Janet Yellen is Wrong About the Cause of Wealth Inequality.

Fed Chair Janet Yellen said in a speech on the subject on Friday, that she is “greatly concerned by the extent, and continuing increase, of wealth inequality in the United States.”, noting the “significant income and wealth gains for those at the very top, and stagnant living standards for the majority.”

She is echoing economists’ growing concerns of recent years.

The statistics are shocking. A 2012 academic study by NYU economist Edward N. Wolff, ‘The Asset Price Meltdown and the Wealth of the Middle Class’, revealed that the richest 5% of Americans hold 88.9% of the nation’s wealth. A study by European Central Bank economists estimates that just the richest 1% of Americans control 35% of the wealth.

In her speech, Janet Yellen singled out the two main problems as rising college costs, making it difficult for young people to get an education, and tougher lending practices that make it more difficult for people to start their own business.

Economists and politicians blame the inequality on the inequity of the tax codes, the cost of healthcare, the welfare and benefit systems to care for the bottom 10%, rising costs of education versus the increased demand for more highly educated employees, the aging of the population, and so on.

The proposed fixes therefore are to lower the burden on the middle-class by raising taxes on the wealthy, downsizing welfare and benefit systems, and raising the minimum wage.

The problem with that analysis is that it indicates why those striving to achieve higher incomes and wealth in the future may have more problems. However, it does not explain how many of those who have had their educations, successful careers, or their own businesses for decades, have seen their previous wealth stagnate, decline, or even disappear, while the rich have gotten so dramatically richer.

That is, left out of the accounting is how and why huge amounts of capital have periodically moved from the hands of the middle-class to the coffers of the wealthy, creating the inequality in the first place. Yet, it is quite obvious.

I refer to the cycle of recurring 25% to 50% stock and bond market collapses and recoveries, and the bursting of housing and other asset bubbles. Those events gut the wealth of the trusting middle-class, while the top 5% come out of those cycles with their wealth intact, and even enhanced. It is those periodic ‘asset price meltdowns’ that create the inequality.

Those recurring cycles of bull and bear markets in stocks and bonds, the blowing of bubbles and their bursting in real estate and other assets, are hugely profitable for the top 5% because they make it their business to understand what’s going on, so they can buy low and sell high, the basic definition of successful investing.

For instance, it was primarily lower to middle-class buyers using subprime mortgages to buy houses at record high prices, and middle-class homeowners refinancing to take equity out of existing mortgages, near the real estate bubble top. Subsequently, their losses were transferred into big profits for the billionaire-owned hedge funds, private equity firms, and wealthy investors, who bought those houses in bulk at foreclosure auctions a few years later, when crushed home prices began to rise again.

It should not be surprising that it’s a similar situation with bull and bear markets in stocks.

After all, many names in the top 5% are well-positioned within the financial industry, billionaire hedge fund managers, investment bankers, and heads of private-equity and takeover firms. Others run major corporations, owned by middle-class stockholders, but operated largely for the benefit and wealth-building huge salaries, bonuses, and stock options of their top management.

Meanwhile, academic and government studies show that busy middle-class investors, very successful in their chosen careers and small businesses, lose their potential to build wealth over the long-term, by not taking the time to learn more about what they’re doing when they invest the money they earn in those careers.

In 2012, the Securities & Exchange Commission (SEC) published a report on financial understanding among non-professional middle-class investors. Its conclusion was that “U.S. investors lack basic financial literacy, and have a weak grasp of even elementary financial concepts.”

That is the real cause of the wealth inequality, resulting in the periodic huge transfers of wealth from the middle-class to the ‘top 5%’, whose business it is to profit from those cycles.

It is a big problem for the middle-class and for the country.

However, it is largely unknown and not discussed, since it is not in the interest of the financial industry and the top 5% to have it known or discussed.

As Professor Richard H. Thaler, professor of Behavioral Economics and Finance at the University of Chicago put it in his classic ‘Advances in Behavioral Finance II’, “Wall Street needs investors who are irrational and uninformed”.

As long as that situation continues, the wealth and income inequality will persist. In fact, the gap may soon widen further, depending on when the next market collapse takes place.

That is what Janet Yellen, and others worried about the growing inequality between the middle-class and the ‘top 5%’, should be paying more attention to than the need to raise taxes on the wealthy. Raising taxes on the wealthy would give the government more income, but it would not halt the periodic transfer of wealth from the middle-class to the very wealthy.

Only having middle-class investors understand more about how markets really work, particularly how the detrimental cycle of greed near market tops, and fear after bear market losses, never changes (resulting in buying high and selling low), would have a chance of slowing the flow.

  

Sy is president of StreetSmartReport.com and editor of the free market blog Street Smart Post. Follow him on twitter @streetsmartpost.