Stop worrying about wealth inequality

Don’t focus on wealth; focus on consumption

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Feb 04, 2020

Economics and politics are converging on the issue of wealth inequality and a wealth tax. It is a prominent feature of the 2020 US presidential campaign, in particular the proposals by Senators Elizabeth Warren (Democrat of Massachusetts) and Bernie Sanders (Democrat of Vermont) and their economic advisors. 

What is wealth anyway? Is its inequality really growing? Why do we care about wealth inequality, as opposed to other measures of inequality? Why do we care about any measures of inequality, rather than just measures of standard of living and opportunity? Why are some measures of wealth inequality growing? 

Start with the last question. A good part of the rise in wealth and wealth inequality, defined and measured as the market value of net assets, consists of higher market prices for the same underlying physical assets. In turn, higher asset prices stem almost entirely from lower real interest rates and lower risk premia, not from higher expectations of economic growth. 

This raises a deep “why do we care” question. Suppose Bob owns a company, giving him income of $100,000 per year. Bob also spends $100,000 per year. The discount rate is 10 percent, so his company is worth $1 million. The interest rate goes down to 1 percent, the stock market booms, and Bob’s company is now worth $10 million. Hooray for Bob!

But wait a minute. Bob still gets income of $100,000 per year, and he still spends $100,000 per year. Absolutely nothing has changed for Bob! The value of his company is just what some call “paper wealth.”

And why care about wealth at all? Let’s compare Bob to Sally, who earns $100,000 per year in wages and has no assets. The distribution of income and of consumption between these two people is entirely flat. But the distribution of wealth was already concentrated before the interest rate dropped: Bob had $1 million of wealth, because we ignored Sally’s human wealth, the present value of her salary. After the interest-rate decline, wealth inequality is 10 times larger, because we also ignore the higher capitalized value of Sally’s human wealth.

But why should we care? Bob and Sally are both marching along unchanged.

You might object that I just assumed Bob didn’t change consumption. He should sell some stock and go on a round-the-world private jet tour. Or do what gazillionaires really do, start a foundation and give the money away. But Bob won’t do that for a simple reason: originally, he wanted to spend $100,000 per year, and if he sells his company for $1 million and invests it at 10 percent, he could spend $100,000 per year. Now, if he sells his company for $10 million, he can only invest that at 1 percent per year, so the most he can spend is still $100,000!

People don’t want to consume in one big spurt. They want to spread consumption out over their and their heirs’ lifetimes. When the interest rate goes down, it takes more wealth to finance the same consumption stream.  

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To read John H. Cochrane’s full five-part series on wealth and taxation, visit his blog, The Grumpy Economist.

The present value of liabilities—consumption—rises just as much as the present value of assets. This is a rather deep point that gets lost all too often in the static Keynesian thinking about wealth effects of consumption that still pervades macroeconomics.

If the rise in asset value came because people expected the income stream to grow a lot in the future, at unchanged discount rates, indeed Bob would be more “wealthy” than before. But that is emphatically not the situation of today’s market values, at least on average. If you think internet companies have enormous stock values because their profits will continue to grow at astronomical rates, I have some 1999 dot-com stock to sell you.

(A refinement: lower real interest rates do generate a substitution effect. With lower interest rates, Bob may want to rearrange consumption to be earlier in time rather than later in time. But the central point is that the lower interest rate does not have a wealth effect. Though the asset is worth more, he cannot consume more in every year than he could before. The original flat consumption path is still just as affordable.)

There are good questions to be asked about the distribution of consumption, and in particular, lifetime consumption. If Bob averages $100,000 annual consumption over his life, and Sally only averages $10,000, that’s an interesting observation about our society, and we might want to think about the economics, politics, and justice of the situation. But why should we worry about an increase in mark-to-market “wealth” that has no implications for the overall command over resources that “wealthy” people have?

Is this a big effect? Yes. Below, you’ll see a simple plot of real interest rates over 40-plus years, computed as the 10-year bond rate less the inflation rate, as measured by the University of Michigan inflation survey. It declines from nearly 10 percent to negative numbers. 

Real interest rate’s decline

The real interest rate dropped from about 10 percent in the 1980s to negative numbers in the past decade.

In sum, much of the increase in wealth inequality, to the extent it is there at all, reflects higher market values of the same income flows, and indicates nothing about increases in consumption inequality, or command over resources.

Just why should we care about wealth inequality? Obviously, many smart people are very animated by it. Why?

According to University of California at Berkeley’s Emmanuel Saez and Gabriel Zucman, who have advised Senator Warren on her plans to tax wealth, “the public cares about the distribution of economic resources.” But the public doesn’t distinguish between wealth inequality, income inequality, and consumption inequality. And envy is a poor basis for confiscatory policies. 

I think many of us, me included, worry about lack of opportunity, and the many barriers to advancement on the lower end of America’s economic spectrum. And I think society as a whole is better off if the bottom end rises. This worthy impulse is, I suspect, what many people mean when they say they worry about inequality. Perhaps the presence of wealthy people makes the struggles of the less fortunate more painful to watch. 

But if you say inequality per se is a problem, the inescapable logical conclusion is that you think society as a whole is better off if you and I lose $10, and Bill Gates loses $1,000. We are then more equal. If you do not believe this, do not use the word “inequality,” or pursue destructive policies that achieve that leveling loss. 

The life of a poor kid from the south side of Chicago is completely untouched by whether a venture capitalist in Palo Alto, California, upgrades from a turboprop to a private jet. That kid will be made no better off when confiscatory wealth taxation forces the venture capitalist to drive. 

If you’re worried about opportunity, mobility, left-out and left-behind people and areas, good for you. But wealth inequality is a poor phrase to describe this worry. Use better words that do not empower disastrous economic policies.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from two posts from a series on taxation and inequality originally published on his blog, The Grumpy Economist.