Wealth dynamics and wealth inequality

 

The rapidly rising wealth we have seen over the last decade or more is not mainly a result of high income inequality or high savings, but of upward revaluations in wealth caused by the trend decline in real interest rates. Trends like this mean it makes little sense to talk about the old gaining at the expense of the young, and instead we should talk about the wealthy gaining at the expense of the asset poor.   

Here is the ONS measure of total UK wealth.

Notes: 2020 refers to a survey spanning April 2018 to March 2020 and so on. There is a break in the official data for 2016, and I have reduced data before that based on the 2016 comparison. Source data here.

The ONS data underestimates wealth, particularly at the top (see here), but as I want to focus on trends rather than levels I will not discuss the complex issue of wealth measurement in this post. The key point is that the total value of wealth in the UK almost doubled over a 12 year period, which is a much greater increase than nominal GDP or earned incomes. Yet this itself is not mainly the result of any dramatic accumulation of income by those earning a lot, but rather a revaluation of people’s existing wealth.

The most obvious example of this is housing, which made up just over 40% of total wealth at the beginning of this period and a little over a third at the end. The rise in housing wealth over this period is mainly a result of higher house prices rather than more houses. But the same point applies to another large category of total wealth, private pensions, which was just over a third of total wealth at the start of this period and over 40% at the end. Pensions are mainly made up of shares and fixed income assets like government debt, and their increase in value mainly reflects the upward revaluation of these assets rather than their accumulation. For more on this see this useful piece by Ian Mulheirn.

Why have valuations been going up? The main reason is the trend decline in real interest rates (see the Mulheirn piece again) - what macroeconomists call secular stagnation. I discuss why house prices rise when real interest rates fall here, but the reasons are the same for shares or government debt. In all three cases these assets provide a nominal income stream largely independent of short term interest rate changes (rent or housing services for housing, dividends for shares and a fixed interest rate for most government debt), but holding a short term variable interest rate asset is always an alternative. If short term interest rates fall, then if the price of these other assets did not rise they would become more attractive, so their price will rise. Lower short term interest rates leading to higher asset prices is financial arbitrage at work.

This is why the current debate over what will happen to interest rates once the current burst in inflation is over is so important. If secular stagnation is really over, then long term real interest rates will rise over time and the price of many assets (including houses) will fall. As a result, we will see the value of total wealth at least stabilising, and perhaps even falling. On the other hand if secular stagnation has not gone away, then these higher levels of wealth will persist or increase further.

Which turns out to be the case also influences how we think about higher wealth today. It is often said that for most home owners higher prices don’t really make them richer, because if they sell their house they are likely to buy another. It’s also often said that higher house prices benefit the old at the expense of the young. I think this way of looking at current levels of wealth only makes sense for erratic movements in real interest rates (and therefore the value of wealth) rather than sustained trends in real interest rates (and therefore wealth). To understand why we need to think intertemporarily.

Let’s take the case where secular stagnation persists, so higher wealth also persists. Consider two couples in the 40s, one of whom owns a house and the other of whom rents. The couple that own their own house know that at some point many years ahead they will no longer need their house, and they can convert its value into money to spend in their old age (on better care or more holidays), or perhaps as a gift to a child. In either case they are substantially better off than the couple that rents, who will not be able to do either. The case is analogous to a couple that has a private pension and another that does not. You don’t have to be old to feel better off when house prices rise or the value of your pension increases. Instead you just need to think ahead, and hope that higher house or asset prices last until you downsize or retire.

But what, you may ask, happens if all the pension or the money from downsizing goes to buy an annuity? Because of lower real interest rates, annuity rates will be low, so the income you receive from the pension or house sale will be lower. Is what you gain in higher wealth lost in a lower return from it? The answer is to some extent, but certainly not completely. In particular if real interest rates are very low, you will almost certainly be planning to spend some of your wealth in retirement, so you still benefit from its additional value.

Your benefit is someone else’s loss. As we should all know, higher house prices have made it much more difficult for first time buyers without wealthy parents to buy their own house. More generally, persistent upward revaluations in wealth relative to income reduces the possibility of social mobility, which benefits the wealthy at the expense of the not so wealthy. This is I think the basic reason why it’s wrong to think of higher wealth through long lasting revaluations as benefiting the old relative to the young. Instead it benefits the wealthy and disadvantages the not wealthy. It’s one of the reasons why I think those that advocate permanently low nominal interest rates as a policy goal on distributional grounds are very mistaken.

Only when such upward revaluations in wealth are short lived does it make sense to talk about the current old versus the current young. In that case the house owning couple in their 40s will never see the benefit of the current increase in house prices, because by the time they come to sell their house and move into a retirement home or whatever prices will have fallen again. Equally only would-be first time buyers right now will be disadvantaged by unaffordable housing, because house prices in 10 years time will be much more affordable.

Short lived movements in asset prices also influence pensions. Those taking their pension can either get lucky (if real interest rates are temporarily low, so asset prices are high) or unlucky (if the opposite is true). It is also why a pay as you go, government run pension scheme can be a lot fairer than private schemes because the value of pensions do not depend on short term fluctuations in real interest rates and asset prices. (A failure to think intertemporarily also bedevils discussion of the triple lock for the UK state pension. If the state pension was gradually reduced in value relative to the triple lock, those who would lose out most are those currently in work, not current pensioners.)

Whatever happens over the next decade, global real interest rates have been falling since the 1980s, and so house prices and the value of existing pensions have been rising. That counts as an upward shift in wealth that has persisted or increased over decades, making the wealthier more wealthy at the expense of those with no wealth at all. The last few decades have been a great time to be wealthy, and a correspondingly bad time for the asset poor.