Great Perks of Being Rich




Most people want to own property because paying rent is wasted money; but while that might be the reason they tell themselves, the real reason that everyone wants to own property is that property is virtually the only way the average person gets access to leverage.

Professional investors are always seeking low volatility assets that appreciate“reliably” – especially if they have the ability to leverage that asset. Throughout most of the 20th Century, most everyone had witnessed (usually from afar) the wealth growth that could occur through the ownership of property. Historically property prices do not appreciate very much on a yearly basis, but they do generally rise in line with inflation.  If inflation is two per cent and the buyer has access to leverage of five to one, it means the buyer is making 10pc per annum on his or her investment.

Thus buying property with leverage provides a good return on an initial investment even in a low inflation environment.  This return, however, gets better, much better, if the asset inflation far outstrips consumer price inflation.  If property is rising at 10pc per annum, then the five times leveraged return is 50pc.  It is easy to see why so many people want in on this action.

Most people understand that expectations are a major factor in financial markets, and confidence is the major intangible in an economy as a whole.  Policymakers understand that people, and the media in particular, look at the state of financial markets as a guide to the health of the economy.  Therefore, as the conventional thinking goes, if one wants to make sure people feel relatively confident about the economy, one probably needs to make sure that financial markets do not tank.

So despite their supposed belief in efficient markets, after the bust of the dot-com boom in 2000, the US Federal Reserve consciously re-inflated the system by lowering interest rates, which had the side effect of making mortgages very cheap. Coincidentally, around about the same time, banks were beginning to discover the process of “disintermediation”.

Disintermediation allowed banks to sell off their loan portfolios to third party investors (meaning that whether the loans performed or not became someone else’s problem) and this freed up capital for further loans; ultimately to people who never would have had access to leverage before.

Thus banks’ irresponsible lax extensions of credit, and central banks’ irresponsible lax oversight of the amount of credit in the system served to kick start a positive feedback effect.  Excessive positive feedback in any asset market amplifies market synchronicity which can ultimately cause a herding effect to emerge; turning the so-called “Wisdom of Crowds” into the “Madness of Mobs”. In engineering terms, this is equivalent to  turning a damping force into a driving force; in a sense it is a bit like friction in reverse; heat turning into motion.

Such inefficiency in asset markets is not good for society as a whole for they usually mean that markets start behaving like a ponzi scheme.  Rapidly rising market prices are like a raging forest fire that constantly needs more fuel.  In bubble markets this fuel comes increasingly from the weaker members of society.  In the face of almost daily gains for everyone else, eventually everyone gets sucked in, even those who cannot afford it.

During the property boom, banks fuelled this ponzi scheme by recklessly lending to the ever less creditworthy; which meant that as in all ponzi schemes, the less well off were getting in last, often buying from those who got in first.  Inefficient asset markets are generally speaking a very effective way of transferring wealth from the poor to the rich!

The less well off being allowed to participate in the leveraged game of easy money usually signals the end of yet another positive feedback driven up-cycle.  After the debacle of 2008, the Fed once again, in order to avoid a positive feedback driven down-cycle, decided to reflate; this time not only by dropped interest rates, but also by actively bidding up financial asset markets.

This time around however, although the Fed probably saved the global economy from global collapse, the only people that really benefited were those people who could still afford to own financial assets.

Unfortunately this did not include the vast majority of the population, who even if they were not massively in debt, found that they no longer had any access to leverage, and as a result are no longer able to participate in the game of easy money.

Furthermore, as if to add insult to injury, the taxpayer ended up picking up the bill for the crash, and in general the rich do not pay very much in tax

So, all in all it is great to be rich!  While most people only have access to excess leverage at the tail end of a policy-induced ponzi scheme, the rich have access to leverage all the time (and not only for property).  Some rich people will say that the reason for their ever-increasing wealth is that they are smarter than everyone else, but the truth is, it is so easy to get richer when one is rich, and so hard to get out of the starting blocks for everyone else.



By Kieran Kelly
is an experimental mathematician. He can be reached at kieran@complexitydynamics.com.

Published on Mar 07,2016 [ Vol 16 ,No 827]


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