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Both Democrats AND Republicans are wrong about this

Democrats think that the solution to rampant income inequality is to tax the rich. To be fair, Democrats think the solution to a leaky faucet or an insolent child is also to tax the rich but I digress. Republicans don't even seem to acknowledge that income inequality is much of a problem. Both sides are wrong.

Income inequality has become a major problem and continues to get worse. Historically, if this problem is allowed to progress to unacceptable levels, it ends with a violent reboot. To anyone who thinks that there is zero chance of "nobles" being beheaded in the town square, I would say there are volumes of history books that would disagree.


Tony Bums | Lonely Planet Images | Getty Images

Most of the rhetoric we hear regarding wealth inequality has two things in common: 1) it's politically motivated 2) it contains just enough truth as to not be considered an outright lie. Unfortunately this serves to confuse the issue and, it needs to be addressed immediately because I want to keep my vacation home — and my head.

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Of the many factors that have contributed to the dramatic increase in income inequality, the most significant has been a steady decline in interest rates from late 1981 to their current levels. In 1981, the yield on a 2-year Treasury note was 16.5 percent. A decline over more than three decades has left 2-year yields at a current level of .35 percent. When we subtract the 11-percent inflation rate in 1981 and the current 2-percent inflation rate we get a "real rate" of 5.5 percent in 1981 vs. -1.65 percent currently.

This march to negative rates has been the primary driver of wealth inequality by altering key economic and behavioral trends. Critics of the Federal Reserve correctly claim that inorganically low interest rates effectively transfer money from retirees searching for safe investments to banks in the form of cheap funding. Unfortunately, this only scratches the surface. Here's are other effects of low interest rates:

1. They tend to inflate assets held disproportionately by the wealthy, like real estate, stocks and bonds. The S&P 500 has risen 1571 percent (from 116 to 1885) since 1981.

2. They have inarguably fueled two asset bubble-bust cycles. A normal pattern of these cycles is to draw in the weakest money at the latest stage of the boom phase. Then, as the bubble bursts, these late comers are disproportionately punished after having purchased the asset at wildly inflated levels. The typical buyer in the late stage boom cycle is a person with limited assets and has used leverage in the purchase. In the bottoming phase of the bust cycle, severely undervalued assets are then purchased by those in good financial shape. The depressed assets then return to more normal price levels completing a transfer of wealth from those that can least afford it to those who are already much higher on the relative wealth scale.

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3. They tend to drive up the prices of energy by increasing speculation. Costs of food and energy tend to eat up a far greater portion of the incomes of the lower and middle class. As an example of this phenomenon, oil prices have increased 700 percent since the mid 1980's despite relatively low inflation elsewhere. (Proving that food prices have risen will present a slight challenge as current tools don't distinguish between premium and mass-produced food products.)

4. They dramatically discourage savings in favor of consumption. This tends to encourage and reinforce a short-term pattern of borrow and buy over traditional, long-term savings. Oddly, it took ten years before we saw this behavior significantly accelerate. Perhaps because, although rates were declining in the 1980s, they were coming from historically high levels and didn't reach single digits until the early 1990s. The proliferation of SUV sales serve as a perfect metaphor for the accelerating consumption economy of the early 90s. The material change in lifestyles in the U.S. in the early nineties can be graphically represented in charts of many different things. For example, stock prices, contracts for athletes and musicians, consumption of sugar, imported foods, bottled water and countless other trends.

5. They provide incentive for companies to invest in technology at the expense of labor.

6. They provide incentive for companies to buy back shares creating a further concentration of wealth at the executive level.

7. They increase corporate and individual risk-taking that generally manifests itself in increased levels of acquisitions by corporations. This creates companies that use efficiencies created by scale to streamline operations and eliminate jobs made redundant. Wealth is then concentrated at the executive level. Over time, this also creates the "too big to fail" phenomenon that's is far to prevalent today.

Here's an example of how increased individual risk-taking plays out over long periods of depressed interest rates:

Imagine there are 12 people who each have 100,000 of investable money. Psychology suggests that several of these people have a genetic predisposition for risk-taking, let's assume that number is four. Let's also assume that four of these people are genetically risk averse. That leaves the middle four people who have a more neutral attitude toward risk. These 12 people are each approached with an investment opportunity that has a 33-percent chance of succeeding, in which case your money would increase by 400 percent.

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Each investment opportunity is individual for each person in terms of success or failure. If, however, the investment fails, you would lose your entire amount of investable money. In an environment that offered normal "risk-free" interest rates, I think we could expect the following: All four of the risk takers would opt for the investment opportunity because of its risk-reward ratio. We also could assume that all four of the risk avoiders would shun the investment in favor of the safe rate. Let's assume that the middle four then split 50/50 on the investment. The net result of this model would be that two of the 12 would have 400k, six of the 12 would have 100k (+ the safe rate) and four of the 12 would have nothing left.

Now let's look at that same model in an environment where the "safe rate" has been eliminated as an option. Keep in mind that there is no arguing the fact that the Fed has intentionally and admittedly engineered an environment that forces money further out the risk spectrum by eliminating a safe rate of return in order to spur economic activity. I think it's safe to assume that all of the middle four will, over time, grow tired of earning a paltry safe rate and opt for the more risky investment. The behavior of the most risky and least risky would probably stay the same. The most favorable net result of this example would be that three (2.64) of the 12 would have 400k, four would have 100k plus the safe rate and five would have nothing.

In the first example, a net initial aggregate total of 1.2 million is turned into 1.4 million. In the second example, a net initial amount of 1.2 million was turned into 1.6 million. However, in the second example wealth is more concentrated at the top -- and there is a greater number of those left behind.

Although this particular example is hypothetical, a similar scenario plays out everyday in an extended period of low rates. I bought a restaurant in early 2012. This was a decision I would never have made had I been receiving 7 percent to 9 percent on safe interest-bearing instruments.

There are several other significant causes of growing wealth inequality. Among those are increases in information and communication technology that allows a company or individual a far greater distribution area for their product or their service. Also, the development a more global economy combined with currency manipulation fueled an exodus of 22 million U.S. manufacturing jobs and a resultant disappearance of packaging and transportation jobs. These types of jobs have historically bolstered a vibrant middle class.

There have also been significant social changes that have fueled wealth inequality.

Most significantly, a dramatic shift in family structure to a point where 53 percent of babies born to women under 30 years old, are born into a single-parent family. Households headed by single parents are far more likely to struggle financially.

Finally, the women's movement that began in the 60's has fueled a movement of family formation characterized by two highly educated and earning parents in opposition of the one bread winner model of the 1950's.

The purpose of this is not to dismiss any of these factors. These particular factors have been adequately identified and covered, whereas the interest-rate portion has not despite its position at the top of the list.

Then there's the relationship between government fiscal policy and Fed monetary policy. As Chairman Ben Bernanke implied often, aggressive monetary policy is necessary to counterbalance fiscal inaction. Our current corporate tax structure, for example, provides obvious incentive to offshore capital and production, slowing an already sluggish recovery. Easy money tends to cushion the blow of this bad policy decisions providing little incentive to correct it. So the negative cycle has a tendency to continue drawing us nearer to a point of reckoning.

Commentary by Jim Iuorio, managing director at TJM Institutional Services. Iuorio is a 27-veteran of financial markets, where he has traded and provided analysis for large institutional clients. Much of his focus has been on rate policy and its effects on equities, commodities and U.S. Treasurys. Follow him on Twitter @jimiuorio.

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