Funny Money and the Super-Rich

Increasing inequality is bemoaned by the left worldwide. Financial Times columnist Edward Luce doubtless made President Obama choke on his cornflakes by claiming recently that “U.S. inequality will define the Obama era.”

Yet, contrary to the left’s fond belief, the increasing inequality and the crass behavior of the super-rich are, on their part, responses — not actions. And they are responses not to inadequate levels of taxation, but to two decades of monetary policy that has imposed negative real interest rates on the world economy.

Fed Chairman Ben Bernanke, his predecessor Alan Greenspan and their imitators abroad are responsible for the rise of a global nouveau riche class. It is thus central bankers who have created not only the uniquely privileged, but — in many (though not all) cases — have also enabled what the world now rightly bemoans as a group of people that is uniquely unpleasant in its ethics and behavior.

Where’s the proof for these bold assertions, you wonder? Just compare the first Forbes 400 list of the richest Americans back in 1982 with the 2012 list. You will notice a startling change.

A clear majority of the 1982 list — 32 of the top 50 — had inherited their money. In 2012, a larger majority of the list — 34 of the top 50 — were self-made. They came from families that were poor or middle class, and in most cases without a significant business presence.

That surely sounds dynamic and entrepreneurial. And it seems to attest fully to America’s great ability to see fortunes created virtually overnight.

Now take a look at an earlier list prepared by B.C. Forbes, the founder of the magazine, all the way back in 1918 (a year in which income tax records were available to the public). What you will find is that even in that era of high inequality and low income taxes, 17 of the top 30 U.S. fortunes were inherited — and only 13 self-made. That means it is 2012, not 1982, that is the anomaly.

Furthermore, as is well known by now, since 1982 the rich have gotten richer. The combined net worth of the Forbes 400 was 2.8% of U.S. GDP in 1982, but over four times that — 11.5% of GDP — in 2012.

How did this come about? The 18-year stock market boom from 1982 to 2000 helped, of course. But what is most noteworthy is that it is only since 1997 that the great switch to the “self-made” ultra-rich has taken place.

That is puzzling, since that increase in individual fortunes cannot be explained by the relatively modest growth in stock values (less than doubling in nominal terms, up only 10-20% in real terms) during the period.

As it turns out, the explosion of the self-made super-rich from 1997 to 2012 and the increase in their net worth were due to the same cause: the highly expansionary U.S. monetary policy that was instituted by Greenspan in February 1995 and has been exacerbated by Bernanke since 2006.

The mechanism is quite simple. Interest rates close to or below the rate of inflation favor borrowers over lenders, since borrowers are able to attract borrowed capital at close to no cost in real terms.

Hence highly leveraged strategies, which rely on borrowing large amounts of money and investing in relatively low-yielding assets, create wealth very rapidly. It is this money-fueling mechanism that has enabled the nouveaux riches to overtake established wealth holders.

Of course, established wealth holders could leverage themselves too, but they haven’t traditionally done so because the downside risk is too great. Wealth preservation is the name of the game for them.

Highly leveraged operations are thus a no-no, since in view of a sharp downturn — such as the one in 2008 — wealth can easily be destroyed. That is unacceptable for the established rich.

But high leverage is an acceptable risk for those whose fortune is recent in origin and not yet well established. The upside benefit to them of becoming truly wealthy exceeds the downside risk of losing the wealth they have.

You can see the result of this attitude in the long career of Donald Trump. He has filed for bankruptcy several times, either directly or through parts of his real estate and casino empire.

Given that, it seems hard to comprehend that he would nevertheless continue to enjoy the lifestyle of a multibillionaire. In the current environment of high asset prices and low interest rates, he is almost certainly genuinely worth several billion dollars.

The last five years of Ben Bernanke’s tenure at the Fed — during which short-term interest rates have been reduced to zero — have intensified the tendency for new money to outshine old money.

Why? Because many of the new money moguls have learned from the 2008 debacle that bankruptcy can be avoided and that the risks of leverage, at least for the borrower, are much lower than they used to be.

The key to getting rich in the modern economy is thus no longer the ability to build a good long-term business, but access to cheap leverage.

Thus, typical members of the Forbes top 50 in 2012 were Ray Dalio (33rd) and Steve Cohen (40th), both heads of massive hedge fund groups. (Cohen’s SAC Group is mired in what we may politely call controversy, with several insider trading indictments handed down.)

Technology has also had an effect. Businesses that are largely virtual and essentially ephemeral, such as Google and Facebook, can be built up much more quickly than old-fashioned businesses requiring massive investments in bricks and mortar or a worldwide sales force.

Globally, the same tendency is even more apparent. Russian and Chinese billionaires, in particular, are noted for their ability to obtain debt financing and use leverage.

The massive swings in value in Russia since the fall of communism, the low real interest rates that have prevailed in that country and the ability of those with political connections to get loans at especially favorable rates from the banking system have enabled the nouveaux riches to acquire control over a share of the Russian economy that would be impossible in the West.

Similarly in China, the state-controlled banking system has been a generator of massive fortunes unknown to the glory days of the Song dynasty.

In conclusion, I want to make a threefold prediction:

• The prevalence of nouveaux riches is a temporary phenomenon. It is produced by pathological monetary policies worldwide.
• Once those monetary policies are changed, most of the fortunes built largely on leverage will vanish.
• Likewise, those fortunes built on virtual technologies will also mostly prove short-lived.

However unpleasant the current plutocrats are, popular resentment should be focused on the real source of their ill-gotten wealth: Ben Bernanke and his funny-money colleagues worldwide.

This article is adapted from a version that appeared earlier on the author’s blog, The Prudent Bear.