Why are the rich getting richer?

If you are reading this, I’m sure you have your opinions on why the rich are getting richer. You might feel strongly about it, but here you won’t find vilification. This piece is about the mechanisms behind this phenomenon. You will learn about money creation, why central banks have interest rates, and how quantitative easing works. However, not everything will be covered, and some nuances will be missed. Like an infinite onion, each layer of the financial system peeled back reveals yet another. Invariably, there are many reasons why the rich are getting richer, wrapped up in the actions of accountants, government procurement, and tax considerations that won’t be discussed.

Throughout the article, most financial jargon has been avoided. However, when it does appear, it is introduced with a clear explanation in English. Moreover, if a simpler phrase conveys the same meaning as the jargon, that has been used.

What wealth is

Society typically measures wealth by bank balances or possessions. At a superficial level, this makes sense. You have a certain amount of money and you buy what you want with it. However, bank balances have become a poor way of measuring the wealth of high-net-worth individuals and companies. The reasons for this are multifaceted, but at the core is the fact that money is merely a societal construct, as are all concepts of value and worth.

Money doesn’t have intrinsic value and exists as a medium of exchange. One reason that your pound, dollar, or dong has value is because shops and businesses are obliged to accept it. Likewise, if you take out a loan or mortgage, you are expected to pay it back with the same currency. Taxes are also paid in this manner. All these factors create a demand for money, and because its value is fairly constant over time, there is trust. As money is merely a medium of exchange, it is closer to a tool, like a lawn mower, than it is to a commodity like oil, wheat, or gold. It enables the exchange of work and goods without the need for a direct barter. Just as you could mow your lawn with your teeth, but a lawn mower makes the process faster and easier, money expedites trade and transactions.

Trust and desire give money its worth. This mechanism becomes apparent when considering items with sentimental value, such as artwork. The value of an original painting, be it by Rembrandt, Vermeer, or Picasso, derives not from anything intrinsic, but rather from the egos and bank balances of those who desire it. If you tried to sell The Scream to a nomadic Mongolian tribe, they wouldn’t be captivated by the cultural history of the painting or its representation of the human condition’s constant anxiety. Additionally, they probably wouldn’t want to carry it around all the time, as it wouldn’t be a good store of value for them. However, if they knew where a large stash of shiny metal and compressed carbon was located, they might trade you for it, since the trade would be inconsequential to them. It’s all relative—hence, it is the wretched impotence of gold.

This may all seem inconsequential, but when discussing why the rich are getting richer, the lack of a definite worth to money is important. Before delving into that, however, we need to understand how the monetary system functions – how money is created, destroyed, and controlled. Most of what you will read is taken from documents freely available on the Bank of England website. The following, therefore, represents the British system. The American and European systems are similar, though different names are used for similar processes. It is worth noting that there are various concepts and definitions of what ‘money’ is, some of which include government debt, mortgages, and loans. For the sake of simplicity, I will refer to money as bank deposits and currency, with occasional mentions of the latter.

Currency

Physical money, known as currency, constitutes a mere fraction of the total money in existence—approximately 3% in the UK.

In the ancient world, coins were crafted from valuable materials such as iron, copper, silver, and especially gold. The value of these coins stemmed partly from the scarcity of the metals. Gold, resistant to corrosion and able to endure in rivers for millions of years, has long been favoured. Yet, its practical utility did not grant it value; rather, it was the belief that others would desire gold for its scarcity and appearance.

A historical example illustrating the connection between quantity and value transpired when Emperor Mansa Musa embarked on his pilgrimage to Mecca. Accompanied by 12,000 slaves, each bearing 1.8kg of gold bars, camels laden with gold dust, and a 60,000-strong entourage, Mansa Musa distributed such vast quantities of gold that its value plummeted in the countries he visited. This sudden influx of gold led to a bidding war, with prices soaring as the relative value of money dwindled. Mansa Musa’s generosity inadvertently crippled the economies of the countries he traversed. Realising his error on the return journey, he removed much of the gold from circulation by repurchasing it from merchants, offering the value plus future interest, thus stabilising its value.

In today’s world, gold has been replaced by coins and notes. While it may seem logical that these represent their face value, they actually function as Central Bank IOUs or debts. Should one demand repayment from the Central Bank, they would simply receive more notes, the value of which is not fixed to anything tangible. This is evident as the cost of goods fluctuates over time. Coins, though they could be scrapped, are typically worth less than their face value, and melting them is illegal. The notion that value relies upon trust rather than something more concrete can be disconcerting, as it hinges on a collective game played by an entire nation.

Modern money, known as fiat money, derives its relative value from the amount in circulation. The term “circulation” is used instead of “existence” because even a vast amount of money would hold high relative value if not exchanged among people. This situation mirrors our present reality.

The Central Bank, in the UK’s case, the Bank of England, typically prints and controls the amount of currency. However, this was not always the norm. Fox and Fouler, a private UK bank, issued their last banknote in 1921. In the early 1800s, numerous banks issued their own banknotes, as these were essentially IOUs. It is worth pondering whether this decentralised monetary supply offered greater resilience. If a bank failed, its losses were localised to the people and companies that used its services, preventing widespread damage to the financial system.

So if a mere 3% of money is currency, where does the remainder reside?

Bank deposits

Bank deposits differ from currency; they are electronic rather than physical. Depositing notes in a bank involves exchanging physical IOUs for an electronic number in a database—a record of the bank’s debt to you. This record does not represent anything tangible. Bank deposits are not lent out; they are a service provided to customers in the hope that they will take out loans and utilise other services, which is how banks generate income.

While your deposit remains untouched, you can still use it for purchases. When buying items with transfers or debit cards, electronic IOUs are exchanged between banks. For example, if you spend £10 on a bag of manure using your Barclays debit card at a shop with an HSBC account, Barclays reduces your account balance, and HSBC increases the shop’s balance. At a higher level, Barclays and HSBC possess reserve accounts at the central bank, which records the transaction, adjusting the balances accordingly. With millions of transactions occurring daily, the reserve accounts’ final balances tend to remain relatively stable.

Debit cards operate in this manner, whereas credit cards function similarly to loans.

Reserve accounts are not the backbone of the financial system. Banks can and do exchange other assets, such as mortgages, loans, or government debt, among themselves. These assets are traded with the central bank to obtain funds for their reserve accounts. The reserve account exists to expedite processes and comply with government regulations.

In normal times, reserves are supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheets. The aggregate quantity of reserves does not directly constrain bank lending or deposit creation.

Having established that banks do not lend out your deposits, the question arises: how do they make money?

Where Money Comes From

sells existing assets from or to consumers, or, more often, from companies or the government.

The buying and selling of government bonds by banks is a crucial method through which the purchase or sale of existing assets creates and destroys money. Government bonds, which are sold to financial institutions as a means of raising funds for day-to-day expenses, are often acquired and held by banks as part of their liquid asset portfolios. These assets can be swiftly sold for central bank money if, for instance, depositors wish to withdraw large sums of currency. When banks purchase government bonds from the non-bank private sector, they credit the sellers with bank deposits. Central bank asset purchases, also known as quantitative easing (QE), have similar effects on money creation.

In theory, money creation should not be excessive. When a bank lends money and fails to recoup it, the bank suffers a loss. Banks earn profits through interest repayments on loans, debts, and mortgages. Without interest, they generate no profit. If a £100,000 loan is defaulted and no assets are recoverable, the bank must utilise its own profits to cover that £100,000, as the initial deposit must be destroyed and removed from the bank balance sheet. As businesses, banks must make money, which means they will not simply provide loans and create infinite money without reason. This concept is described by the Bank of England as follows:

“Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.

Lending is also constrained because banks have to take steps to mitigate the risks associated with making additional loans.

Regulatory policy acts as a constraint on banks’ activities in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system”

While money creation shouldn’t be excessive, banks are run by people, meaning that things can go awry. People can get over-excited about opportunities and fail to see downsides, dot-com boom, subprime mortgage, green tech bubble. Which is one reason why economies are so cyclical. Humans are irrational. Central Banks seek to stymie this irrationality.

Central Banks

The significance of central banks has emerged relatively recently. Prior to the 20th century, most retail banks were small compared to their present size, and they primarily served local communities. This was before the advent of the internet, cars, and globalisation, when news, money, and people travelled slowly. Today, banks have transformed into interconnected global corporations, with central banks at the apex of the pyramid. However, central banks differ from commercial banks in that they are not profit-seeking; their purpose lies in monetary policy.

The modern central bank serves as the government’s banker. In the UK, it acts as an intermediary between the Treasury and the retail world, enabling the government to buy and sell debt and pay companies through retail banks like Barclays and HSBC. Most western central banks are independently run organisations owned by the government. Their independence arose from past instances of politicians manipulating interest rates and monetary supply before elections to boost their popularity. The Bank of England was granted independence in 1997 with the aim of fostering financial stability. However, considering the decline in living standards, sustained poor economic growth, and the 2008 financial crisis, the success of this experiment remains debatable.

The independent Bank of England, along with other Western central banks, has a couple of mandates. Firstly, during prosperous times, they ensure that the amount of money in the economy grows at a rate that maintains its value relatively stable, aiming for an inflation rate of 2%. Theoretically, this means that the cost of equivalent goods increases by 2% annually. In practice, however, this flawed mandate lies at the heart of the widening wealth gap, with the reasons to be explained shortly.

In troubled times, central banks strive to maintain sufficient money circulation in the economy to prevent widespread debt crises, aiming to avert companies and individuals from defaulting on their loans en masse. In practice, this means that during a financial crisis, they seek to ensure banks continue lending money.

Central banks primarily achieve these mandates by: firstly, varying the base interest rate, which is the interest rate paid to banks on their reserve accounts and the rate charged to retail banks for loans; and secondly, through quantitative easing.

Interest rates and inflation

Central banks adjust interest rates to control inflation, but inflation is merely a concept. Often discussed in terms of quarterly changes, inflation represents how the cost of goods has shifted since a specific point in the past. However, this explanation is superficial; the inflation rate is actually a calculated figure produced by the UK Office for National Statistics.

To understand this, consider the Consumer Price Index (CPI). The CPI includes various items that people spend money on, such as food, housing costs, electricity, gym memberships, fuel, and more. The index comprises multiple smaller measurements. For example, if the price of bread increases from £1 to £1.10, the inflation on that bread would be 10%. If the cost of internet service decreases from £20 to £18, that would be a 10% fall. These changes are entered into a spreadsheet, weighted, and averaged to create “the rate of inflation.” The weighting adjusts the individual price changes based on the amount of income spent on each item, with cheaper items having less impact on the final figure.

In the UK, there are three main inflation measurements: the consumer price index (CPI), consumer and housing price index (CHPI), and retail price index (RPI). Each is used differently by various organizations. The CPI is generally the lowest and is often used by companies that want a lower inflation figure to reduce payments to customers. The RPI is typically the highest and is frequently used in contracts, causing prices to jump from year to year.

Central banks around the world aim to maintain inflation at 2% to avoid deflation, which would result in lower prices for goods in the future. Deflation could discourage spending, as money would gain value over time. A 2% inflation rate serves as a buffer to prevent deflation and encourages spending rather than saving. However, there are more insidious issues associated with inflation targeting.

A significant problem with inflation targeting is that technological advancements lead to efficiency and cost savings. This can result in lower production costs for various goods, but the price in pounds does not always fall accordingly. To achieve the 2% inflation target, the prices of other items in the hypothetical shopping basket must increase to offset the decrease in some items.

The Bank of England cannot directly manipulate specific prices to even out inflation. Instead, it lowers interest rates, making debt cheaper and encouraging people to take out larger loans. This leads to more money creation and theoretically reduces its relative value. However, the newly created money is not spent on everyday items like bread or clothes but on expensive things like houses and cars. Consequently, housing and expensive items see a dramatic increase in cost, while everyday items don’t increase as much. People with low incomes, who cannot access low-interest loans, end up trapped in an inflation cycle where their income barely covers the inflation increase.

Another issue in the UK is that the weightings of the items making up the CPI are updated annually, resulting in the index measuring different things each year. Maintaining price stability in this context is paradoxical and illogical.

Inflation targeting is a significant problem, as is the notion of inflation itself. Aggregating numerous unrelated variables and attempting to maintain a target for how the aggregate measurement of those things changes each year is nonsensical. Inflation targeting and quantitative easing are both poorly conceived approaches to managing economic growth.

Quantitative Easing

If a government does not receive enough money from taxes or investments to finance itself, it obtains loans by issuing bonds. These bonds are typically bought by investors like pension funds and insurance companies. The organization that buys the debt from the government receives a bond, while the government gets the deposit it needs.

When the Central Bank decides that it cannot achieve its aim of stable 2% inflation by solely lowering interest rates, it may consider implementing Quantitative Easing (QE). QE is when the Central Bank buys back government debt, such as bonds. In the process, government bonds are transferred to the Central Bank’s balance sheet, and the government effectively holds its own debt. It pays regular interest payments to itself, and upon bond maturation, it pays the bond value to itself.

The former bondholder, now with a bank deposit, is likely to start buying things with their deposit since it is risky and pays little interest. They may purchase stocks, shares, or corporate bonds. Regardless of what they buy, the consequence is that interest on loans is reduced, and borrowing becomes cheaper.

However, there is a paradox to QE. By lowering interest rates on commercial bonds, it becomes less costly for companies to borrow money, thereby boosting investment. Companies then spend money on upgrading their equipment, making them more efficient and lowering the costs of the products they sell. This, in turn, lowers inflation, which is the opposite of what the policy is meant to achieve. It’s like trying to extinguish a fire by smothering it with hay.

QE effectively acts as a giant subsidy for asset-owning companies and individuals, increasing their wealth as the value of their assets rises. This effect is compounded by how the financial system operates. Wealthy people and companies do not buy houses or expensive items by selling their assets like shares or property, as they would have to pay capital gains tax on them. Instead, they take out loans, as debt is not taxed. Borrowing against their existing assets means their interest rates on loans are lower, decreasing their risk of losing money.

In essence, a two-tier financial system exists. One where those with more assets are rewarded with artificially inflated asset prices, and another where people without assets struggle to afford them due to rising costs. This system exacerbates wealth inequality and perpetuates a cycle where the rich get richer while others struggle to keep up.

Why the Rich are Getting Richer

Wealth and value are determined by the market, and when the market is distorted by government policies, high-value scarce items like grand houses, artwork, land, exceptional jewelry, wine, and antiques disproportionately increase in value compared to basic necessities like bread. This effect compounds inequality, as the higher asset prices of scarce items provide the wealthy with more assets to loan against, allowing them to secure loans at lower rates and gain a competitive advantage over those with less wealth.

The rich get richer primarily because the monetary policies that governments implement through Central Banks are not conducive to rebalancing the economy. However, the issue goes beyond that – it is a systemic incompetence that has persisted within governments for years. People often blame politicians as the face of the government machine, but the real issue lies with the faceless bureaucrats who write the rules and shape policies. Blaming the rich for being wealthy is misplaced; it is the Central Banks’ distortion of the market that exacerbates wealth inequality.

Value and worth exist in stratified layers, much like geological ages expressed in the rock beneath our feet. Money and wealth form regimented strata, one layer upon another, representing distinct levels of wealth. The billionaire cannot spend enough money on local goods, services, or donations to ensure their wealth trickles down to those less fortunate. It is only when a significant shift or event occurs that a rebalancing of wealth distribution can happen.

To address these imbalances and create a more equitable society, governments and central banks must reevaluate their monetary policies and prioritize measures that promote a fair distribution of wealth. This may include policies that encourage investment in education, healthcare, and infrastructure, as well as those that support small businesses and entrepreneurship. By focusing on the root causes of wealth inequality and addressing them through targeted policies and regulations, societies can work towards a more balanced and just economic landscape.

John Ewbank 25/03/202