European Central Bank in a study entitled ‘’How does monetary policy affect income and wealth inequality?Evidence from quantitative easing in the euro area.’’ More unconventional policies such as Quantitative Easing also do not necessarily increase inequality and the positive relationship to stock prices isn’t the clearest cut. A study from the Eurozone found that it compressed the income distribution, because it increased demand for labor and real wages at the expense of the owner class.
‘’We find that the earnings heterogeneity channel plays a key role: quantitative easing compresses the income distribution since many households with lower incomes become employed. In contrast, monetary policy has only negligible effects on wealth inequality.’’
‘’The paper finds that the QE in the euro area has diminished income inequality, mostly via the earnings heterogeneity channela sizeable reduction in the unemployment rate for the poorer part of the populationand to a lesser extent via wage increases by the employed. The Gini coefficient for gross household income drops from 43.1 to 42.9, one year after the QE announcement. ECB’s asset purchases have also contributed to reduce net wealth inequality, albeit to an almost negligible extent. This is explained by the fact that QE has a positive impact on housing wealth, a component of the net wealth, which is quite homogeneously distributed across the distribution.’’
The policy mechanism by which QE might improve the economy is thus. As we have already seen, 100-basis points (or 1 percent) change in rates can have effects on the distribution of incomes:
‘’To gauge the relevance of the effects of QE, notice that our quantitative easing shock (an exogenous drop by 30 basis points in the term spread) has roughly the same effect on GDP as a 100-basis-point surprise drop in the policy rate.’’
The European Central Bank also published another very similar paper entitled ‘’Monetary policy and household inequality.’’ They come to similar conclusions, including that expansionary policy raises wages and employment for workers, and the benefits of lower rates go to people who owe some form of debt:
‘’In this paper we argued that all monetary policy decisions tend to have re-distributional consequences. Expansionary monetary policy, both standard and non-standard, tends to reduce income and wealth inequality.’’
Stock prices did not significantly rise in Europe despite a similarly or even more lengthy process of easing, although the ECB study found some positive effects. Placing the blame for rising stock prices in the United States all on unconventional monetary policy seems to be an observation of a spurious correlation.
Similarly, a study by the Federal Reserve concluded that expansionary policy could *reduce* stock prices, not just modestly increasing them while having overall egalitarian effects. The effect of higher wages, higher employment and higher inflation is there. In specific, the study also identifies decrease precautionary saving (if we want to be cynical about it, ‘’money hoarding’’) by the rich. Expansionary monetary policy has several means by which to increase stock prices and some more to suppress them, including the negative effect on precautionary saving. Expansionary monetary policy can increase inflation more than stock prices, but that is most likely when rates are higher and a central bank has more range and space to decrease rates.
Studies on inflation
One study found that the inflation of 1969–1975 reduced inequality. This is primarily because the inflation negatively affected most people who own assets and stocks, whereas while the people on the lower end of the income distribution do earn wages which can be reduced by inflation (true); they are also in debt relatively more than higher incomes and pay interest to a lender, which can also be reduced by inflation. This confirms my above thought experiment with the mortgage:
‘’The biggest gainers from this inflation were home‐owners with large mortgages and the biggest losers the large stock holders.’’
This can be observed in wealth inequality charts. The top 0.1% share of wealth (not the broadest measure, to be clear) stayed constant from 1948 to 1970 at about 10% and then declined about one-third until 1978.
Positive economic effects of monetary expansion
According to figures from the Center on Budget and Policy Priorities, QE increased GDP approximately 1.5% as of 2015. The Federal Reserve also maintained an interest rate close to 0% (as low as 0.07%) for several years after the Great Recession.
Expansionary monetary policies also expand the long-term output of the economy and can have positive effects on other areas affected by the changes in output.
High interest expenses are also a drag upon key economic indicators, especially ones that matter for workers.Expansionary monetary policies can increase employment and wage levels, as significant cash constraints in the form of high interest expenses relative to cash flow will usually lead to decreased employment. Surveys of European businesses demonstrate this:
‘’Figure 1 shows that, in Europe, the ratio of corporate interest payments relative to cash flow initially rose as the global financial crisis began in 2008, before falling markedly alongside actions by central banks to ease financial pressures by cutting interest rates as well as through other non-standard policy measures, e.g. buying government debt and giving cheap term funding to banks.’’
‘’What kind of effect might such easing have on employment? In firm-level studies of labor demand, employment is shown to decrease as a result of financial pressure experienced by the firm — as measured by the ratio of interest payments to company cash flow. This ratio has been termed the “borrowing ratio” . Loosening monetary policy, including cutting policy interest rates set by central banks, reduces interest payments and thus the financial pressure experienced by firms. The term captures the premium on borrowing costs and/or the probability of credit being completely unavailable or rationed.’’
‘’A sample of UK companies provides evidence of the expected link between monetary policy — via the borrowing ratio — and the level of employment . Lower interest rates supported employment by reducing the cost of interest payments relative to cash flow. The effect was quantitatively quite large. A 10% reduction in interest expense increased companies’ employment by around 0.5% in the short term (i.e. within the year) and by 2% in the long term (after five years or more).’’
‘’In another analysis of manufacturing firms in 11 European economies for the period 2003–2011, a 10% fall in interest payments (relative to cash flow) was found to raise employment by 0.35% in the short term; the study did not analyze long-term effects .
So although there are significant positive effects, the analysis also found that positive effects are about three times larger in a crisis or downturn year than when the economy is more stabilized or growing steadily. This fits well with the common idea that economic multipliers rise at the beginning of the business cycle and decrease further towards the end of the cycle.
We should also observe the history of monetary policy as a class issue. Consider who supported the gold standard. This policy limited the ability of the government to increase the money supply or decrease interest rates and left this to market forces. The gold standard was quintessential contractionary monetary policy.
The supporters were generally capitalists: business owners and employers, the disproportionately rich owners of interest bearing assets such as bonds and savings and especially finance capital.
‘’What gives? For generations, the hard-money issue has broken down pretty much along class lines. Starchy conservative bankers loved the gold standard because it generally kept inflation in check and protected the value of their assets. Poor Midwestern farmers, not so much. These were people who benefited from inflation, which ate away at their debts, and who were crushed by deflation, which made their outstanding loans more expensive. (That whole “Cross of Gold” speech at the 1896 Democratic convention had something to do with this…’’
Significant conflict in US politics occurred during the 1890s between supporters of the gold standard, usually business interests, and supporters of the silver standard, usually mid-western farmers, debtors and generally the working class. Even the essentially socialist, very radical (and very based) Knights of Labor got on the anti-gold action:
‘’In the following years Congress took steps to put the U.S. currency on the gold standard. To replace greenbacks, silver coin and other currency, Congress favored gold-backed bank notes. These notes were issued by federally chartered private banks — most of which were clustered in the Northeast.
This move toward gold-based currency provoked a “battle of the standards.” Gold had strong support among the wealthy, including banking executives and conservative Republicans and Democrats mainly from Northeastern districts.
But many workers and farmers equated hard money with hard times. This perception grew stronger the further one lived from the financial centers of New York and Philadelphia.
By the 1870s and ’80s, anti-monopolist leagues, the farmers’ Grange and the Knights of Labor fought back against the gold standard. Many of their members supported the Greenback Labor Party that stood for labor rights and greenback dollars.
This “battle of the standards” came to a head during the depression of the 1890s. A coalition of farm and labor groups had formed the Populist Party. Among other reforms, the Populists demanded an expansion of the money supply by minting silver and printing greenbacks.’’
The result of the gold standard was that prices, in fact, fell. This inflicted enormous damage, especially on producing farmers:
‘’Hard money meant a general deflation of prices in relation to the dollar. Each year from 1875 to 1896, farm prices fell 3 percent. Georgia farmers saw the price of a pound of cotton fall from 10 cents to 5 cents. The price of Illinois wheat dropped even further. Corn prices fell so low that Nebraska farmers decided to burn it for fuel rather than spend money and time shipping it to market to sell it.
At the same time crop prices fell, the cost of mortgages and loans soared. Farmers needed credit for machinery and other supplies. But an unregulated credit market meant that in some regions loans were either sky high or not available.’’
Many industrial workers had reason to oppose the gold standard as well, besides being debtors themselves. It created instability in industries such as steel manufacture that produced commodities:
‘’Farmers were not alone when it came to the burdens of hard money. During the long economic depressions of the 1870s and 1890s, workers and manufacturers felt the weight of the same deflationary price cycle. They asked why anyone would invest in an iron mill, for example, when the price per ton of iron stagnated or fell’’
Overall, the policy of the gold standard was incredibly beneficial to finance capital:
‘’But gold was good for those who controlled the currency, held gold or issued loans. It was good for the banking corporations, Wall Street financiers and other creditors. As a result, the gold standard shifted resources from the poor to the rich, and from the Midwest, West and South to the financial centers of the Northeast.’’
Even today, similar trends are present. As the Economic Policy Institute observes, the members of the Federal Open Market Committee who are directly appointed or surrounded by local banking interests and are closest to them tend to be more conservative, pro-finance and ‘’hawks,’’ meaning that they prioritize controlling inflation. They generally are more likely support interest rate increases and oppose expansionary policy such as QE.
However, even though the formal voting power of the district bank presidents is limited, all 12 district bank presidents participate in FOMC meetings and have “voice.” This enables them to influence interest rate policy. Moreover, that influence is formidable because the Federal Reserve prides itself on consensus decision making. Since district bank presidents have historically been more pro-business and pro-finance (reflecting who elects them), this gives a meaningful invisible anti-working-family tilt to the process governing interest rate policy decision making. This pro-finance, pro-business attitude shows up in “hawkish” attitudes toward inflation.
Hedge funds have also come into conflict with the Federal Reserve over its Quantitative Easing policy.
Expansionary monetary policy is often superior to contractionary monetary policy. It decreases inequality and lessens the powers of capital by increasing employment (and bargaining power) and increasing wages. It also promotes inflation that devalues assets predominantly held by the wealthy and decreases interest rates, which can be to the benefit of poorer borrowers and the detriment of richer lenders. Decreased interest rates also hurt wealthy bond holders.
Increased inflation and expansionary monetary policy is not necessarily a negative for the poor because the effects of decreased interest payments on debt such as mortgages, cars and consumer credit can outweigh the negative effects on wages. Wages are also decreased as they are paid when rates increase. Increasing rates and fighting inflation will likely have a larger negative effect in many to most circumstances.
Expansionary monetary policy can have positive economic effects such as increased long-term output.
The class politics of monetary policy have also been very clear throughout history. Since the days of William Jennings Bryan, the working class has fought for expansionary policy, then in the form of the silver standard, whereas capital supported contractionary policy in the form of the gold standard.
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