... not to mention all of modern investing. The rich always get richer, but their incomes are growing even faster because investment returns preference the top percentiles.

600 ows greed REUTERS Lucas Jackson.jpg

One of the chief gripes of the Occupy Wall Street protesters is that the ridiculously rich have been getting even ridiculously richer over the past few decades. They're right: the income gap has been widening. But what some of them may not realize is that they've got the right target in their sights, even if for slightly different reasons than they think. Wall Street is to blame in a sense -- modern investing makes it very easy for the incomes of the rich to growth quicker than the incomes of everybody else.

The Problem

Let's start with this now-popular chart from the Center on Budget and Policy Priorities, because it demonstrates the complaint (I even saw a picture of it blown up on an Occupy Wall Street protest sign):  

cbpp income inequality 2011.png

There are ways you could nitpick this chart. For example, you could note that it ends in 2007, so it misses the big decline in the incomes of rich Americans that occurred in 2008. But the chart does demonstrate the growing inequality accurately enough, so let's accept it as a fairly accurate picture of the problem.

This Reminds Me of Something. . .

As you can see, the red line is meant to be the serious issue. The income growth of the wealthiest Americans has far outpaced that of everybody else. But the red line also reminded me of something else I'd seen. It looked sort of familiar. Here's a chart showing the performance of the S&P500 over the precise period shown in the incomes chart:  

sp500 1979 to 2007 -2.png

Now this isn't an exact fit, but you can see that the shapes here are nearly identical. The big difference is that the income inequality chart gets steeper in the 2000s. But then, the S&P500 doesn't fully capture the wealth that was created (and later destroyed!) by the housing bubble.

Money Makes Money

These two lines look sort of the same, so what? Well, imagine you're an ultra-rich person. Stop thinking about all the stuff you'd buy -- but think about how much money you could invest. Remember, we're talking about the top 1% here. So these people have incomes that provide them more money than they can reasonably spend. That excess income is invested. With that money invested, it creates even more income because it earns some return.

Less affluent Americans don't get this benefit. Most are living paycheck-to-paycheck, save very little, or aren't investing as wisely as wealthier Americans. As a result, their income growth barely beats out inflation. Their incomes look flat, because they don't benefit from investment returns and their compounding.

Who owns most of the S&P 500 stocks above? Rich people do, of course. They're the ones with lots of extra income that they can invest. And when stocks rise, so does their income.

The inequality problem here might just be a reality about modern investing. If you have extra money and a decent financial adviser, then your income will grow faster than someone's income who has neither benefit. It's really just simple math. Why has inequality grown faster over the past few decades than it had in the past? It could just be that modern investing is easier. Before markets became computerized and accessible to most people, achieving a healthy return on investment was probably more difficult for some affluent people. These days, anyone who can't at least match the average market return is doing something wrong. Of course, hedge funds try to ensure that some ultra-rich do even better.

There's really no simple way to "fix" this problem. As I see it, we have (at least) four options.

  1. We could shutter Wall Street and modern investing, making it harder for the wealthy to get an edge. This would probably do more harm than good, however. You would hurt everyone else in the process, because business investment would be difficult and economic growth would slow.
  2. We could increase tax rates on investment to try to slow the growth of the income inequality. But remember, this wouldn't stop the income gap from growing altogether. Income inequality will always grow as long as those with more money can invest it to allow that money to grow faster.
  3. We could increase tax rates on regular income to provide those with higher incomes less money to invest. But this would also likely slow economic growth, since once that money gets redistributed more of it will be spent on consumption and less invested.
  4. Or we could just leave the investing as is. If you think the current system works pretty well in terms of incentives and economic growth, then you might not be so worried that rich people can get richer. You may instead wish to focus on well-being. For example, does a smaller portion of Americans own a home, own a television, own a telephone, or own an automobile than 40 years ago? 

Those options can be debated. But one thing is clear: growing income inequality should not surprise us. Everybody knows that money makes money. Modern markets just ensure that investment is made easier and more efficient, meaning that wealthier people find it even easier to increase their wealth. As tax rates have fallen over the past 30 years, they've also got more to invest.

Image Credit: REUTERS/Lucas Jackson

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