Update Magazine III/2018 › Download the complete magazine

1 The conventional explanation for rising inequality

In the academic literature, the automation of production processes from the 1970s and 1980s onwards is generally regarded as the main cause of growing income divergence, with manual and repetitive activities increasingly being taken over by machines and new technologies. The upturn in international trade at the beginning of the 1980s – which was accelerated by the opening-up of China’s economy (from 1979) and the collapse of communism (1989-1990) – is closely related to automation, since it contributed to the large-scale relocation of production sites abroad.

The result of increasingly automated production was that the demand for – and the salaries of – highly qualified and well-paid employees increased by more than the average. On the other end of the spectrum, low-skilled employees were in less demand, and saw their wages decline after allowing for inflation. For middle-income earners, the earnings trend was slightly positive, but the proportion of employees in this income bracket declined – and they were particularly affected by new technologies that displaced routine activities.

The declining unionisation of employees is also held up as a reason for increased income divergence. Lower- and middle-income groups have been especially hard hit by the associated reduction in bargaining power in pay negotiations.

The rise of the financial sector is frequently cited as another cause of increased inequality. Large, internationally oriented companies and their staffs have been benefiting from the greater international mobility of capital, which is a result of several decades of deregulation in capital markets. Wider access to financial instruments and the resulting ability to acquire and leverage knowledge and expertise – for example, in the form of training loans – can exacerbate inequality, particularly in emerging markets. However, the financial sector is considered to be a secondary cause of growing inequality compared with real economic developments, such as automation and international trade.

Finally, state redistribution in the form of progressive income tax rates – as well as inheritance and wealth taxes – can lower inequality without taxation necessarily being a drag on growth.

2 How central banks view monetary policy’s role in inequality

Central banks essentially agree with the assessments we have outlined above. For these policy makers, inequality is largely explained by factors beyond the control of monetary policy – namely technological change and globalisation. In this view, the ultra-expansionary central-bank policy adopted all over the world since 2007 is not seen as another cause of inequality, but instead is believed to have positive effects on the distribution of income.

So what is the basis for this thinking? From the perspective of central banks, the unprecedented monetary stimulus of the past decade led to an economic recovery, and therefore led to a significant improvement in labour markets and employee compensation. Admittedly, in a low-interest-rate environment, corporate income increases and private households’ net interest income tends to fall, though the net effect on income distribution is positive.

A quote by Mario Draghi from 2016 sums up the beliefs of central banks very well: “Monetary-policy actions that boost the economy typically reduce income inequality.” Of course, this does not rule out the possibility that wealth inequality will increase as a result of monetary-policy stimulus. However, the net effect on asset distribution ultimately depends on several factors:

• which asset classes (bonds, equities, real estate) grow and to what extent;
• how assets are allocated by private households (there are significant differences between countries); and
• how the different asset classes are financed (debt or equity).
  
  

But central banks believe that monetary policy has a neutral impact on wealth and income distribution in the medium to long term. They believe that if monetary policy is symmetrical – that is to say, if the stimulation and tightening phases of monetary policy are equally pronounced – then the positive and negative distributional effects should balance out over time.

3 Monetary policy has been asymmetrical since the 1980s

But it is precisely this assumption that can and must be called into question, as we have already pointed out in previous studies. In this respect, we share the opinion of the Bank for International Settlements, among others: monetary policy has been asymmetrical for several decades.

According to our estimates, monetary policy in the US and Europe has been somewhat too loose on average since the 1980s, and below the estimated “neutral” value at which the economy is neither stimulated nor slowed down (see Chart A/).

Over approximately the last 35 years, monetary policy has generally been relaxed in times of recession, and in anticipation of possible upheavals on the capital markets. (For example, the Fed boosted liquidity at the end of 1999 to cushion possible financial-market upheaval from “Y2K” computer problems.) At the same time, central banks were slow to normalise monetary policy in economic booms because they focused on goods-price inflation, and did not take into account asset-price inflation. This is what the Jackson Hole Consensus is all about. Even today, more than ten years after the outbreak of the global financial crisis, the relevance of asset prices to monetary policy is anything but clear. At most, they are of secondary relevance to the key function of central banks.

Loose financial conditions for the corporate sector are one result of this approach. This is the case today: with nominal trend growth in the United States of approximately 3.5%, the “neutral” nominal fed funds target rate is 3%, rather than the current rate of around 2%.

The National Financial Conditions Index calculated by the Chicago Fed also indicates that conditions are far too loose – and have been since 2013. Our assessment is similar for the European Central Bank and the Bank of England. In Japan, especially in the years after the Plaza Accord in 1985 and before the bubble burst in 1989-1990, monetary policy was also too expansionary. During this time, the strength of the yen – and consequently a relatively low rate of goods price inflation – prevented the Bank of Japan from pursuing a more restrictive monetary policy.

A/US Federal Reserve interest rate relative to the neutral rate vs. the Chicago Fed's National Financial Conditions Index

Source: Thomson Reuters Datastream, AllianzGI Economics & Strategy. Data as at 13 August 2018.

4 Structural support for asset markets through asymmetric monetary policy

So how is monetary policy relevant to the debate over rising inequality? The answer lies in how structurally overexpansionary monetary policy stimulates prices of risky assets, as market participants discount stronger economic activity in the future. In fact, equities have generated above-average returns worldwide since the mid-1980s – despite the bursting of what was probably the largest equity bubble in the history of financial markets in 2000, and despite the financial crisis in 2007-2008.

A closer look at the returns in the mid-1980s emphasises this point:

• Annualised real stock returns in the US were just under 9%, and in Europe close to 7%; compare this to their long-term averages of just below 7% and 6%, respectively.
• Real estate also generated solid average returns in this period (3%-4% per year in real terms), partly because real-estate prices made a strong recovery after 2006– 2007, when the bubble burst in many western industrialised countries.
• Even global bond markets achieved slightly higher-thanaverage returns, though they were well below those generated by equities. This is largely because lower central-bank interest rates led to falling yields at the long end of the yield curve, and thus to higher bond prices.
  
  

During more than three decades of too-loose monetary policy, asset owners consequently benefited from the rise in asset prices and capital incomes. As a result, wealth and income inequality has risen structurally, marking a fundamental change in how the global economy operates.

5 The misallocation of resources hurts growth and increases inequality

In fairness, interest rates that are too low can still provide an initial boost to economic activity, and they can increase investment activity and demand for loans. In 2015, the global investment rate reached its highest level since 1990 (26%); today, the rate is only slightly lower.

At the same time, worldwide private-sector debt has increased massively in recent decades, especially after the financial crisis: relative to GDP, debt among companies and households is at an all-time high of 150% (see Chart B/). Admittedly, debt has fallen slightly in many industrialised countries since the financial crisis. However, debt has increased significantly in some countries that were not or barely affected (Canada, Sweden, Norway, Australia, New Zealand, Hong Kong and Singapore) as well as in some emerging countries (Thailand, Korea, Turkey and especially China). This is because low-cost financing conditions have been, and are still being, exported to the rest of the world through international capital mobility.

Not only does this trend have negative medium- and longterm effects on overall economic productivity, but it also increases inequality over time. Why? If financing is too cheap, the profitability hurdle for investments is lowered: even lessefficient investment projects become worthwhile. This leads to a misallocation of resources.

Examples of this can be found in the repeated real-estate bubbles in the last three decades: Japan and Australia at the end of the 1980s; Northern Europe around 1990; and the United States, Britain, Spain and Ireland in the middle of the last decade. Real-estate markets are also overheated today in countries such as Canada, Sweden, Australia, Hong Kong, China and Turkey, to name but a few.

B/ Corporate and Household Debt in % of GDP

Source: Allianz Global Investors, BIS. Data as at 2017.
Legend: Analysis includes G20 countries, GDP (USD weighting)

6 More high-risk “zombie companies”, fewer innovative young companies

High private-sector debt also means that in economic downturns, especially after a debt-financed asset bubble bursts, the need for banks to write down their loan portfolios increases significantly. However, banks have an incentive to minimise writedowns in order to limit losses and avoid expensive recapitalisations. This ultimately leads them to extend the loan payoff period (a process known as “evergreening”) for existing, weak borrowers.

As a result, weak companies in recent years have done less to reduce their debt, and they have shown less discipline in their investment activities and in the sale of assets. Various empirical studies – by the Bank for International Settlements, for example – confirm this.

At the same time, banks have been restricting loans to healthy, young and innovative companies so as not to increase the overall risk of their loan portfolio. And the large, healthy and internationally oriented companies that may be a bank’s best customers can avoid using bank loans because they can instead turn to the capital markets for financing.

The evergreening trend will be prolonged, maintained and ultimately intensified if central banks do not normalise monetary policy during upturns – or if they do so too late.

Interest rates that are too low mainly help weak companies or industrial sectors that would otherwise have to withdraw from the market or undergo harsh adjustments. Too-low interest rates also increase the likelihood of asset and credit bubbles, such as those observed worldwide since the 1980s. Stricter banking regulation with tighter capital requirements, as is usual after a bubble bursts, can lead to additional limits on lending to new customers.

This is at least a plausible explanation for the fact that in the last three decades, which have been characterised by relatively expansionary monetary policy, there has been a significantly increasing share of older and weaker companies in the overall corporate universe known as “zombie companies” – firms with interest expenses that exceed their operating profits (see Chart C/). At the same time, the proportion of younger companies has fallen significantly (see Chart D/). The result is weaker overall productivity growth.

This is a key point to consider: in contrast to the economic consensus, the current low-interest-rate environment might not be the result of, but at least to some extent the real cause of, low productivity growth.

C/ Proportion of Zombie Companies versus Probability of remaining a Zombie Company

Source: Allianz Global Investors, BIS. Data as at 2014. BIS definition of zombie companies similar to OECD definition: companies from all sectors except financial sector with interest coverage < 1 for at least 3 years in a row, at least 10 years old and with 20+ employees from the following countries: Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK and US. Probability of remaining a zombie company = proportion of companies that were already a zombie company in the previous period.

D/ Proportion of younger Companies and weak older Companies

Source: OECD, Allianz Global Investors. Data as at 2013.
Data based on companies from all sectors except the financial sector with 20+ employees and more than 10 years old from 24 OECD countries. BVD database. Weak older companies = companies with negative EBIT for three years in a row or a record loss.

7 Productivity differences between companies are steadily increasing

The OECD’s analyses have produced other interesting results: productivity differences between the most-efficient companies (“frontier firms”) and the rest have risen significantly (see Chart E/). The OECD also concludes that the likelihood of remaining in the group of the most-efficient companies has increased over time.

Increasing digitalisation only explains this to a limited extent, as divergences in productivity are also observed in sectors with low absolute productivity growth. Both observations clearly indicate a loss of market power and competitiveness, consistent with an increase in the share of zombie companies and a decrease in the share of younger companies. Increased M&A activity, favoured by rising share prices, could also explain the decline in competitive momentum.

The increasing productivity gap is also relevant to income distribution, as it explains the growing divergence in the pay of frontier companies’ employees relative to those in other companies.

E/ Productivity of “Frontier Companies” versus other Companies (indexed)

Source: Andrews D., Criscuolo C., Gal P. (2016), “The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy”, OECD Productivity Working Papers, No.5, Orbis data of Bureau van Dijk (BVD), OECD, Allianz GI, data as at 2013.

8 Rising share of the financial sector

Asymmetric monetary policy can ultimately have a negative impact on income distribution via another channel. The financial sector in particular initially benefits from positive trends on capital and credit markets.

There are two main reasons for this. First, the financial sector invests directly in asset classes (such as equities and bonds) whose prices are positively influenced by an expansionary monetary policy. Lower productivity growth in the real economy and the growing risk of a boom-and-bust scenario also explain why companies themselves invest more in financial assets than in productive ones.

Second, banks achieve above-average increases in commission and interest income in a favourable financial market environment. In fact, banks’ and insurance companies’ share of total value added has increased significantly since the mid-1980s. (In the United States, for example, this figure rose from around 4% to more than 7%.) Although the share fell again immediately after the financial crisis, it has now returned to pre-crisis levels (see Chart F/). In line with the share of GDP, the relative pay of people employed in the financial sector, (especially those employed in the securities sector in the US) also increased relative to other branches of the economy.

In Europe, however, it is a different story: there, the financial sector’s share of GDP has declined slightly since the financial crisis, and the same has happened in Japan since the 1990s. However, in many countries that have been completely or largely spared by the 2007-2008 financial crisis (such as Canada, Sweden, Australia, China or Hong Kong), the financial sector is still on the rise and reflects the increase in debt and the rising real estate market.

F/US Financial Sector: Share of GDP versus Debt

Source: Thomson Reuters Datastream. Data as at 2017.

9 More than a “veil”, monetary policy can have negative real-world effects

Our view of monetary policy in the debate over wealth and income distribution and productivity is very different from the mainstream view. We accept that monetary-policy distortions are not the only explanation for low productivity growth and rising inequality; other factors such as competition policy, banking regulation and tax policy are also relevant. However, the monetary framework is more than just a “veil” over real economic trends, and can itself trigger negative effects on productivity, growth, and the distribution of wealth and income.

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