How could it be that the $4.5 trillion on the Federal Reserve’s balance sheet, a real short-term interest rate still beneath 0%, and an array of tough post-crisis regulatory reforms have done so little to make many Americans better off and have even made them angrier about income inequality? Although the Federal Reserve has acknowledged the need to study this conundrum, continued economic malaise combined with profound political discontent make income inequality the most critical question facing policymakers in 2017. It’s a question that cannot just be studied but must be answered through action.
The 2016 U.S. election demonstrated that the widening of U.S. income and wealth distribution since 2008 is forcing structural realignment in U.S. policy on economic, social welfare, foreign policy, trade, and other vital issues. Although most if not all policymakers recognize inequality’s pernicious impact, too often they do nothing about it because inequality seems to have so many causes that it frustrates even modest efforts to reduce it. A recent book on income inequality concludes, “Only all-out thermonuclear war might reset the existing distribution of resources.”
Whatever the income-inequality curative benefits of conflagration, I prefer to identify a more modest, achievable way to mitigate widening income distribution. This comes via rapid adjustments to U.S. monetary and regulatory policy (PDF) (together referred to here as financial policy because of their combined effect). While financial policy does not on its own cause income inequality, post-crisis actions have inadvertently contributed to it and to broader political discontent that, if it isn’t meaningfully assuaged, may result in more radical demands with more destructive potential. The most significant financial policy changes with meaningful inequality-mitigation impact are as follows:
- Reduction in the Federal Reserve’s asset holdings so that natural market forces reassert their impact on asset valuations and low- and moderate-income households achieve gains on their homes more in line with those that wealthier households win in the stock market.
- Normalization of U.S. interest rates so that lower-income households can effectively save for wealth-accumulating activities (e.g., home ownership, education) and generate the borrowing needed to enhance growth. Higher rates also motivate lenders to provide the credit needed for income-equalizing growth.
- Revisions to regulatory policy so that banks can transmit monetary-policy signals through financial intermediation, serving as a source of stable, prudent long-term credit across the spectrum of consumer and corporate borrowers.
A fundamental premise of this analysis is that the U.S. remains in what Richard Koo and others have described as a “balance-sheet recession.” In a balance-sheet recession, monetary policy – including the accommodative approach used by global central bankers – can’t lean into the wind, but is instead blown over by it. Interest rates are muffled tools that can’t channel a central bank’s wishes into economic expansion. This is because the 2008 Great Financial Crisis (GFC) did drastic damage to the willingness of savers to spend or borrow and the ability of lenders – also hobbled now by tough new rules – to convert whatever savings accumulated under ultra-low rates into loans. Without this critical financial-intermediation engine, economic growth stagnates no matter how hard a central bank tries. The combined effect of borrowers and lenders to repair their balance sheets creates a collective-action quagmire in which traditional monetary policy tools are of limited value and unconventional ones have a profoundly negative impact on income and wealth inequality.
The 2008 Great Financial Crisis did drastic damage to the willingness of savers to spend or borrow and the ability of lenders – also hobbled now by tough new rules – to convert whatever savings accumulated under ultra-low rates into loans.
Accommodative monetary policy and stringent prudential rules don’t on their own cause a balance-sheet recession, but they widen the adverse distributional impact during a period of slow economic growth. Conversely, reversal of accommodative policies and tough rules won’t reverse a balance-sheet recession on their own – fiscal and trade policies must also play vital roles. However, because U.S. financial policy exacerbates already deep disparities in income distribution, it perpetuates a balance-sheet recession, slows recovery, and makes a bad economic situation worse, sowing the seeds for more fervent economic nationalism and populism.
Financial Disintermediation
It is well established that credit availability stokes economic growth. Importantly, the GFC proved an important corollary to this rule – credit availability stokes growth, but this growth proves dangerously procyclical if not accompanied by appropriate underwriting and securitization practices. Therefore, credit availability is critical not only to ensure lending but also to promote and regulate lending so that the majority of borrowers repay their loans. As discussed below, it’s important to consider not only gross credit-origination data but also what type of credit is being originated for whom and at what cost.
If borrowers can’t take out sustainable loans and/or lenders can’t make those loans that generate sustainable economic activity, then a balance-sheet recession occurs because both savers and lenders that went bust at the depth of a crisis can’t resume their usual place in growth-generating financial intermediation. Instead, balance-sheet repair is the rational choice: household and corporate borrowers become savers and lenders become investors as they rebuild capital. During periods slow growth, balance-sheet recessions are potentially severe because of the time it takes both borrowers and lenders to rebuild their capacity to resume their critical place in the financial-intermediation chain that converts savings into funding, first into near-term consumption and then into the longer-term investment that increases employment.
A balance-sheet recession sinks all economic boats. In practice, the current balance-sheet recession has exacerbated income disparities because it existed before the crisis and the distorting effects of U.S. financial policy helped to make it worse. This is because of the following:
- Accommodative policy skews asset valuations, favoring the capital-market holdings largely owned by the rich.
- Ultra-low rates frustrate wealth accumulation, especially for lower-income households that find it harder to put away funds, with any savings used to repair their balance sheets. Businesses are pressed under low rates and slow growth to distribute capital instead of reinvesting it in a new plant or employment-generating assets.
- Stringent new rules in concert with ultra-low rates make it difficult for regulated lenders to deploy deposits for productive purposes because it takes time to amass enough capital to support prudent lending, thus further impacting low- and moderate-income households.
How the Rich Get Richer
Research from numerous sources finds that conventional monetary policy doesn’t affect income or wealth distribution. However, the distributional impact of unconventional policy is uncertain in the post-GFC financial-market framework because of its novelty and continuing macroeconomic stress in each regime that has deployed it. Evidence indicates that the large asset holdings most global central banks have amassed may make adverse distributional effects worse. This is because quantitative easing (QE) works primarily through the “financial channel” – that is, central banks soak up large balances of targeted assets in an effort to force private investors to divest nonproductive assets (e.g., government securities) in favor of direct investments and, through intermediation, loans that promote recovery. Because of the lingering effect of a balance-sheet recession combined with low rates and new rules, funds obtained through central-bank asset purchases aren’t deployed into loans. Instead, banks put them into nonproductive assets and other investors put them into equities and other financial assets that earn disproportionate returns because of investment flows powered by yield-chasing (not value-chasing) incentives.
As a recent Bank for International Settlements (BIS) study describes, central-bank purchases of nonproductive assets appear to lead to large inflows into equity markets, increasing asset valuations for holdings held largely by the wealthiest households. Because the disparity in equity holdings is so large in the U.S., and perhaps because its QE program was first and largest, wealth inequality in the U.S. has, the BIS found, increased more in recent years than in any of the other industrialized nations studied other than France. A new study from the Organization for Economic Co-operation and Development (OECD) finds that income inequality is at least in part attributable in the U.S. to the fact that these capital-markets holdings are disproportionately owned by wealthy households, with the study showing – as does the BIS analysis – that moderate-income individuals principally derive wealth from their homes. A new study from authors at the European Central Bank (ECB) also finds that home ownership is the principal wealth-accumulation engine in the U.S.
The current balance-sheet recession has exacerbated income and wealth disparities because it existed before the crisis and the distorting effects of U.S. financial policy helped to make it worse.
One might counter these conclusions by noting that house prices have significantly increased since the depth of the recession, presumably reversing this wealth-distribution effect. However, a closer look beneath total house-price appreciation data shows that these gains, too, are unequal. New data covering markets until the end of 2015 finds that house prices in ZIP codes with the most expensive houses rose 21% from 2004 while the bottom 90% of ZIP codes rose only 13%. The lower down the house-price curve one goes, the less these gains, with the worst-hit areas (e.g., Detroit) still seeing little to no appreciation. Notably, the U.S. housing market is shifting more toward rentals in part because many households can no longer afford to buy a home in the areas where they want to live. So, despite QE and other U.S. financial-policy initiatives, home ownership – and, therefore, wealth accumulation for moderate-income households – now stands at close to its lowest level since 1965.
When house prices fall precipitously and remain depressed for moderate-income properties as they have in the U.S., moderate-income household wealth is adversely affected and distribution widens because of improvements at the top of the wealth-distribution curve and flat or negative gains below it. This effect is exacerbated if mortgage credit is scarce for first-time homeowners and lower-income individuals, as is discussed in more detail below with regard to new rules. An increasing number of households below the highest wealth levels are now unable to obtain a purchase-money mortgage to buy a home or to reduce borrowing costs on the homes they own, reducing consumption capacity or even threatening household economic viability. Because of this, wide distribution curves will grow still worse.
Importantly, adverse wealth-distribution effects should be reduced over time if accommodative policies have their desired effect on income-advancing employment. However, it appears that prolonged continuation of expansionary policies – especially those started by the combination of large amounts of QE and ultra-low rates – has adverse effects on lower-income households when a nation’s economy does not provide significant transfer payments and lower-income households depend on wages, as is the case in the U.S. Although employment is at nominally “full” levels, extensive research suggests that post-GFC employment improvements have in part resulted from individuals obtaining lower-paying jobs than those held before the crisis, new labor-market entrants obtaining lower-income positions than they believe their educational investment warrants, and early retirement for older workers unable to re-enter the workforce. That is, wages aren’t recovering as employment data might lead one to expect, even as the value of assets held by lower-income households loses more ground to financial-asset values.
This challenge points to the complexity of the problem affecting U.S. financial policymakers – not only does income inequality result from forces outside their control, but changing one policy under their aegis will have only limited effect unless others they can change are also altered to mitigate as much adverse-distributional impact as possible. Specifically, asset valuations that better reflect market determinations – not the artificial pricing resulting from central-bank holdings – may prove beneficial to both wealth and income equality. However, this only occurs if rates rise to permit positive savings such as down payment accumulation, and financial intermediation transfers savings into growth through assets such as new mortgages for low- and moderate-income households.
Why Low- and Moderate-Income Americans Are Worse Off
Conventional thinking about monetary policy expects the “interest-rate channel” to promote expansion because low rates benefit lower-income households as the reduced cost of credit encourages productive investment that spurs employment. However, a balance-sheet recession undoes this traditional monetary-policy transmission channel because low rates don’t deter savings even as they encourage corporate capital distributions that don’t advance economic growth, firing up yield-chasing in part because traditional providers of financial intermediation – banks – are hobbled by their own balance-sheet constraints and, in the wake of the GFC, costly new rules that prolong balance-sheet repair.
The case of U.S. mortgages is again instructive in this regard. Because the U.S. has a mortgage-finance system largely dependent on fixed-rate mortgages, reduced interest rates don’t automatically translate into lower mortgage payments unless a borrower is able to refinance into a lower-interest loan. Changes in mortgage-underwriting and securitization practices have, as a new National Bureau of Economic Research study and much related research demonstrate, altered the U.S. refinancing market so that creditworthy borrowers use housing value to reduce payments on a newly lower balance – essentially using the new loan as a savings vehicle, not a store of value for new consumption as was the case with cash-out refinancing before 2008.
Without artificial asset pricing resulting from central-bank purchases and ultra-low rates, the ability of U.S. financial intermediation to restore long-term, resilient, and stable growth is at best uncertain.
Remedying a balance-sheet recession requires that borrowers put these newfound funds to use generating consumption or investment, not to repair their ability to continue to honor their mortgage obligation, which – desirable though it is – doesn’t enhance economic recovery or promote wealth accumulation unless or until recovery permits borrowers to deploy these savings for additional consumption or investment. The latter point is particularly important given that mortgage credit is historically a significant source of funding for startup small businesses that are in turn a major employment engine (with one estimate finding a quarter of small-business owners use home equity to fund their businesses). Importantly, small-business loans have declined below levels in 2010, when lending was suppressed by fragile U.S. economic conditions. FDIC data shows that commercial and industrial loans of less than $1 million have fallen as a percentage of bank loans from 31% in the second quarter of 2010 to 20% in the third quarter of 2016.
Ultra-low rates also mean that savers earn little or even lose money on a real basis when they put what they can afford in the bank. One of the paradoxes of the post-crisis period targeted by Chair Janet Yellen as an important research topic is why lower-income households actually save more during stressed economic conditions. As Koo and others have demonstrated,savings tend to increase during recessions because individuals, households, and businesses focus on repairing their balance sheets, not taking on new risks. Under ultra-low rates, these savers must struggle longer and harder to accumulate the resources needed for resilience in the face of a lost job or unexpected medical bills and to amass the cushions needed for home ownership, education, and secure retirement. Ultra-low rates also exacerbate the valuation differences resulting from accommodative policy because large companies borrow more but often use this debt not for productive investment because of low product demand, but rather for capital distributions to wealthy shareholders through higher dividends and share repurchases. Between the third quarters of 2012 and 2015, nonfinancial companies added $1.4 trillion in debt yet spent $1.3 trillion repurchasing stock.
The savings-rate paradox is clear evidence of a balance-sheet recession. Collective-action incentives result when large populations of individuals and holders of private sector capital remove themselves from the economy to safeguard assets instead of spending or investing them. As discussed below, this problem is significantly exacerbated if financial institutions holding savings also don’t lend them out and thus spur growth. A balance-sheet recession can be relatively short-lived, especially if fiscal policy spurs productive investment by adding incentives for growth. However, it’s likely to be prolonged and even more painful in the absence of such fiscal policy alongside financial-policy incentives that, though well intentioned, create a collective-action problem in which capital retreats from productivity-producing assets and activities.
Because the lowest-income or most vulnerable middle-income households are put at most risk immediately through ultra-low rates that put them increasingly behind their basic-consumption needs and their longer-term life objectives, this facet of financial policy is perhaps the most immediately damaging to income distribution no matter the traditional growth results expected from a low-interest rate conventional monetary policy.
Frustrated Financial Intermediation
The final leg of the U.S. financial policy tripod – quantitative easing, interest rates, and regulation – largely under the control of the Federal Reserve Bank, is post-crisis financial regulation, especially the many new capital rules that demand unprecedented amounts of shareholder equity ahead of possible risk, most stringently at the largest U.S. banking organizations on which the U.S. relies for most credit origination.
It’s not the purpose of this article to debate the relative merits of some or all of the new capital framework. It’s clear that capital bulwarks before 2007 were insufficient, especially outside the regulated-banking sector in the U.S. Advocates of higher capital also argue that income and wealth equality are far more damaged by financial crises than higher capital – and this was surely true in the GFC’s wake. However, the benefits usually attributed to higher capital as a crisis prophylactic are uncertain because of the many causes of financial crises that have nothing to do with credit quality or banks.
The extent to which the new rules adversely affect credit availability has been extensively debated since the crisis, with two recent global literature surveys (here, and here) reaching ambivalent conclusions on this question. In general, studies concluding that capital hikes don’t adversely affect credit availability are based on the market rewarding safer banks with lower funding costs. This has not, however, occurred because of the adverse profit impact of capital that leads investors to demand higher interest rates on debt instruments to compensate them for the risks associated with reduced profitability, due in part to low interest rates. The markets also appear to concur with work such as a recent OFR report that finds higher capital is a poor predictor of greater risk.
Timing and the reason for higher regulatory capital are also important in judging the impact of intermediation. A new study from the Bank of England found that higher capital may well lead to more loans, but only during periods in which the economy is growing. When it is not, higher capital is used for balance-sheet repair, not boosting employment and improving income distribution. A recent study by The Clearing House also demonstrates that the beneficial credit-availability impact some studies expect from higher capital are generally obtained when a bank ends up with higher capital, such as when earnings are robust, not when the bank is required to do so regardless of underlying risk and thus at cost to its risk-adjusted rate of return. As one of the governmental studies cited above notes, “In conclusion, both theoretical and empirical studies are not conclusive as to whether more (stringent) capital (requirements) reduces banks’ risk-taking and makes lending safer.”
Under current U.S. circumstances – slow growth, tough new rules, and ultra-low rates – it’s clear that every dollar of capital a bank must post against a loan that is not offset by a concomitant reduction in funding cost, taking credit and funding risks into account, makes the loan more costly to originate absent a liquid secondary market that absorbs credit availability without adding so much cost that it suppresses borrower demand. The large balances banks now hold in excess reserves at the Federal Reserve Bank instead of deploying funds into productive assets is ample evidence of the challenges to credit availability under current conditions, reflecting both reduced borrower demand and higher regulatory cost. If banks could prudently make more money lending out these funds, they surely would – the Federal Reserve’s rate of interest on excess reserves is well below the interest rate banks need to achieve positive net interest margins even in an ultra-low rate environment. Importantly, the OFR paper cited above notes the rise in “shadow banking,” concluding that much of this transformation of U.S. finance results from the new capital rules and that credit from less-regulated sources may offset credit-supply constraints but sharply heighten systemic risk.
Conclusion
Conventional monetary policy aims at stimulating expansion by reducing the cost of funding through lower interest rates. Based on the frictionless assumptions underpinning traditional policy, these lower rates are then expected to move through the bank credit channel and reduce the cost of lending that in turn improves the supply of affordable credit for households and businesses. Unconventional monetary policy is based on these same frictionless assumptions but seeks to ensure expansion also through other channels such as changing the supply of investable assets so that safeguarded funds are forced into the intermediation chain. However, resorting to nontraditional monetary policy in concert with other stresses and new rules isn’t a cure for balance-sheet constraints for which neither conventional nor new monetary-policy tools are designed.
As shown here, the Federal Reserve Banks’ portfolio creates a significant obstacle to economic recovery because of the resulting distortions in asset valuations that divert funding from the lending that advances wealth equality. Ultra-low rates – another facet of unconventional policy – similarly fail to cure a balance-sheet recession because borrowers are reluctant or unable to seek credit and regulated lenders can’t put deposits into the productive assets that advance income equality. To the extent that demand improves as recessionary conditions wane, ultra-low rates also reduce equality-generating credit availability because of the limited ability of regulated banks quickly to supply critical new credit for household and business borrowers.
Raising rates from the current negative real levels will gradually reduce the adverse impact of interest-rate policy on income and wealth equality, especially as the Federal Reserve Bank’s portfolio begins to roll off. Nonetheless, even without artificial asset pricing resulting from central-bank purchases and ultra-low rates, the ability of U.S. financial intermediation to restore long-term, resilient, and stable growth is at best uncertain as long as the post-crisis rulebook also limits the ability of regulated banks to provide the financing needed for new jobs, new homes, and new starts. Over time, the adverse impact of new rules on the ability of borrowers to borrow and lenders to lend may dissipate with the entry of new financial services providers outside the reach of the post-crisis rules and thus freer to accept deposits at higher rates and convert them into productive assets. However, a transformation of U.S. finance from a regulated to a “shadow” market clearly has significant implications for financial stability. By the time enough financial intermediation capacity emerges from the shadows, the stage may well be set for the next balance-sheet recession or, still worse, a GFC rerun with still worse consequences for income and wealth equality.
About the Author:
Karen Shaw Petrou is Co-Founder and Managing Partner of Federal Financial Analytics. She is a frequent speaker on topics affecting the financial services industry.
Prior to founding her own firm in 1985, Petrou worked in Washington as an officer at Bank of America, where she began her career in 1977. She is an honors graduate in political science from Wellesley College and also was a special student in an honors program at the Massachusetts Institute of Technology. She earned an M.A. in that subject from the University of California at Berkeley, and was a doctoral candidate there. She has served on the boards of banking organizations and sits as a director on the board of the Foundation Fighting Blindness and the Fidelco Guide Dog Foundation. She is also an advisory member of the board of the Morin Center for Banking and Financial Law.
