It is a well known fact that in a capitalistic society rich get richer and the gap between the rich and poor keeps growing. While the overall standard of life might improve due to human innovations, the gap between rich and the poor continues to grow with time. The current recession has once again proved this point. “The wealthiest 10 percent of Americans — those making more than $138,000 each year — earned 11.4 times the roughly $12,000 made by those living near or below the poverty line in 2008, according to newly released census figures. That ratio was an increase from 11.2 in 2007 and the previous high of 11.22 in 2003.” (Read more here). Philosopher Adam Smith has summarized the phenomenon as: "The problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money"
In this post, I want to explain this with an analogy. The analogy of capitalism is like a water tank with an outlet near its top (say at 75% of its height). This tank is elastic which means its base area can be expanded or shrunk. For a given volume of water, If we shrink the area of tank the water level rises whereas if we expand its area the water level falls.
The water tank in this analogy is the rich-capitalist class. The common man derives his income from the outlet which is located near the top of the tank. In other words, common man receives the excess-capital which the higher class is willing to invest for Job creation. The amount of capital available for investment is not dependent on the total volume of water available in the elastic-tank but on the water-level of the tank. This means the excess-capital is not dependent on the hard-cash like dollar-bills (or notes) but the market-value of the existing investment. The water that comes in the tank is the revenue from production and services. For a healthy business environment the water inflow has to be greater than the outflow (as most of the businesses are profitable).
Now, the interesting thing to note here is how the whole boom/bust sequence actually make the rich richer whereas common person ends up getting poor (at least after taking into account the inflation).
During the boom period (like late 1990s), the area of the tank shrinks and the water level rises. This higher water level means more water coming out of outlet (i.e. more jobs, more income, more returns on their nominal investment for common man). Note here that the actual volume of water might have increased in the tank (due to actual growth in production and innovation) but the increase in water-level is much more due to shrinking of tank’s area than by increase in water volume. That is to say that the amount of capital available for investment during the boom period is not because of actual increase in book-value but because of anticipation of higher returns and the perception of favorable business-conditions. This can be seen in the high price-to-earnings (PE) ratio of stocks and the low yields-values of bonds.
The increase in water level means more water getting dispensed from the outlet which means more jobs and higher salaries for common people. A common person, for what he is, does not grasp the entire picture and starts to make allowances which he cannot afford during normal times. The real-estate boom of 2004-2005 is a classic example where the crowd got deceived by the low unemployment rate and higher wages and started buying houses on Interest-Only loans or ARMS.
Increased outflow and profitability leads to higher inflow in tank which leads to actual increase of water-VOLUME in the tank. That is to say the appearance of increased prosperity will lead the crowd to spend more which in turn helps capitalist to increase their real wealth due to increase in production and consumption. Thus during the boom-period the rich folks benefit from the increased spending of the whole society. Because of rapid rise in water-level of the tank due to shrinking base-area (i.e. perception) as well as due to real increase in water volume due to increased inflow (i.e. real increase in wealth), the height of outlet increases. For examples if it was at 75% of tank’s height before boom-time, it goes to 80% during boom-time. This rise in outlet level is necessary to increase the amount of profits made by the capitalists. This means the increased company earnings does not linearly translate into increase in salary/compensation of workers. For example Microsoft's net worth has grown from $6/share in 1990 to $59/share in December 1999 (approx. 10 times increase), however this did not lead to a 10 times growth in income of a normal software engineer.
Of course, the boom has to end somewhere and it generally starts with an external event which shakes the belief that prosperity cannot continue forever (i.e. water level in the tank cannot grow forever). The first effect of this change in perception is that the tank starts to expand in area which means the water level which has gone up due to shrinking of tank area (during boom-time) starts to retrace and go lower as the tank-size increases. This means the capitalists who have enormous wealth on paper starts to see it going down as the changed perception causes the stock prices to go down and yields to go higher. This decrease in water level means less water coming out of outlet. This means the common man who was receiving high wages and bonuses starts to realize the sudden decline in his income. He suddenly realizes the allowances that he made for himself during the boom time are no longer affordable. The effect is worse as the level of outlet during the boom-period has increased (as we mentioned earlier from 75% to 80%). This decreased prosperity of common man leads to a "real" decrease in wealth of capitalists due to falling retail sales and profit margins. The level of water begins to fall not only due to increase in tank area (i.e. perception) but also because of decreased inflow (i.e. actual wealth reduction). This can be seen in lower earnings per share (EPS) as well as low PE ratios of stocks during recessions.
The starvation of common man due to decreased capital investment causes the government to come into action. It has to do "something" to assuage the sufferings. The central bank (which is not completely independent of Federal govt., as mentioned in Federal-Reserve act) starts to lower interest rates and adds more liquidity into market. This is like putting more water in the tank by an external source. Fear about the business condition keeps growing. The area of tank continues to expand and Central bank keeps pouring water into it to bring up the water level in order to feed the thirsty crowd. Note how every govt. intervention HAS to go through the water-tank otherwise it will be labeled as communism! (i.e. the system is designed in such a way that the well-being of common man is completely dependent on the prosperity of capitalists).
Ultimately huge monitory easing leads to disappearance of fear and arrival of hope. Confidence develops and begins to increase with government assistance. This means the growth in tank area stops and the water level begins to increase (i.e. the beginning of next boom cycle). In the worst case the water tank keeps expanding and might even develop cracks leading to depression. If the cracks are not mended even by govt. intervention, it might lead to a systemic failure (which was almost the case in October 2009 when Lehman failed and AIG was on the verge of failing).
In this whole episode, the volume of the tank has increase enormously which is to say the rich have gotten even richer. The common man ultimately gets his income from the same old outlet at may be a slightly higher rate. The ratio of water available in the tank to what is dispensed rises substantially compared to what it was in the previous boom/bust cycle which means the ratio of wealth held by rich and poor keeps growing!
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