By Blair Fix at Economics from the Top Down

2023, April 16

[I]nterest rates are, first and foremost, a distributional variable
that affects the income shares of various social groups.

— Louis-Philippe Rochon & Mark Setterfield (2007)

When I read about monetary policy, I have a rule of thumb. Every time I see the phrase interest rate, I replace it with the term wage rate. Then I ask myself whether the discussion still makes sense. Often, it does not.

The reason I make this substitution is that in conceptual terms, the interest rate and the wage rate are similar: they are both rates of return. Wages are the return on employment. Interest rates are the return on credit.

Now, the important thing about rates of return is that when we change them, we are toying with the distribution of income. Hike wages and we send more income to workers. Hike the rate of interest and we send more income to creditors. Sure, the specifics of this redistribution are open for inquiry. But by definition, rates of return are ‘distributional variables’ — they determine how the income pie gets divvied up.

Back to my word substitution. When it comes to wages, the issue of distribution is typically front and center. That’s why talk of a minimum-wage hike prompts businesses (and many economists) to complain about reduced profits. But when creditors hike the rate of interest, talk of income distribution is curiously absent. Instead, we get a barrage of macroeconomic jargon — terms like the ‘natural rate of interest’ and the ‘non-accelerating inflation rate of unemployment’.

Why the discrepancy?

One possibility is that economists know something that we don’t. Perhaps they’ve looked at the evidence and concluded that interest rates have a ‘neutral’ effect on the distribution of income.

Another possibility is that the macroeconomic jargon is mostly a distraction. In other words, like wages, the rate of interest is a ‘distributional variable’. But it’s one that mainstream economists prefer to ignore.

So which option is true? In this post, I let the evidence speak for itself. Looking at cross-country evidence, I find that interest rates are decidedly non-neutral. As interest rates rise, three things happen:

1. the interest share of income increases;
2. the labor share of income decreases;
3. income inequality increases.

In short, the evidence suggests that interest rates play a key role in the game of class warfare. And that makes sense. Interest, after all, is a rate of return. And when it comes to divvying up the income pie, rates of return are always zero sum.

How economists learned to ignore the distribution of income

Before we jump into the income-distribution data, it’s worth reviewing some history. Among heterodox economists, the distribution of income is a hot-button topic. But among mainstream economists, it remains a secondary concern. Why?

To understand this apathy, we need to retrace the trajectory of economic thought. When the study of political economy got rolling in the 19th century, the distribution of income was front and center. For early political economists, what mattered most was class-based income. Why did land owners, capitalists, and workers receive their respective cuts? So crucial was this question that David Ricardo deemed it the ‘principle problem in political economy’.

As the 19th century played out, thinkers like Karl Marx and Henry George recognized that distributing income involved obvious conflict. For example, if Alice the worker and Bob the capitalist both want a 60% cut of the pie, only one of them can get their way. In other words, the zero-sum nature of class-based income necessitates class warfare. Or rather, it necessitates class warfare, supposing that the various classes want more than their current take.

Enter John Bates Clark. Seeing the instability involved in class struggle, Clark wanted to show that conflict was unnecessary. And he found an ingenious way to do it. With a few swift assumptions, Clark ‘proved’ that in a competitive market, each agent gets back the amount of wealth which that agent created. Thus was born the theory of ‘marginal productivity’, which tells everyone that they earn what they deserve. The message? In market economies, class struggle doesn’t exist.

Of course, Clark’s theory is based on assumptions that are obviously false. (For example, you must assume that society produces a single commodity.) So the real question is why economists settled on a theory that was clearly wrong.

Here’s my take.

First, Clark’s theory of marginal productivity told powerful people what they wanted to hear — namely, that the distribution of income is ‘just’.

Second, Clark’s approached gelled nicely with the emerging obsession with economic growth. In the mid 20th century, economists found that if they treated all of society like a single firm, they could use a production function to ‘explain’ economic growth.¹ Importantly, this function assumed not only that each class earned their ‘marginal product’, but that their income shares were constant. In other words, when modeling economic growth, economists could treat the distribution of income as a non-issue. And so they did.

Of course, the larger backdrop is that following World War II, humanity massively increased its consumption of resources — a pattern that had nothing to do with economists’ models and everything to do with the exploitation of fossil fuels. But like everyone else, economists came along for the ride. And so they got obsessed with economic growth, and learned to ignore the distribution of income. Figure 1 illustrates this ideological shift as it is written in English word frequency.

Looking to the coming century, my guess is that economists will eventually rekindle their interest in the distribution of income … but only because they will be forced to. As the fossil-fuel era wanes, economic growth will become a relic of the past. And so economists will be dragged back into the business of studying how the income pie is divided. In this post, we’ll get ahead of the curve.

The national income pie

Jumping into the study of income distribution, today we have excellent data on how the income pie is divvied up. And that’s somewhat ironic.

You see, the income data largely comes from the national accounts, which were designed as tools for measuring economic ‘production’. Here’s the irony. Because the national accounts are based on monetary transactions, they are a dubious measure of ‘production’. But they are a good measure of income.²

To study the distribution of income, we do the opposite of what most economists do. Instead of using the national accounts to look at the size of the income pie, we measure the pie’s composition. Typically, that means splitting the pie into five categories of income:

1. employee compensation
2. profit
3. proprietor income
4. rent
5. interest

To give you a sense for the size of each income category, Figure 2 shows the US income split in 2021.

Looking at these income categories, we naturally want to know where they come from. Economists have an answer. They claim that each class represents a ‘factor of production’.

This jargon reflects economists’ love of equating income with ‘production’. I advise you to ignore it. The reality is that the various classes of income are legal constructs. In other words, the law defines different forms of property rights. And from these rights stem different categories of income.

For example, people who own corporations by definition earn ‘profit’. People who own unincorporated businesses by definition earn ‘proprietor income’. People who own physical and/or intellectual property earn ‘rent’. People who own debt earn ‘interest’. And people who own nothing earn ‘wages’.

Are these different types of property rights arbitrary? Yes. But in some sense, rules are always arbitrary. What matters is that these property rules are heavily enforced, which means that they dictate the terms of class warfare.

The interest share of income

Speaking of class warfare, let’s talk about the rate of interest. As Rochon and Setterfield put it, interest rates are primarily a “distributional variable that affects the income shares of various social groups.” That’s a subtle way of saying that interest rates are a tool for waging class war.

On this fact, the evidence is quite clear. But before we get to the data, let’s frame the battle. In the national accounts, interest income is tabulated as ‘net interest’. (The ‘net’ part means that when adding up interest payments, statistical agencies subtract interest received from interest paid.)

Returning to Figure 2, we can see that net interest is currently the smallest slice of the US income pie. But don’t be misled by this recent data. When we look at US history, we find that the interest share of income is extremely volatile.

Figure 3 tells the story. Here, the red curve shows the interest share of US national income. Over the last 120 years, it varied from a low of 1% (in 1946) to a high of nearly 10% (in 1982). What explains this variation? Well, the trough and peak of the interest share of income correspond to some important geopolitical events (the end of WWII in 1945 and the stagflation crisis of the early 1980s, respectively). But in more abstract terms, the interest share of income is dictated by something simpler: the rate of return on credit.

In Figure 3, the blue curve testifies to the connection between the interest share of income and the interest rate. This curve shows the long-term history of US bond yields, which rise and fall with the interest share of income. And bond yields, if you’re unfamiliar, are a way of measuring the return on credit — otherwise known as the rate of interest.

Summarizing the evidence, it appears that Rochon and Setterfield are correct to call interest rates a ‘distribution variable’. We can think of the rate of interest as a dial for setting the interest share of income.

That said, it’s unwise to draw sweeping conclusions from studying a single country. So before we declare interest rates an income-share dial, let’s widen our net.

To do that, we’d ideally look at data for a huge sample of countries. But the problem with this approach is that income-share data is not widely reported. (This data scarcity stems from the fact that economists mostly care about the size of the income pie, not its composition.) To date, I’ve been able calculate interest-share data for a handful of OECD countries covering the last two decades. This sample is not great. But it’s enough for a consistency check.

On that front, Figure 4 shows that the OECD data fits with the pattern found in the United States. Across these countries, the interest share of income rises and falls with the rate of interest.

My debt, your income

So the interest share of income is controlled largely by the rate of interest. Is that surprising? In some sense, no. If we had to pick a rate of return that set the interest share of income, the interest rate is the obvious candidate. Yet when we reflect on how creditor income is determined, the primacy of interest rates is not obvious.

You see, creditor income is shaped jointly by the rate of interest and by the amount of outstanding debt. And taking a cue from individuals, we know that the level of debt can vary immensely. For example, my friend Alice owns $10 of debt. But her friend Bob owns $10 billion of debt. Who earns more interest income? Obviously Bob.

The point is that debt liabilities vary far more than the rate of interest. So it should be these liabilities (and not the rate of interest) that determine interest income. At least, that’s how it works for individuals. But for some reason, when we switch to countries, the scale of debt liabilities somehow comes out in the wash, leaving the rate of interest as the main dial for setting the interest share of income.

How does that work?

The answer is that at the national level, debt liabilities can’t be any old number. These liabilities are tightly coupled to aggregate income. Figure 5 shows the pattern in the US. Over the last two centuries, total US debt grew at about the same rate as nominal GDP (a measure of aggregate income).

So why are debt levels coupled to national income? Well, if you’ve familiar with how money is created, you’ll know that there is a straightforward answer: debt is a prerequisite for income.

You see, to have income, there must be money in circulation. And to have money, there must be debt.³ That’s because most money is loaned into existence by commercial banks — created via the magic of double-entry book keeping.

Here’s how it works. Starting with nothing, a bank lends you money by inserting digits into your bank account. That’s your debt. On the other side of the ledger, the bank records a corresponding credit, causing the operation to look fiscally neutral. But the reality is that money has been created. When you spend your loan, your debt becomes someone else’s income. Presto, debt creates income.

With this income creation in mind, let’s return to the interest share of income. Because total debt grows at roughly the same rate as total income, it follows that creditors’ share of the pie is determined largely by the rate of interest. (For the math, see the appendix.)

Now let’s take this thinking one step further. Since debt is a prerequisite for income, we can think of the interest rate as a kind of royalty on income. Like all royalties, interest stems from the enforcement of property rights. It’s just that in the case of interest, the property concerned is perhaps the most important public good — the right to create money.

The labor share of income

Turning to other forms of income, we know that by definition, when the interest share of income rises, other income shares must fall. Let’s have a look at these clawbacks.

I’m going to focus on the labor share of income. That’s because (1) the labor share of income is an important income category, and (2) I can actually get widespread data for this share.

Labor foibles

So what is the ‘labor share of income’. Well, it’s obviously the income share paid to laborers. But then who is a laborer? I raise the question because mainstream economic theory taints the data that I’m going to use.

To start with, I think we can agree that wages and salaries are ‘labor income’. But what should we do with proprietors — people who are self-employed? I’d prefer to either lump all of their income into the ‘labor share’, or exclude all of it.

Mainstream economists, however, do something that makes me cringe; they take proprietor income and divide it into a ‘labor’ component and a ‘capitalist’ component. The thinking is that a portion of proprietor income stems from working, and another portion stems from owning capital. In other words, economists attribute proprietor income to different ‘factors of production’.

This division is ridiculous. Like all remuneration, proprietor income stems from a legal classification, nothing more. Anyway, I rant because the data that I use contains this dubious division of proprietor income. So keep that in mind as we review the results.⁴

Eroding the labor share of income

Returning to interest rates, we know that they are the main dial that controls the interest share of income (Figure 4). And since a growing interest share of income cuts into the other pieces of the pie, it seems plausible that interest rates might affect the labor share of income.

Now, when I say ‘affect’, this implies causation. But in strict terms, I’m going to looking for an ‘association’ between the rate of interest and the labor share of income. We can sort out causation later.

Turning to the data, I’ve assembled an international dataset that compares the labor share of income (within each country) to the rate of interest (again, within each country). Figure 6 shows the resulting pattern across countries. Our hunch seems to be correct. Higher interest rates are associated with a lower labor share of income.⁵

Once more, it seems that Rochon and Setterfield are on the mark when they call interest rates a ‘distributional variable’. Not only do interest rates affect the interest share of income, they also seem to affect the labor share of income.

In fact, the relation may be almost mechanical. If we assume that a growing interest share of income cuts directly into the labor share, then we automatically get the kind of pattern shown in Figure 6. (For details, see the appendix.)

Income inequality

Chugging along, let’s look at one last form of income distribution — the income share of the top 1% of earners.

At first glance, the top 1% share has little to do with the class-based income that I’ve discussed so far. After all, the legal category of your income tells us nothing about its size (large or small). And since income size and income class are seemingly unrelated, there’s no reason to suspect that interest rates affect income inequality.

The catch is that income size and income class are related. And because they’re related, the rate of interest does affect income inequality. Let’s see how it works.

The interest-to-wage ratio

When it comes to interest income, the old adage is correct: it takes money to make money. And so it’s a good bet that if you earn more income, you’ll have more money to invest, hence you’ll earn more interest.

To flesh this thinking out, let’s look at the relation between income size and income composition. Specifically, I’m going to calculate something that I call the interest-to-wage income ratio. This ratio takes the income that an individual earns from interest and divides it by the income that they earn from wages/salaries:

interest-to-wage ratio= interest incomewage incomeinterest-to-wage ratio=wage income interest income​

For most people, the interest-to-wage ratio is small, since their wages dwarf their interest income. But for a few individuals, interest is a significant source of money. As it turns out, these individuals also happen to be top earners.

Figure 7 shows the pattern in the United States. Here, the horizontal axis ranks Americans by their income percentile. The vertical axis plots their interest-to-wage ratio. You can see that as we approach the upper crust of earners, interest income explodes.

Now in direct terms, Figure 7 tells us about interest income. But indirectly, it tells us about the distribution of credit. You see, as a first approximation, the rate of interest doesn’t vary much between investors. And so the trend in Figure 7 must be driven by the ownership of credit. Therefore, we can conclude that top earners own far more credit than the rest of us.

With this credit distribution in mind, let’s think about what happens when we raise the rate of interest. Doing so sends money to people who own more credit. And the people who own more credit also happen to be top earners. And so what do interest-rate hikes do? They send money to the rich.

(Actually, the math is a bit more complicated than I’m making out. See the appendix for details.)

To summarize, there’s good reason to suspect that higher interest rates might worsen inequality. So let’s see if they do.

Interest rates and the top 1% share of income

With inequality in mind, let’s look at Figure 8. Here, I’ve gone to the World Inequality Database and downloaded all of their data for the top 1% share of income within countries. Then I’ve merged this data with interest-rate time series, and plotted the result. As you can see, the pattern is fairly obvious. Across countries, higher interest rates are associated with greater income inequality.

Now, the caveat here is that the inequality pattern is non-linear. As interest rates increase, the top 1% share grows — but only to a point. Why? Well, if we assume that changing interest rates operate on a fixed distribution of wages and credit, then this type of non-linear pattern is exactly what we expect. (For details, see the appendix.)

Specifics aside, it’s clear that income inequality is related to the rate of interest. So again, Rochon and Setterfield are correct to label interest rates a ‘distributional variable’.

The average sabotage

All in all, the evidence shouts at us that the rate of interest affects the distribution of income. Of course it’s nice to have this empirical confirmation. But then again, the ‘distributional’ nature of interest rates was never in doubt. As a rate of return, interest rates are by definition a ‘distributional variable’. Or in more incendiary terms, interest rates are a weapon of class warfare.

Now, this language might sound hyperbolic, but I think it’s accurate. Contrary to what neoclassical economists claim, there are no neutral market forces that allocate income in proportion to productivity. Instead there are only ideas and the power to implement them. In other words, people have ideas about what their income should be (and also what other people’s income should be). And they have the power (or lack thereof) to make these ideas a reality. That’s it.

So viewed through the lens of power, rates of return are, by definition, outcomes of social conflict. Still, this vantage point doesn’t get us very far in understanding real-world outcomes. It’s like saying that animal behavior is an outcome of evolution. It’s true. But it’s only the starting point for a scientific explanation.

On that front, how should we study the class struggle involved in interest income? For Marx, the answer was that interest is about inter-capitalist competition. Interest payments, Marx argued, transfer to the ‘money-capitalist’ some of the profits received by the ‘industrial capitalist’.

Although I admire the simplicity of this approach, it implies that we can cleanly divide between ‘industrial’ and ‘money’ capitalists. And by extension, Marx’s view implies that profit is earned from ‘productive’ activities, whereas interest stems from the unproductive ownership of money.

Faced with this Marxist division, capital-as-power theorists Jonathan Nitzan and Shimshon Bichler think that it misses the point. Looking at capital, they argue that all of it is unproductive. That’s because capital is nothing but the quantification of property rights. And property rights, in turn, are inherently negative; they are an institutional act of exclusion. So in that sense, profit and interest both stem from enforced exclusion — what Nitzan and Bichler call strategic sabotage.

Viewed this way, profit and interest represent different tactics for inflicting sabotage:

[I]nterest on debt represents average sabotage, while profit on equity denotes differential sabotage.

(Nitzan and Bichler, 2009; emphasis added)

Unpacking this claim, the idea is that when you purchase equity in a specific company, you are investing in that company’s ability to wield property rights for your benefit. And because you hope that this company will beat the average rate of return, you are investing in ‘differential’ sabotage.

With debt, however, you’re not investing in any specific set of property rights. Instead, you’re buying access to an average return on all property rights — the average sabotage.

Clearly this thinking is a world away from mainstream macroeconomics, which views the rate of interest as a variable for bringing ‘financial markets into equilibrium’ (Gregory Mankiw’s words).⁶ But we should expect as much. The core of neoclassical economics has always been to paper over class conflict.

By using language like ‘sabotage’, Nitzan and Bichler emphasize the conflict involved in setting rates of return. Now whether the rate of interest represents the ‘average sabotage’ is something that we can debate. But one thing seems clear: when it comes to distributing income, interest rates are not ‘neutral’.