Capitalisn’t: Is the Federal Reserve an ‘Engine of Inequality’?

Karen Petrou: Bernanke, Greenspan, Powell, Yellen, too, they believe in the wealth effect. And I don’t think they really noticed that the wealth effect only works for the wealthy.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism, and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Bethany: One thing I hear frequently from sources in the financial markets is that the Federal Reserve, by virtue of its ultra-low interest-rate policy, has stoked all sorts of bubbles in asset prices. Less frequently, I also hear that widening wealth inequality is the Fed’s fault, because low interest rates have benefited the wealthy at the expense of the poor.

Longtime policy analyst Karen Shaw Petrou, the cofounder and managing partner of the Washington, DC-based firm Federal Financial Analytics, makes this argument in a data-driven way in her new book, Engine of Inequality: The Fed and the Future of Wealth in America. She writes, “I’m among the Americans who got angrier and angrier from 2010 to 2020, as America became increasingly unequal, while well-intentioned policymakers assured us that, as the Fed likes to say, the US economy was in a good place.” Her argument resonates with me. Luigi is a bit more skeptical.

Your book, Karen, Engine of Inequality, was published in early March. What made you start thinking about this issue, about the Federal Reserve and inequality?

Karen Petrou: I started thinking about it in 2016 when I was working for a client project on the unintended consequences of the post-crisis regulatory framework in terms of financial stability, market liquidity. And I put some of this together in an initial thought piece that I previewed at the November meeting of the Federal Reserve Bank of Chicago for global central bankers. It laid out both the structural issues, in monetary and regulatory policy, that I was thinking at the time exacerbated economic inequality, particularly in the United States. Ultra-low interest rates. You had the confluence of the Fed, by virtue of monetary policy, setting rates very, very low, and setting bank capital very, very high, which is an unavoidable fact that when capital requirements go up on particular credit exposures, that may make the bank safer . . . it certainly does, but it also makes the loan less profitable. And the banks stopped making many of them. We see the huge influx of trillions of bank dollars not into the economy, after 2010, but into reserves held as deposits at the central bank. That was unexpected by the Fed, it still surprises the Fed, and it contributed to economic inequality by virtue of driving up markets, due to the scarcity of safe assets, and depriving lower-income borrowers of necessary credit from reputable, regulated lenders.

It used to be true, I think this is one of these . . . Theory needs to catch up with reality, because when the United States was a middle-class country, it was true that people would say, “Look, honey, car loans are going down, and our car’s not looking any better. Let’s go trade it in and get a new Buick,” because people had the disposable income. Even before 2010, especially before 2020, the middle spectrum of income and wealth was deeply mired in debt. As I say in the book, 25 percent of the “middle class” in 2019 was skipping medical payments they couldn’t afford.

Government employees, as a really good canary down the mine shaft, look what happened to government employees when the federal government shut down for a month and they missed two paychecks. The average government salary is $85,000. Sixty percent of government workers were unable to make rent or mortgage payments because families, “middle-class” families, aren’t the middle-class families I knew when I was a kid. The financial system, in terms of private equity, that’s where the money is going, because those loans are profitable. There’s a huge corporate debt market outside the banking system, and the banks are very, very willing to enable it for fee income in terms of their underwriting. It’s a different financial system for a different country these days.

Bethany: There’s another version of this argument that I’ve been told by people who are, let’s just use the phrase Fed defenders, for lack of a better phrase, because I don’t think you’re necessarily blaming the Fed. But that is, even if what has happened has exacerbated wealth inequality, that’s relative. And the way in which those at the bottom of the income spectrum have fared would actually be even worse if it weren’t for ultra-low interest rates. They would be even worse off in an absolute sense. So, who cares about the relative, when what really matters is the absolute?

Karen Petrou: Yep, I’ve seen that, I’ve heard that, I’ve been told that a lot lately. If it were true leading up to the 2020 crisis, I would believe it. It only was briefly true towards the very end of 2019, when low-wage households started to gain real wage growth, but in my book, I try to look behind those aggregates and averages. I think tremendous mistakes are made by looking at data in terms of just an average household income, and you look behind it and you see that, yep, household income went up, but that’s because there were more part-time workers, more household members working, and more hours worked. It wasn’t good. It was in a lot of ways worse. It wasn’t genuine wage improvements, or income gains that were absolute, except by virtue of family distress and increased costs in terms of things like childcare, or transport.

Luigi: Karen, I agree 100 percent with the increasing inequality and the falling behind of the middle class. But I’m struggling with the debt component, because there is a paper by my colleague Amir Sufi and coauthors that looks at indebtedness from the 1960 to today, and he divides by the top 1 percent, the next 9 percent, and the bottom 90 percent, and basically says that, by and large, the next 9 percent is flat, and the top 1 percent becomes a huge lender, and the bottom 90 percent becomes a huge borrower. So, I don’t see how this can have a disadvantage. Now, it’s possible that many of them borrowed at very high rates, because of lack of competition and lack of regulation, whatever you want to say, but I don’t think that a decrease in interest rates should necessarily hit the bottom 90 percent hard.

Karen Petrou: But it does for two reasons. I think, Luigi, I would agree with you in the sense that if these families couldn’t borrow, they might simply go bankrupt. But this is a hand-to-mouth existence. An economy that generated investments in capital, intellectual property, a true output, would be one in which families would not be literally scraping end of month to end of month with debt, rather than income.

And critically, I think the debt analysis misses a very important point, which is the inability of families to save. The only way you can get return on investment now is in the financial markets. Any family, and many do, even lower-income people, there’s a surprisingly high savings rate from low-wage workers when they can afford to do so. These folks want to save, and most critically they need the ability to save, whether it’s directly or through a pension plan for their retirement. And, under current ultra-low interest rates, any family that tries to save for their future is a loser on day one. That’s a long-term hollowing out, not only of the middle of the income and wealth distribution, but I think of household financial security, with dangerous, dangerous consequences as the country gets older.

Luigi: But, as you know, the movement to control the interest rate and mass of money, et cetera, by the Fed using reserves, predates slightly, but predates the financial crisis. Bernanke was able to approve that the Fed could pay interest on reserves before the financial crisis, because they wanted to have a different approach to manage the financial system. And then the financial crisis came. Now they want banks to maintain large reserves, because that makes them more stable over time.

The question I have is, which I also raise to people in the Fed, is in Europe the ECB is taxing banks to keep excess reserves, not on the margin, but at least on average, and the United States is subsidizing. Now, the interest rates are so low that the subsidy is zero, but until a year and a half ago, there was a pretty distinct subsidy that the government was transferring to the banks to keep large reserves at the central bank. So, I think that this is not something that the Fed has not thought through. This is a concerted policy that, in my view, has one good aim and one unintended consequence, or maybe an intended consequence. The good aim is to make the system more stable. The unintended—or intended, depending on how conspiratorial you are—consequence is that the banks are making a lot of money on the side on that. So, are you saying that they didn’t understand all this? Or I’m not so sure what you’re saying.

Karen Petrou: What I’m saying is that Bernanke got and received authority to pay interest on reserves in 2006, although the statute did not grant him that actual authority to do so until, I think, 2012, because there was a great deal of Congressional concern about allowing it. And then Bernanke got emergency authority in the 2008 TARP legislation to do so immediately.

The Fed now, and just skip over the middle part, is very much bothered by the large balances of excess reserves, but they haven’t figured it out yet. And the Fed’s got phalanxes of economists, many of them terrific ones. They’re thinking retroactively, and just duct-taping and stapling things together. The reserves now . . . you look at it. Everybody’s expecting bank excess reserves at the end of this year to hit five-and-a-half, maybe six trillion dollars. That the Fed knows. The Fed is projecting that, and that is a lot of money not doing much for the economy. Maybe it’s making the financial system safe. The repo market will reign forever. But it’s not supporting equitable growth.

Luigi: But I’m saying that there is a very simple way to use those reserves, which is to tax them with a negative interest rate. The Fed can do that.

Karen Petrou: Yeah, but then the reserves wouldn’t be there. I mean, you get a plus or minus here. If you think they make the system more stable, as you suggested, and then the Fed wants them, if you tax them, they go out. If you think they make the system more inequitable, as I do, then they should go out, but I think a better way to do that is to gradually raise rates, so banks make money in the economy, not at the Fed. If you want to tax IOER along the way to kick them out the door, that’s an option, but I’d rather not keep solving these structural distortions with more policy. I’d rather just start to let the market normalize and govern decision-making, not the Fed.

Luigi: Yeah, but isn’t the experience of 2008 the fact that the market keeps too little provisional reserves, and that it dries up too fast, and so you should somehow subsidize the holding of reserves, otherwise the market is unstable?

Karen Petrou: Remember, in 2008 there weren’t liquidity rules. Now, the banks—and we’ll get to the nonbank issue in market liquidity—banks are subject to the liquidity coverage ratio and the net stable funding ratio, and about a third of their balance sheets are now in high-quality liquid assets. The reserves are one piece of those assets, and it’s very unclear to me that they need to continue at that level, given the fact that you have the post-crisis regulatory construct. Again, you can’t have it both ways. You can’t have just lots of reserves for stability and expect economic output. It’s a choice.

Luigi: I understand. I understand.

Bethany: I wanted to go back to something you said at the beginning, which is that the Fed didn’t see this coming in 2010, that banks would, instead of lending their money, prefer to keep it in reserves. Why didn’t the Fed understand that coming? It sounds so logical in retrospect.

Karen Petrou: Great question. If you look back, the balances the banks held at the Fed reached well into the, I think, $2.8 trillion to $3 trillion dollars before 2018. And the Fed in 2013 figured the reserve balances would go back to $25 billion. They absolutely misunderstood this. And I think it gets back to the fact that the Fed is looking at its models, not at the market. And it did not, back to my point about it, understand that banks are profit-making institutions.

I have read, and I hope you, Bethany and Luigi, have not had the distinct displeasure of this, pretty much every one of the rules the Federal Reserve and the other banking agencies have put out since 2009. And, when you get to the end, not all of the rules even bother with the courtesy of a cost-benefit analysis, but when the Fed does it, the Fed historically says, this capital rule, for example, will cost banks minuscule percentages of the capital they have, and is therefore irrelevant.

It never looks to see how that dollar total, which largely is conjured up, affects individual institutions or business lines. The banks don’t work that way. They look at something and say, “The risk-based capital weighting on this went up from 100 to 350, and rates are 75 basis points. We can’t make money at that. We’re not going to do it.” And they’ve been consistently deluded by their great models and their cumulative impact analyses without differentiating them by lines of business or types of institutions, or anticipating the growth of what’s called the shadow banking system, the ability of nonbanks to move in in different ways, and then redefine the competitive reality of the marketplace.

And we’re not just talking about little finance companies or pawn shops. We’re talking about entities like Amazon, PayPal, Square, these are huge entities providing increasingly significant amounts of financial services, sometimes riding on the back of banks, taking advantage of these “partnerships” to offer services nationwide at much higher rates than banks are allowed to charge, without any of the consumer protection or safety and soundness rules. That is a very dangerous mixture for both another financial crisis, and again for vulnerable households. I wrote a paper in 2011 predicting the rise of the shadow banking system, and a friend of mine, who at the time was a governor at the Fed, said that would never happen because the regulated banking system would quash them. It would never happen.

Bethany: Let’s talk about that paper for a minute. Because I thought one of the lessons we learned in the global financial crisis was that we didn’t want a shadow banking system. That this was a bad thing and not a good thing. So, how were you able to, even in 2011, see that we were going to have one and it was going to be bigger than ever, and how are we now in this place where it does seem to me, based on what happened with this big hedge fund, Archegos, and countless other examples, that we have more of a shadow banking system than we had in 2006, 2007? How did that happen?

Karen Petrou: Well, the data show that. I mean, if you look, whether it’s the Financial Stability Board or all the other data, on the size of the nonbank, noninsurance financial sector, it’s gotten huge. And, in fact it’s, as the FSB just said last week, nonbanks are bigger than banks in terms of their aggregate asset holdings, and that’s certainly true in the US. So, it’s a fact.

The reason I think I saw it coming is because I had my day job. We analyze all of these rules for major financial-services firms, and for investors. So, as the post-crisis framework was coming together, we were doing a lot of line-of-business analysis, what would this do for very large financial services firms. And in each case, we saw it redefining, and usually it was because of the cumulative impact. It wasn’t just one rule, it was because you had the capital rules running into the liquidity rules, where the banks had to hold large balances of high-quality, liquid assets that are also very-low-return assets when you factor in the leverage risk-based capital requirements. I saw this happening in the advice, the dispassionate advice we were giving our clients. And it didn’t look good to me in terms of financial stability as early as 2011.

Bethany: So, what is the path out? Is it through a—

Karen Petrou: That’s a tricky question, isn’t it?

Bethany: Yes.

Karen Petrou: You’re asking me. I tried to think that through in my book, because the publisher wouldn’t let it go out without solutions at the end, which I thought was very harsh of him, but understandable. My goal in the book, in chapters 10 and 11, is to lay out some constructive solutions. Recognizing, as you said, Bethany, the really important role of the shadow banking system, both in terms of financial stability and the risk it poses to vulnerable consumers. So, I have a number of solutions to that, which is essentially like-kind rules for like-kind activities, and very careful attention to the transformation of the payment system into digital forms of money and digital structures, in which banks play an increasingly smaller role, and Facebook and Amazon and Google play an increasingly bigger and bigger one. I think we need to think really hard about that.

With regard to monetary policy, I’d like to see the Fed, first of all, immediately improve its analytical capabilities to see America as it is, not the way it was, with far better use of distributional data. The Fed two years ago started creating this great data source called distributional financial accounts of the United States. It puts them out every quarter, and every quarter the Federal Open Market Committee happily ignores them. I think we need to think a lot more precisely about America and how money and wealth flow through it, if you want to have effective monetary policy.

I think the Fed needs to issue forward guidance, particularly with regard to its safety net. Go back to what it’s told to do in the law, which is provide emergency liquidity support, and only liquidity support, not solvency support, under “exigent and unusual circumstances, and at penalty rates.” The Fed’s decision in March of last year to subsidize and step in and rescue even junk bonds was a very costly decision, I think, with long-term negative consequences, unless the Fed starts to reverse the Greenspan and now the Powell put. I think it needs to do forward guidance and begin to allow market rates to normalize. If the economy is really going to grow 6.5, 7 percent in the second half of the year, and the Fed thinks it’s sustainable, why are we having rates negative through 2024 and beyond? I don’t think that makes sense. And there are ways for the Fed to reduce its portfolio and demand less of banks. One is the taxation Luigi recommended.

Another one, which is uniquely available to the Fed, is to just essentially forgive all the Treasury debt. The Fed goes in, buys all these Treasury obligations, it pays the interest on the Treasury obligations back to the Treasury in terms of Federal Reserve income. The Fed balance sheet would take a big hit, if it wrote down all those Treasury obligations and stopped paying them, but the balance sheet would be a much more progrowth one without them, and it can simply do that by essentially making them disappear, because it is part of the federal government.

Bethany: Go back to March of 2020. Why do you think the Fed felt the need to rescue junk bonds? Had it created a situation where it actually had to do that in order to save the economy, or was this the Fed expanding its mandate, rather than seeing what might happen if it didn’t do so?

Karen Petrou: I think the Fed created the situation where it needed to step in, unfortunately, to protect the money-market funds and the commercial paper markets. I think the Fed’s dramatically expanded its mandate when it’s stepped in with its primary and secondary corporate-debt facilities. It wasn’t all of the emergency steps the Fed took, even though the market would have been far less fragile had the Fed acted before the crisis. The Fed needed to do some of what it did. It did not need to do all that it did.

Luigi: And why do you think that the Fed went so aggressive?

Karen Petrou: I think the thought of market instability scares the heck out of it. Look what happened in December of 2018, when Powell starts to take tentative steps, and the FOMC says, “OK, we’re going to start to normalize rates. We’re going to raise rates just a little bit.” Markets reacted negatively, well within the tolerance of a normal correction. And the Fed turned around, immediately promised to lower rates in January, and promptly did so. Same thing with the taper tantrum in 2013. Bernanke hints at normalization, the market says, “Uh-uh, we like the candy.” Basically, the market threw a temper tantrum, and daddy kept giving it candy.

Luigi: So, you think that the chairman of the Fed is too influenced by market reaction.

Karen Petrou: The Fed, Bernanke, Greenspan, and Powell, Yellen, too, they believe in the wealth effect. The wealth effect comes from market growth and market stability, market heights, and I don’t think they really noticed that the wealth effect only works for the wealthy.

Luigi: It was a pleasure, Karen.

Karen Petrou: It was a real pleasure as well. Enjoyed it. Thanks again, Bethany, for convening this, and Luigi for your really terrific questions.

Bethany: Luigi, for our listeners who may not be economists, will you explain reserves, the concept of reserves, and why they’re so important for where interest rates are?

Luigi: Oh, absolutely. When you think about money and the Federal Reserve printing money, most of this money is not cash. It is digital money, if you want, that is a liability of the Fed, that it has with the various banks. When you deposit money in Citibank, part of that money is redeposited at the Fed, and that is the reserve that Citibank has at the Federal Reserve. Citibank can, in any moment, transform . . . It probably never wants to, but if it wants, it can transform those reserves into cash. And that’s what makes the reserve so powerful, because it is access to liquidity at an instant’s notice. And because the Fed prints the money, they can provide all the money they want on demand.

Bethany: Does the Fed control the amount of reserves that it has, or does the banking system control the amount of reserves that are with the Fed?

Luigi: That’s an excellent question. And the answer is that’s exactly what the Fed controls. In the old days, it was imposing a reserve requirement. Or it can do it through interest rates. It pays a higher interest rate on reserves or a lower interest rate on reserves. And then the banks decide how much they want to hold. They always want to hold a little bit, because that’s the way they protect themselves against a liquidity shock. But because generally they can make more money lending otherwise, they want to keep this relatively low, and so the question is, exactly what is the right tradeoff?

A big change that took place around the time of the financial crisis, but the idea predates the financial crisis, is that the Fed started to pay interest on reserves, so that could ensure that the banks keep more liquidity available. By paying interest, you make it less costly for banks to hold reserves, and so the banks will hold more. But if the banks hold more, it means that in a moment of crisis, they can access more liquidity.

Before the COVID crisis, when interest rates were positive, the banks collectively were making $30 billion a year of interest on reserves. That was not a minor thing. And what was particularly unappealing is the fact that you and I, when we deposit at Citigroup, we get basically zero interest, right? Sometimes they say 10 basis points, you have to look with a lens to see what they return. But then Citigroup, with that money, deposited at the Fed, was making two-and-a-quarter per year.

Bethany: That doesn’t seem fair.

Luigi: Absolutely. And I remember once I spoke with a congressman who was asking something about banking. I explained that to him, and he said, “This is outrageous.” I said, “Yeah, exactly.”

Now, my economist colleagues, especially the ones involved in monetary economics, et cetera, said, “But, oh, this has this rationale to control the level of reserves,” which to some extent is true. However, there is a more substantive issue. Why don’t you give direct access to the Fed to depositors? If you had the alternative, I’m sure you would prefer to deposit at the Fed, at two-and-a-quarter and zero risk, rather than at Citigroup, where there is zero interest and some risk. It doesn’t take a financial economist to figure it out. So, that’s number one.

Number two, in a world that is very competitive, the banks should rebate this advantage to the customers. In a moment in which interest rates were positive and they were not rebating, this is a sign of the lack of competition on the deposit side, or the concentration in the banking sector. I think that that’s a sign of a problem there.

Bethany: Right. Well, I guess the latter isn’t a surprise, given that too-big-to-fail got too-bigger-to-fail after the financial crisis, so you’d almost expect to see that happen. I guess the tradeoff the Fed is making is that the more profits the banks make, the safer the financial system is. At least you could make that argument. The Fed is weighing the safety of the financial system, in a sense, against stimulating the economy by forcing banks to lend out the money.

Luigi: I think that this is the fascinating aspect, because I know a lot of people who work at the Fed, and even in important positions, and when you talk to them, they are very reasonable people, and I think they are all well-meaning and well-intended. And they will reply that they have two mandates from Congress. One is price stability, and the other is full employment.

Let’s reason in a pre-COVID world. In a pre-COVID world, prices were stable. In fact, they were undershooting the target of inflation, which was 2 percent. There was discussion to what extent there was full employment. But until there was full employment, they would say, “I need to push, push, push the economy, because it’s not my choice. I don’t make those rules. This is what I’m told, and I try to apply it.” Now, what tools do they have to push this? The tool they have is to make sure that rates are low, and these low rates trickle down—I know this is a loaded term—trickle down in the economy.

When you see firms in private equity taking huge amount of loans and buying back stocks and paying dividends to the investors, look from the perspective of the Fed, that’s a feature, not a bug. That’s exactly what they want. Why? Because that’s one of the channels that allows them to reach the objective, which is to get the economy more stimulated. And you can be the most radical leftist on the face of the Earth, but they are saying the Fed does not have a mandate to go and throw money in poor neighborhoods with a helicopter. The only way to stimulate the economy they have is to do this kind of operation, and that’s collateral damage. Sorry, you want to say something.

Bethany: Yes. I want to be a radical leftist, and ask why, if one of the Fed’s mandates is full employment, given that private-equity firms, after loading up a company with debt, often end up laying off a significant portion of the employees, how do those two things fit together?

Luigi: No, because remember, those dividends go into the pockets of investors, who are going to spend it or invest somewhere else, creating more demand for the economy. So, I think that it is consistent with that goal. Now, you might not like the distributional aspect, but those distributional aspects, to be honest, are not in the mandate of the Fed. So, the question is, how do you interpret the mandate more broadly? But I think that we need to be aware that there are some limits on what the Fed does. And also, there is a risk of the Fed overreaching. There is a risk in two senses. One is, of course, if you try to reach too many objectives, it’s difficult to reach any one well. And two is, you lose political legitimacy. The central bank is ultimately a representation of a democratic government and cannot be a technocratic enclave that operates under different principles and rules, and I think that that’s a very important tension to keep in mind.

Bethany: What do you make of Karen’s overall argument that this has played a dramatic role in widening wealth inequality? And then of the second part of her argument, that when the Fed says the economy is functioning well, that the Fed falls into a trap of looking at big-picture data, rather than going underneath the surface and looking at how the data actually breaks out, and who’s being affected?

Luigi: I have mixed views. She understates what I said at the beginning, which is you have to realize that these people have a mandate. There is no question that a lot of the lending might increase global warming, but if I say the Fed makes global warming worse, you might say, “You know what, it’s not our mandate. There is a political authority that can tax CO₂ emissions. It’s actually something that is very simple to do, and if they don’t want to do it, why should I do it through the back door?”

In the same way, distributional issues are very important, but also, they are incredibly politically charged. It would be very, very difficult for an unelected official to take this into full consideration. Now, on the margin, could they be more aware and willing to accept that there are these consequences, et cetera? Yes. It is a fairly hierarchical institution, and it has a lot of influence in the economics profession. So, there is a group of economists that are the Fed groupies. And they always say, “Well, the Fed says,” and they never deviate and never criticize, because otherwise you’re cut out from the right conferences, the right meetings, and so on and so forth.

So, there is a need for more diverse thinking inside the Fed. No question. But I think that, at the end of the day, in my view, she over-pushes the argument. Now I’ve learned over the years that sometimes you end up being useful by over-pushing, because if the other people are particularly close to a certain argument, if you make it in too subtle a way, it’s not heard. So, you need to shout it, and overstate it, and then finally people start paying attention. So, maybe if you’re saying strategically, is she doing the right thing? Maybe. If you’re saying, do I buy the entire argument, 100 percent? No. I think she overstates the argument.

Bethany: What about Karen’s argument, which I find compelling, that this is a giant transfer of wealth away from savers? You know, 20, 30 years ago, if you had a million dollars in the bank, you could basically earn enough interest on that to live, decently, for a year. And that provided a level of stability to retirees that is completely lacking today. Because that same retiree with a million dollars can’t earn any interest on their money, and it creates not only a real lack of financial flexibility, but it also creates a sort of social instability, in the sense of an insecurity writ large through the population. As an economist, how do you measure that cost, which seems to me as a financial cost that is filtering through society and creating more instability than perhaps our system can handle right now?

Luigi: I actually would say that, more than a transfer from savers, I would say it is a transfer from ants to cicadas, if you take the La Fontaine fable. Because actually, as a retiree, if you want to live on a fixed income, it’s a tough life, but if you’re invested in equities, you’re doing fine. The problem is that the return on purely safe instruments has been incredibly low. But that’s partly because the demand for these incredibly safe instruments has been incredibly high.

Think about Japan. And Japan has been through this situation 20 years ahead of us. And part of the story is precisely a massively aging population. So, if everybody wants to hold safe securities, then those safe securities must have a very low interest rate, and potentially even negative. And the more that there is an aging population, the more this will be the case.

There is also an international dimension, because it’s true that in the West there is a massive aging population. But that’s not true in the world overall, and especially there are plenty of young kids in Africa who would be very happy to have some capital to develop some enterprises over there, if you were to lend it. And the same is true in India. So, there is no shortage of people without capital in need of capital. However, there is a shortage of safe, institutional ways to do it.

Imagine that we were to make, as the United States, massive investments in India for the next 20 years. India would be delighted to receive more of this investment for the next 20 years, but then, once they develop and they have to start to pay a return, they say, “Oh, you know what? We changed our property-rights system, and we say that you foreigners, we don’t like you, and we’re going to tax you twice as much.”

So, bye-bye your return. And at that point you have lost the bargaining power, because today, some of your power is that we stop investing in you. And that’s very costly if you are in shortage of capital. But the moment that they develop, they have plenty of capital, they can say bye-bye. And by that time, it is very difficult to get any money back.

So, I think that the problem is that the West is aging, and there are not enough safe ways . . . by safe I mean institutional, not safe business, risk. I’m willing to take business risk, but I’m not willing to take political risk. There’s not a politically safe way to invest a massive quantity in the part of the world that needs that money, because there is not a guaranteed way to get it back when we age.

Bethany: That’s actually fascinating, because I think you . . . It’s counterintuitive in some ways, not once you explain it, but counterintuitive in some ways, in that most of us believe global capital flows, capital is fungible. It moves around the world like water, except it really doesn’t. And if it did, and if there were a global system of property rights and laws that were consistent, then perhaps it would move more readily, and we could address some of these issues.

Another part of Karen’s argument that resonated with me is that the Fed looks at the economy as it used to be and not the economy that we have today. And to me, part of that disaggregation, and this is the nonquantitative journalist in me coming out, but I can’t but believe that the rise of private equity has skewed the way in which low interest rates used to benefit low earners, in the sense that low interest rates benefited those who were indebted, because they had to pay less interest on their debt. But today, when I think of all the billions that private-equity honchos have made, as a result of ultra-low interest rates, and being able to do these dividend recapitalizations of the companies they’ve taken public, I can’t help but believe that low interest rates have actually benefited, even on the debt side of the equation, have actually benefited high earners more than they have benefited low earners. Or at least benefited them in a way that is not reflected in the traditional way of thinking this through.

Luigi: I think we need to divide the population into various quintiles or quartiles of distribution, in the sense that, if we look at probably the bottom half of the distribution, people who either don’t even own a house or own a very small and not particularly valuable house, I think that these people, by and large, did not benefit at all. They cannot borrow significant amounts of money, and if they do borrow, they borrow through credit-card loans, which are not particularly sensitive to interest rates, because they are outrageous anyway. To be fair, these people were not . . . They don’t have huge savings, either, so they’re not really people taxed in any way, but certainly they don’t benefit.

Then you take the, let’s say, the other 40 percent, from the 50th percentile to the 90th percentile, or something like that. These people benefited a bit from having a lower interest rate on the house, not massively. They got a little bit less by having a lower return on their bank deposit, but on average probably they had a bigger mortgage than they had a bank deposit, so on the margin they benefit. Of course, not as much as a private-equity guy that can borrow a billion, but I think that they do benefit a little bit on average.

And then the 10 percent, and here I think that it is maybe the grasshopper, it is not a cicada, it is a grasshopper. What is the fable of La Fontaine? I will divide this group into the ants and the grasshoppers. The ants clearly were penalized deeply, because they kept their money in safe instruments, so they got a low return, and they were not borrowing very much. But if you are a grasshopper, you had a great time here. Part of the problem, and this is where it is a bit controversial, is if you have a cycle, and sometimes interest rates go up and sometimes they go down, on average you’re kind of fine. If you look at the last 20 years, basically it’s been only one direction. Down. The distributional effect has been quite remarkable. So, that’s problem number one.

And problem number two is that some people are better connected than others, so if I am a private-equity guy, and among my friends are all the former governors, I get to understand what the next move of the Fed is before they do it, I can take risks more aggressively, because I know that I’ll get an early warning. It’s a bit like, what’s the name of that . . . in a gang of robbers, there’s a guy that stands there to call when the police arrive, there’s a name. What is the name?

Bethany: I don’t know.

Luigi: Lookout.

Bethany: The lookout. I was going to say the warning system. The lookout. Yes. Yes, yes, yes.

Luigi: So, basically, if you have a lookout, then you can afford to stay longer and rob the bank longer, because you have a lookout. And not that these guys are robbing the bank, but you can take more risk if you’re well-connected with your lookout, and that’s what seems a bit unfair in the system these days.

Bethany: That was making me think back to our conversation with Matt Stoller, and his argument about the Cantillon effect, that those closer to the source of the money can figure out ways to enrich themselves or to benefit more. Now you’re sounding a bit more like Karen.

Luigi: Look. Any time there’s a government policy, the people close to making that policy end up making a lot of money, because they know ahead of time. Italy, at some point, introduced some subsidy for renewables, and the people who were well-connected made a bundle on that. And not that the policy in principle was not correct, but, gee, you are deploying it in a way in which a few people became super-rich. So, this is unfortunately the risk of every government policy, and it becomes even more so when the government has not done . . . the policy is not done in a transparent way.

Bethany: That’s interesting. Because I think I’m a naïve American in that sense, in that this horrifies me, and I think many people raised here probably feel similarly. And in years past, we didn’t have this focus on the Federal Reserve, I think up through the financial crisis. We didn’t have this focus on the Federal Reserve. It was just this thing that existed in the shadowy background. So, even though some of what you speak of may have been true for decades, we didn’t notice it to quite the degree that we have since the financial crisis. And now that it’s front and center, it’s hard not to be offended by it.

Luigi: You know that this has been going on since the beginning, at least of the republic. Alexander Hamilton, of the musical fame, because that’s what he’s famous for, his real claim to fame, in the economic history of the United States, is that he consolidated the debt of all the states into federal debt. There are a lot of rumors, and I think some evidence, that before doing that, he bought debt on the cheap and made a bundle.

OK, so one of the founding fathers was a crony capitalist himself. Many years ago, I wrote this book with Raghuram Rajan, Saving Capitalism from the Capitalists, and our publisher came up with a cover. It was awful, it was like a one-dollar bill with George Washington with a black eye. And I wanted to pull the book. You know that the publisher, unfortunately, has complete rights over the cover. And I hated the thing so much that I wanted to pull out of the deal. Raghuram, who is much better than me, was trying to calm me down and said, “Look, the cover is not that important.” And so, finally, we arrived at least at a compromise, that is Alexander Hamilton and not George Washington receiving a black eye. And that’s exactly because I knew of that fact. It’s very subtle. I think that only three people in the universe know about that, but at least it made my conscience clean.