Of Public Debt and Private Wealth

By Steven Pearlstein
Wednesday, December 27, 2006

With Democrats about to take charge on Capitol Hill, we're going to be hearing a lot about the widening income gap between rich and poor.

There are a variety of different measures for inequality and lots of factors that drive the data, ranging from winner-take-all labor market competition and the weakness of unions to the pace of immigration and the tendency of high-income people to marry each other.

Furthermore, during different periods, this widening of the gap has been most apparent at various rungs of the income ladder -- between the poor and the middle class in the '80s, between the middle class and the upper class in the early '90s, and, most recently, between the very rich and just about everyone else.

All of this is about to become grist for a great national debate on inequality, with everyone picking the income measures, gaps and causes that best support their economic views or their preferred solutions. As it plays out, it's important to remember that there isn't one correct analysis or any silver-bullet solution.

In that spirit, I'd like to toss out an idea borrowed from a reader in Canada with no particular training in economics but an intuitive sense about the connection between trade flows and income inequality. The idea goes something like this:

In terms of the global economy, the elephant in the room for much of the last 25 years has been the large and persistent U.S. current account deficit (loosely, the trade deficit), which this year is likely to exceed $800 billion. Roughly speaking, the richest country in the world spends 106 percent of its income.

If the United States were almost any other country, we wouldn't be able to sustain this huge imbalance for very long because the rest of the world would be unwilling to finance it. But, as it happens, developing nations suddenly have more savings than they know what to do with, much of it denominated in dollars as a result of selling us inexpensive clothing and electronics and very expensive oil.

These countries know that if they were to try to exchange all those dollars for their own currencies, it would drive down the value of the dollar -- and with it, demand by American consumers for all the things they sell. Rather than accept slower growth and higher unemployment, they have decided to keep their currencies loosely pegged to the dollar by investing those trade-surplus dollars in U.S. assets.

One obvious effect of this decision is to drive up demand for U.S. stocks, bonds and real estate, which foreigners have purchased either directly or through such intermediaries as hedge and private-equity funds. Their money was a significant factor in the tech and telecom bubbles of the 1990s, the current bubble in corporate takeovers and commercial real estate, and the just-ended bubble in residential real estate. Indirectly, it also helps explain why stock prices are at or near all-time records.

Moreover, because so much of the trade deficit is reinvested in debt instruments such as Treasury bonds, it has had the effect of lowering interest rates below where they would otherwise be. Low interest rates, in turn, encourage both foreign and American investors to use more borrowed money in their investment strategies, allowing them to buy more assets with the same amount of their own money.

So what does this have to do with income inequality? Quite a bit, actually.

We've known for a long time that increased trade with low-wage countries depresses wages of workers who produce goods and services now imported. A trade deficit equal to 7 percent of economic output obviously magnifies that effect.

But as the trade deficit is depressing wages at the bottom, it is now boosting incomes at the top by significantly inflating the value of stocks, bonds and real estate -- assets whose ownership is concentrated heavily in the hands of high-income people. By buying and selling these assets, and borrowing against them, these people have been transforming their paper wealth into spendable (and measurable) income at a record pace.

Finally, let's remember that all this buying, selling and monetizing of assets has created lots of fat fees for handling these transactions or serving as financial intermediaries. Those fees, in turn, translate into eye-popping bonuses for Wall Street investment bankers, hedge fund managers and partners in private-equity firms.

It would be an exaggeration, of course, to argue that our large and persistent trade deficit is the major factor in rising inequality. After all, inequality also is rising in countries with trade surpluses.

But I think the deficit does help explain why so much of the country's income gains have gone into the pockets of investment bankers, money managers, real estate developers, wealthy families and corporate executives loaded up with stock options. I'm sure these folks believe they are pulling away from the pack because they work harder and create more economic value than the rest of us. But in the coming debate, we need to remember that they are also the lucky beneficiaries of a runaway trade deficit and the bubble-prone economy it has created.

Steven Pearlstein can be reached at pearlsteins@washpost.com.


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