The Effect of Equal Access to Capital Income through Equity Markets on Income Inequality

Darien Leblanc

Econ 231

Professor Frank Lewis

November 25, 2016

As changes in social and economic policy attempt to close the income gap it is of use to examine

the historical progression in the income of individuals as a result of access to capital income.

Investments in manufacturing and other large scale projects were not feasible for majority of citizens

during the Industrial revolution, due to sizable investment requirements or lack of collateral needed to

access debt markets. The emergence of equities markets allowed for investment opportunities with less

initial monetary outlay. It is worth asking how equal access to capital income, through equity markets,

affected income inequality. Many historians and economists have done so and recorded data relative to

Income over many years. This essay will analyze that data in order to come to an independent prognosis

regarding the emergence of accelerated income inequality in relation to capital income changes.

I

It is important to first recognize the components of income if understanding its inequality is of

interest. Income is comprised of earnings which one would gross through the sale of their labour

services, capital income which is derived from investment in any number of markets and opportunities,

and government transfers or the redistribution of wealth performed by the government using taxation

and subsidies. For the purpose of simplicity government transfers will be omitted from all the following

calculation. Thus the income equation will become; I = E + K. It is useful to observe income inequality

without government intervention for a number of reasons. Of greatest significance is that this essay is

not designed to understand or critique how social policy effects income inequality but rater how the

basics of economics can be applied to understand how individual choices and market characteristics can

lead to an income gap between classes.

It is abundantly clear that both earnings and capital have a direct relationship with Income. This

means that the rate of appreciation or depreciation of both earnings and capital will directly affect

income by the same rate. Examining the literature that exists regarding this subject one particular

conclusion from the prominent economist Thomas Piketty comes to light. After scrutinizing many years

of income data over a broad spectrum of countries Piketty came to the conclusion that; “the private rate

of return on capital, r, can be significantly higher for long periods of time than the rate of growth of

income or output” (Piketty, 2014, 571)8. He exemplifies this using the historical average return on capital

(r) and tracking earnings growth over an extensive time period. Since capital income will appreciate at a

much faster rate than earnings one can conclude capital income will have a much greater effect on the

change in income of individuals1 over the long term, or as Piketty calls it the principal destabilizing force.

To exemplify this I will show how a one dollar investment in the British equities market would

appreciate over the period 1825-1870 if the investor were to receive the average return for the year. I

will also invest in a theoretical earnings market where the return is the appreciation in the wage for that

year. Both investments will be fully invested at all times taking advantage of compounding interest. The

data used for return on British equities is a total return which factors in capital appreciation and

dividend yield. It is safe to assume any rational individual with an average risk profile who invests in the

market will strive for diversification and thus their portfolio will be a blend of equities from all sectors

and dividend yielding shares. The reason for using this specific data set was not only due to its

availability and its preferred organization but also that it adds perspective to how a booming equities

market can affect the uninvested. The wage data used are average nominal earnings in Britain for the

respective year.

18251829

18331837

18411845

18491853

18571861

18651869

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

Investment in K and L Markets

Apreciation of Wage Investment Appreciation of Capital In-vestment

Valu

e

Figure 1: Investment appreciation of $1 in the British equity markets and the theoretical labour market during the period 1825-1870. Core Data for equity markets from Graeme G. Acheson, Charles R. Hickson, John D. Turner and Qing Ye (2009). Core

Labour market data from Gregory Clarke (2016). Calculation data listed in table 1.

18251828

18311834

18371840

18431846

18491852

18551858

18611864

18671870

-20

-10

0

10

20

30

40

Change in Wage and Capital

Wage Rates Capital

Retu

rn (%

)

Figure 2: Capital and wage return fluctuation over the period 1825-1870. Core Data for equity markets from Graeme G. Acheson, Charles R. Hickson, John D. Turner and Qing Ye (2009). Core Labour market data from Gregory Clarke (2016).

Calculation data listed in table 1.

The value of the dollar invested in the theoretical earnings market over the 45 year period

appreciated to $1.75, a 75% increase over 45 years. While the dollar invested in the British equities

market appreciated to $169 over the same period, a 16,800% increase. This Example has proven the

truth of Piketty’s conclusion. His proposal is quite profound, in that it exemplifies that those who do not

or cannot invest their earnings will fall substantially behind in terms of income compared to those who

do. It is because of this conclusion that only one variable over time will have a profound effect on

income inequality, that variable being capital income2. This allows us to focus our study on capital

income its emergence and transitions, and their impact on different income classes.

II

If capital is the driver of income inequality it is important to look for instances where inequality in

capital availability emerge between classes. One instance of such a disparity between classes would be

the industrial revolution. It is now accepted that the growth during this period was not as great as

previously thought. This economic change of heart doesn’t alter the fact that barriers of investment

needed to access this growth existed during this period. The inability for some to take part in the growth

however mediocre it may have been creates income separation between classes.

The industrial revolution is characterized by innovation driving growth. Changes in technology

that created, improved and drove industry like had never been seen before. A suitable example would

be the textile industry. With inventions like the spinning jenny, carding engine and the water frame,

textile production could now be mechanized. This led to factories where a multitude of machines could

be housed and production standardized. The large production and standardization of labour tasks

allowed for economies of scale previously unexperienced. By leveraging of these economies of scale the

factory could create unheard of profit margins raising substantial wealth for their owners and lenders.

To participate in this wealth, one would have to invest in all the necessary capital required. The

average cost of a 24 spindle spinning jenny was around 70 shillings (Allen, 2007, pg.5). Which adjusted

to the current pound value3 would be around £1, 4724 (Lawrence H. Officer and Samuel H. Williamson,

2016). By comparison the yearly earnings of farm labourer, middle group individuals, and artisans in

1755, in current pounds3, were 19.01, 25.17, and 42.30 pounds respectively (Lindert, Williams, 1983,

pg.12 figure 1). As the Investment in capital necessary for entry far exceeded than any of these income

groups’ yearly earnings and by extension their ability to access debt markets, it would have been

impossible for them to enter the booming textile manufacturing industry. Considering, only the rich

could access this from of capital income they held an almost complete monopoly over it. Creating

unequal capital income and thereby accelerating income inequality.

Using data collected by Piketty we can exemplify this change. Firstly he allows us to study this

change by analysing the makeup of capital income during this period. As he explains a major

transformation of capital took place. More specifically, that financial capital and industrial capital

emerged as the main source of investment rather than the previously dominant land capital (farm land)

(Piketty, 2014, pg.342). This statement is proven by the data he compiled represented in figure 3.

Figure 3: Capital split in Britain. Source: Piketty (2014)

There is an obvious downward trend in the value of national capital comprised of agricultural land

with other domestic capital (financial and industrial), making up the majority of its loss for the period

under question. The importance of this is that we can now assume all wealth and capital data is

primarily made up of increases in financial and industrial capital. In other words, allowing us examine to

his data set on wealth inequality in Britain, under the pretence that changes are mostly driven by

increases in financial and industrial capital. During the later stage of the industrial revolution the share

of wealth of the top 10% increases from 80% to almost 90% (Piketty, 2014, figure.10.3). This bolsters the

presumption that only the wealthy were able to invest in capital during this period and thereby

benefited tremendously from it.

Figure 4: Wealth inequality Britain 1810-2010. Source: Piketty (2014)

Research done by Peter Lindert over an expansive time period, 1610 - 1910, yielded the

conclusion that “wealth other than real estate, or gross ‘personal estate’, became more unequally held

during the industrial revolution era” (Lindert,1986, 1130). With all fingers pointing at an increase in

capital inequality it is safe to say that the industrial revolution and the income inequality that emerged

was due to barriers of entry into capital investment for the less well off. If the inability of some to invest

could create such inequality one would expect that the emergence of equal access to capital income

would help to close this widening gap.

III

Around the same time period the equity markets in Brittan had gone through devastation after

devastation. Chief among them the South Sea and Bengal bubbles of 1720 and 1769 respectfully. Both

had a considerably adverse effect on the economy as a whole and severely damaged investor

confidence. This period in capital markets housed the earliest version of joint chartered stock

companies. With suspect regulation and a lack of honesty between the companies listed and investors,

speculation and fraud ran wild. The eventual crash of these bubbles hurt all income classes and severely

affected the British economy. It would be dubious to call this an equity market. With all most no

regulation and ramped fraud it could be better characterized as a financing ploy benefiting from an

unobservant investor base.

Many provincial exchanges existed up until 1845. The original expectation was that they would be

more informed about the local listings and thus be transparent. The rail road speculation washed away

all but the most financial sound exchanges. This episode represented the need for a central exchange

governed by standards and principals that could inform the public and avoid the mass speculation.

The London Stock Exchange which was originally formed in 1801 and represented precisely what

Britain required. Creating the LSE allowed for new rules and regulation to be enforced. These rules

forced the exchanges member to be transparent and work in the interest of their customers rather than

their own self-interest. The LSE represented the largest and most financially sound of all the exchanges

and was able to navigate many financial storms and emerge steadied. The LSE inaugurated a ticker

system to allow for equal knowledge of equity price fluctuations in 1830. Then around the rail road

speculation era, officially in 1846, they assured the public about their pricing system by having each

published price marked by an official of the LSE to assure that all quotes in flotation were legitimate. By

1853 the dominance of the LSE in Britain was all but assured as over 70% of all rail road equity, the most

traded and abundant during this time period, was listed on the LSE (Ranald Michie, 2001, chp.2). The last

piece of the puzzle, forging full transparency, is the Investors Monthly Manual, which was first published

in 18695 (YSM, 2016). The importance of the IMM cannot be understated. This publication allowed for

all investors to peer into the financials of all listed companies. The IMM posted changes in the equity

and debt of each company listed on the LSE and reviled potential threats or opportunities each listing

possessed. Which I believe is the most important step in creating an equal exchange as it garners trust

and transparency between investor and the equity they are purchasing.

Calling the British equity markets up to 1869 unjust would seem counterintuitive based on the

example I gave in part one. During the period 1825-1870, as I have already shown, investment in British

equity would have been extremely lucrative, seemingly countering my proposition. The problem is that

variance in return was extremely high during this period, representing a disparity in return between

investors. The standard deviation7 in total return during this period was 11.73, with a max return of

53.23 and a minimum return of -16.93 (Acheson, Hickson, Turner, Ye, 2009, Table 5). By comparison the

current standard deviation of the NYSE is 0.6307 (macro axis, market close Nov 23). The 1825-1870

variances could be explained as knowledge gap between investors of different income classes. More

specifically that the higher income classes making gains through a thorough understanding of the

companies and the poor failing to make the same return by not fully understanding the company, more

often falling into fraudulent traps. Once again turning to the data on wealth accumulated by the top

10% from 1825-1870 provided by Piketty, it is evident that the top 10% increased their share. Since we

already know this change was driven by financial and industrial wealth we can assume the wealthy drew

most of the gains from this 45 year bull market.

The dissemination of company information through the investor manual would then prove to be

the key to end unequal returns in the equity market. This is not too bold a proposition as the variance in

return post 1870 pre WW1, dropped to constrained 3.89 when foreign and British expected return (on

equity) are set equal6. (Andrey D. Ukhov and William N. Goetzmann, 2005, Table 8).

Some may find the reliance on variance data being the lynch pin in this assumption suspect. To

further solidify my inference I will appraise the risks involved with investing in industrial and financial

capital pre/post 1869. In order to do this one must consider the field of modern portfolio theory more

specifically, the expected value theorem and applying it to the two investment type’s pre/post 1869.

Assuming that investors are risk adverse, they will strive to receive returns that will pay for excess

risk. The expected value is equal to the value of an investment multiplied by the probability of that

outcome. Without going too much into the actuarial side of finance and investment theory we can

observe that the probability will become less and less accurate as the unknowns increase or are harder

to quantify. From this qualitative assumption it is easy to see that capital investments expected value is

much easier to quantify for the pre 1869 period. Thinking of capital investment as purchasing a machine

where one can examine its proper functioning before the investment is made. Thus the only risks are

business specific to the industry the machine will apply to. Conversely investment in equity during this

period was obviously less tangible, but also close to impossible to observe the risks as the company

financials were not readily available. Without knowing the financial health of the company or the

external factors it may be exposed to there is limited ability to assess risk. After the introduction of the

Investors Monthly Manual it becomes much easier for the investor to quantify risk and make informed

choices. At this point the expected value of investment in capital and equity of the same out lay will

become similarly appraisable. Now that the expected values of financial and industrial capital could be

calculated investors would be able to select investment for either sector with similar expected returns.

Proving that after 1869 investors of all incomes could receive a similar capital income relative to their

investment outlay.

It is because of the progressive changes ending in the introduction of the Investors Monthly

Manual that I would consider the London stock exchange to be fully equal and trusted for all in the year

1869. Allowing for all income classes to participate, invest and receive capital income without the huge

monetary outlay required by investments in industrial capital. One would then expect a quick and

deliberate decrease in wealth inequality around 1869.

IV

Interestingly enough the data collected by Piketty actually showed acceleration in the capital

share owned by the rich from 1870 to 1910. Thus increased capital income received by the top 10%,

increased income and thereby heightened income inequality. Running contrary to what was expected,

which begs the question, why? How is it possible that all incomes classes having the opportunity to

receive capital income widened income inequality? The simplest answer would be that the lower

income individuals didn’t take advantage of the newly just equity market. To examine the possible

explanations one must consult the field of behavioural finance.

As previously explained it is safe to assume that the lower income individuals were more often

caught in fraudulent investments or in the bubbles that ensnared much of the working class. These dark

days in the market negatively affected investor confidence making it less likely for investors to return to

the market. The war stories of lost fortunes in the market told to children enshrined the market

fraudulence in the mind of generations of low and middle class citizens. This would be an example of

anchoring, the tendency to think from a reference point, usually illogical, in the decision making process.

For example, the child of a failed investor may forever swear to avoid the equity market due to their

families past monetary loss. Their decision doesn’t reflect the realities of the current equities market

and would cause them to lose possible capital income. A second behavioural finance principle that

could explain the situation is overreaction. In a single security this would be explained by investors

reacting to bad news and pushing the share price down to a new low, which should then not change

until new information is provided. This is similar to the reaction observed during bubbles and other

negative market phenomena. Investors seemed to discount the market as a whole deciding toward a

wait and see approach, where only constant good news would change their minds allowing them to

invest once again. Lastly prospect theory may explain the more emotional side of low participation. The

theory states that investors tend to have a higher emotional response to losses than to a proportional

gain. Since the majority of this income class received low or negative returns prospect theory would

state these losses would provide an extreme negative response, possibly creating an investor who could

no longer handle the market as a whole causing them to remove funds. In all cases a psychological

tendency would have compelled the market participants’ action to remove funds and all together avoid

the market forgoing future capital income. Needless to say those who have lower earnings will find

capital losses more painful to their bottom line than those of higher earnings.

The age old phrase, time is the healer of all wounds, seems to be especially true in the case of

equity markets. As represented by Pikettys chart the capital share received by the top 10% significantly

decreases after WW1 and WW2 decreasing by about 20%. Piketty explains the final decrease in

accumulated capital by the rich as due to the inauguration of a tax on capital income during WW1 and

the emergence of a thicker middle class, among others. The taxation doesn’t seem like a reputable

answer as it would affect all incomes similarly and forgoing an important source of income simply due to

small taxation and doesn’t seem like the actions of utility maximizing and rational consumer. The

increase in the middle class does however represent an increase in the number of citizens who could

afford to invest in equity markets. Work done by Martin also indicates that during 1920 real wages

increased representing a surge in disposable income (Martin, 2007, Tbl. 12.3). Meaning there was an

increase in the amount of British workers who could now afford to invest a portion of their earnings

than in previous years. With the tragedy’s’ of the war firmly planted ahead of the fortunes lost in post

market failures, one could assume the psychological traits that were previously hindering market entry

were all but removed. The inauguration of the old age pension in 1908 may have also contributed to

increase investment. With this land mark social welfare reform citizens began to think longer term and

realized the need to invest to receive enough income to last through retirement, a new concept. With an

increase in the middle class investor base, their ability and the willingness to enter the equity market,

wealth was swiftly apprehended from the hands of the rich, as seen in figure 4.

Figure 5: Income Share Over time. Source: The Equity Trust

V

Although there was a significant lag between the decrease in the top ten per cents’ wealth

accumulation and the emergence of a just equities market it is assured that equities markets and more

specifically, the London Stock Exchange did truly represent equal opportunity for all to receive capital

income hence closing the gap in income inequality. As shown in figure 5, income inequality did

significantly decreased from the 1930s up to 1979. One explanation for this decrease could be the

emergence to equal access to equities markets and a more inclined and active middle class investor

group. The precipitous increase in inequality from 1979 to the present, forming much of today’s political

fodder may derive its solution from the past triumphs of capital income among the middle class investor

from 1910-1970’s.

Notes

1) It is assumed that individuals in each income class are working fulltime at the average rate applied to their income class. Historically, with the exception of the 1990’s-2000’s, inequality hasn’t been driven by a polarization in earnings. By simply examining the rate of change in earnings, over a specified period, this becomes enormously evident. The Earning differential that took place in the1990’s- 2000’s can mainly be attributed to the loss of manufacturing and other low skill middle class work and the increase in demand and hours worked of more skilled labour (Stewart, 2016, lecture 5).

2) It is worth noting that an increase in the yearly earning will change the income of an individual by an equivalent ratio, but over this period there was no substantial change in earnings and over the long view, wage disparity is extremely low. Thus it is all but assured that only capital will fluctuate and there by alter the individuals income.

3) It is understood the current pound value is not the value in 2016 but in 1983. This was necessary due to the timing of the release of Lindert’s paper and there by his “current” Values. Thus to properly compare the prices I used the current value during the same period. The measuring wealth site using Lawrence H. Officer and Samuel H. Williamson formulas allowing me to provide this value in 1983 terms.

4) Under the pretence it seemed most appropriate to use the labour value associated with cost. This value is the cost associated with the earnings a worker would need to purchase a basket of items during this time then indexed and varied for value of purchase.

5) Note that it only lasted until 1929 but at this point there were significant other options to receive news and information about the company one was investing in. That is why its death wouldn’t change the level of openness in the market.

6) Setting the expected value equal allows investment to flow through each on a level that would have been seen during the industrial revolution when access to foreign equity was to a lesser extent available

7) Variance = square root of the standard deviation. Variance and standard deviation are closely related and essentially both measure variability, or the spread of data points. I left the standard deviation number for the sake of keeping data raw, but speaking of variance and using standard deviation numbers should be understood.

8) Piketty refers to income here but it is understood he is talking about all non-capital income, as he later states “the inequality r > g implies that wealth accumulated in the past grows more rapidly than output and wages” (Piketty, 2014, pg.571)

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