Updated: Jun 15
How would most Americans respond if an emergency arose and their household faced an unexpected $400 expense? This is a well-known scenario posed by the Federal Reserve. The resulting statistic is that 50% of all adults would have difficulty paying the expense, and 19% wouldn’t be able to afford it. The point being there is a notable wealth disparity in the U.S., where only 31% of adults wouldn’t have to hesitate to pay a $400 emergency expense.
Some in the economics world like to say there’s what’s called a “trickle-down effect” that rectifies the situation. But what does this really mean, and does it tell the whole story?
As discussed in a previous blog post, debt can create greater wealth. But the sad fact is that debt also fuels greater inequality. There is less relative wealth trickling down to the lower and middle class, unfortunately the gap is continuing to get wider. So, debt builds wealth and wealth inequality.
How Wealth Inequality Happens
The great news is that the U.S. has been quite prosperous. The total net worth of households grew from 376% of GDP in 1950 to 654% of GDP in 2021. This is a great improvement overall. But that doesn’t mean some in the country didn’t fare better than others.
The two largest contributors to this wealth increase were stocks and real estate, which also happen to be the leading ways in which disparity is inserted into the economic mix. The popularity of stocks and real estate began to rise in the 1980s and 1990s, with the start of the Great Debt Explosion. That’s when the relative value of these assets began a strong climb.
However, since the top 10% of Americans own 61% of all stocks and real estate; the next 30% own 25%, and the bottom 60% own only 14% of the country’s stocks and real estate, big increases in the value of stocks and real estate means the difference in the wealth of these two groups widens dramatically.
The U.S. is not alone in this predicament. Other developed countries face the same issue: stocks and real estate are by far the largest component of net wealth in the country and simultaneously the largest cause of wealth inequality, since most stocks and real estate are held by the top income earners.
Indicators of Inequality
The total net worth of the top 10% of Americans between 1989 and 2019 increased from 161% to 288% of GDP. That’s a 78% increase. At the same time, their debt-to-income ratio has increased by less than 20%, from 52% to 61%—a small amount in the context of their overall balance sheets.
In this same period, the total net worth of the bottom 60% declined as a percentage of GDP, from 63% to 59%. A small this decline, but still a big deal. Especially when compared to the dramatic 78% increase for the top 10%. The debt-to-income ratio of the bottom 60% increased by a whopping 92%, from 38% to 72 % of GDP.
Clearly, debt is viewed as a minor issue for the top 10% and a monumental one for many in the bottom 60%. Per the Congressional Budget Office, the income of the top 10% has gone from $168,000 to $562,000 per household, while the income of the bottom 60% has gone from $24,000 to $62,000. That means the top group’s income has gone from being seven times higher than the income of the bottom 60% to being nine times higher. This disparity will most likely continue to widen.
This rising inequality is also evident when comparing the debt service ratios of high-income groups to low-income groups. For the top 10%, from 1989 to 2019, that ratio improved by 10%, while for the bottom 20%, it got worse by 15%. More debt equals more inequality. The same increase in debt that brought the increase in household net worth also brought much greater inequality. While rising net worth is the goal, it brings the likelihood of rising inequality.
This bottom 60% is most Americans, which includes the middle class. They struggle every day to make ends meet and have daily challenges with debt. Tens of millions of these households have essentially no net worth. And much of their debt is for purchases of goods and services from companies owned largely by the top 10%.
Historically, the wages of the bottom 60% are simply not high enough to accumulate a significant stake in real estate or common stock. They largely spend what they make. Even if they received regular salary increases that exceed inflation, inequality would continue to increase because debt always grows faster than GDP. Making the value of stock and real estate increase, and the stock and real estate holdings of the top 10% greater when compared to the bottom 60%.
Of course, not all inequality is because of debt trends. Life circumstances, education, family resources, and tax and compensation practices matter too. And while households can jump from one group to another, it’s not very common.
Increased Debt Brings Increased Asset Values
Increased debt itself is a key contributor to the increased values of stocks and real estate. We can see this in that stocks and real estate have increased most rapidly as a percent of GDP in the very years that total debt has grown the fastest, the period from 1981 to the present that we call the Great Debt Explosion.
In fact, the increase in stock market capitalization correlates more closely to total debt than to either company earnings or GDP.
This is true in part because margin loans are often used to buy stock. A broker extends the loan to purchase stock, which is collateralized by the stock itself. The initial “margin” cannot be more than 50% of the value of the stock. Stockbrokers and investment banks often rely on “broker loan” debt from a bank to fund those margin loans. More deposits to fund stock purchases (amount of debt) translates to more buyers and higher stock prices.
According to OECD, privately held stocks grew from 145% of GDP in 1950 to 275 % in 2021, nearly doubling in value in ratio to GDP, and having a major influence on U.S. household net worth.
It's also important to note that most of the increased value of stocks over time comes from the rise in prices of existing stocks. Not the addition of new stocks from new companies. And even though stock creates net worth overall, individual companies often pay a very high price when they issue more stock. The price of the ownership they relinquish through dilution.
The Mortgage Money-Making Game
For real estate, debt usually involves the mortgage loan obtained to buy a house or land. If it’s a new home, the builder relied on debt to finance the purchase of materials and other expenses involved in building it. As a result, the availability and use of debt are the most critical source of high real estate values. And over time growth in real estate-related debt has been correlated very closely to the increase in home prices.
This stems from the fact that the number of potential buyers and offers is determined by how many can get a mortgage loan. The more debt-financed buyers of houses, then the more house prices will rise. Real estate value as part of household net worth doubled from around 93% of GDP in 1950 to 195% on the eve of the Great Financial Crisis (GFC). With that crisis, it plummeted to 127% of GDP and regained ground to 182% as of 2021.
Combined, the net value of stocks and real estate assets has gone from 238% of GDP to 456% of GDP—nearly doubling.
Of course, a trend of rising debt is not without a number of issues. There is a concern about going too far. Prices can get ahead of themselves in an eruption of debt growth and then crash. From 1945 to 2020, household debt grew sixfold, from 13% to 79%, but it contained periods of excessively rapid debt growth, especially in the savings and loan crisis of the 1980s and the Global Financial Crisis of 2008 that brought financial grief to millions.
Getting a Leg Up
While there are numerous obstacles, there have been a select number of ways that have been the primary contributors to increased household net worth. These are:
The act of bank lending, which creates new money “out of thin air;” and finances the acquisition of stocks and real estate and the investment in new enterprise.
The issuance of common stock, which, through appreciation, can rise in value beyond the total amount of debt and deposits used to pay for it; and
The appreciation of land values, which is in large part a function of debt, and can create net worth “out of thin air.”
While these have taken US household net worth to unprecedented highs, the disparity in ownership of stock and real estate has meant that inequality has only increased. In an economic system based on debt, rising inequality is therefore inevitable without some major equalizer like a change in tax policy.
This blog is adapted from The Paradox of Debt: A New Path to Prosperity Without Crisis by Richard Vague.
For more insights on the vital role of debt—both government and private—in our economy as well as policy provocations that attempt to tame the dark side of debt while allowing it to continue to create wealth, be sure to pre-order your copy today!