Growing wealth inequality around the world has been exacerbated by rising income inequality – including a divide in who earns income from assets and investments. To reduce the widening gap between rich and poor, mid- and low-income earners should gain more exposure to the “risk premium” offered by financial markets.
Economic inequality isn’t a new phenomenon, but in recent years some important shifts have been taking place under the surface.
As automation has taken away more middle-income jobs, the global economy has swelled the ranks of higher- and lower-income earners, which has widened the inequality gap. Meanwhile, the affluent have invested in the capital markets, taken risks and earned a “risk premium” – and this has helped them increase their wealth even more.
This is becoming a serious issue for society at large: in addition to taking a human toll, economic inequality suppresses economic growth, stretches governments’ capabilities and destabilises social systems. Addressing this situation will require action on many fronts, but we believe the answer lies at least partially in encouraging participation in the financial markets.
Capital income is rising while labour income is falling
In the field of economics, there are two primary components of overall income: capital income, or money that is earned from investing, and labour income, or money that is earned by working.
Since the 1970s, labour income’s share of overall income has decreased around the world, while capital income’s share has increased. That means growth in investment earnings is outpacing growth in earnings from wages. According to Branko Milanovic, a visiting presidential professor at the University of New York, a shift such as this one contributes to rising inequality when the following three conditions are met – as they are in all rich economies today:
- The rate of return for capital outstrips income’s growth rate.
- Income from capital is concentrated among the wealthy.
- The income source that is less equally distributed is correlated with overall income.
In the capital markets, taking risk has paid off over time
For those who are willing to take a risk, capital income can be earned in the financial markets via the “risk premium” – a return on riskier investments that can be higher than that of safer investments. Consider the risk premium offered by the “risky” S&P 500 vs the returns offered by “safe” US Treasuries: as the accompanying chart shows, since 1801, it has paid to take risk.
Clearly, when one factors in the existence of the risk premium with the growing number of wealthy individuals who are earning more capital income, one can conclude that the rich are growing richer at least in part because they are willing – and able – to take more risk.
Over time, taking risk has consistently paid a premium
Risk premium on US stocks vs US Treasuries (rolling 30-year yields)
Source: Jeremy Siegel database (1801-1900); Elroy Dimson, Paul Marsh and Mike Staunton (1900 – 2009); Datastream; Allianz Global Investors Capital Markets & Thematic Research. Data as at 31 December 2017.
Embracing the risk premium can help address inequality
Of course, capital-market participation is not the only factor contributing to rising economic inequality: globalisation, taxation, deregulation and automation all play a part. But society would be well-served by enabling more middle- and lower-income individuals to embrace the risks associated with capital markets in order to pursue the rewards of the risk premium.
We estimated how this could work in the real world by performing a study of a hypothetical equity savings plan in Europe. We imagined that between 1992 and 2015, every gainfully employed person in Germany, Italy, Spain, France and the UK participated in their local equity markets by investing EUR 50 each month between 1992 and the end of 2017.
The result was impressive: if this savings and investment plan had been put in place more than 25 years ago, gainfully employed people in these five countries would nowadays own around 53% of the market capitalization of the MSCI Europe (equivalent to some EUR 4 trillion) and would have earned an average return of more than 10% a year on their savings. And all this would have happened in spite of the crises that occurred during this period, such as the burst of the dot-com bubble, the 2007-2008 financial crisis and the European debt crisis.
Granted, this was only one hypothetical study, and past performance does not guarantee future results. Moreover, getting everyone to participate in the financial markets is far easier said than done; many low-income people simply do not have the extra money to invest.
Nevertheless, we believe this study illustrates the potential for more people to embrace the risk premium and earn an appreciable return on their investments – and in doing so, to help address the worsening problems created by rising economic inequality.
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Interviews with consumers in the UK revealed that 25% believe the current economy is stable, similar to the December 2017 Grassroots® survey, while 28% said it is improving slightly or significantly, a 3% increase vs. December.