The Private Sector and Inequality
The private sector can contribute to inequalities in terms of influencing the distribution of risk and return between stakeholders. Workers assume significant risk and likewise contribute to value creation. However, their “social” or “human capital” is often undervalued and therefore rewarded much less than financial capital. Investors can also contribute to inequality in their decisions about where to allocate financial capital, and how to price risk. Often smaller companies and developing markets face an uphill battle to grow because of structural preferences across institutional investors for larger companies and asset managers, as well as more developed markets.
On the other hand, investors and companies can also alleviate inequalities. Several companies are exploring models of sharing equity ownership with workers and communities. These strategies offer strong paths for stakeholders to be compensated for the risk that they take and the value that they create, building wealth alongside executives and investors.
Diversified investors who sit at the top of the “capital markets value chain” – like pension funds, endowments, and sovereign wealth funds – have an incentive to reduce socio-economic inequality. Their portfolios are so broad across geographies, industries, and asset classes that their financial success is dependent on the health of the economy. Inequality has been widely observed to lead to secular stagnation and poor economic conditions, including undesirably low interest rates – thus threatening these investors’ portfolios.
Asset Bubbles and Credit Crises
The marginal propensity to spend of the wealthy is much lower than that of the poor. Thus, when a few individuals in the economy have such extreme wealth, they tend to invest and lend the balance of what they don’t spend. Meanwhile, to finance daily needs and basic consumption, the less well-off may become dependent on the “cheap” debt that has become available.
Low interest rates are also taken advantage of by businesses and investors who may take on significant leverage to magnify equity returns. But too much leverage is dangerous. Under the burden of high debt, many companies do not have the financial resources to offer quality jobs and quality and affordable goods and services. With weak balance sheets, they may also be unprepared for economic downturns, unexpected shifts in market dynamics, a need to raise interest rates, or other dynamics that threaten debt coverage. Restructurings may require mass layoffs, and in essential sectors such as healthcare, nursing homes, and water, for instance, consumers and end-users may be unknowingly assuming significant risk.
The very market dynamics that contribute to inequality may thus also contribute to credit crises (due to both high corporate and household debt) and asset bubbles (due to low interest rates and market concentration).
The Role of Policy Makers and Regulators
Private sector actions that deepen inequalities make the jobs of central banks and financial stability regulators harder. Professor Atif Mian at Princeton University and several of his peers refer to the related rise in debt burdens as a “debt trap,” as it becomes difficult for central banks to raise interest rates if needed. Moreover, rising social tensions relating to disenfranchisement and polarization jeopardize financial markets. For instance, France’s sovereign credit rating was recently downgraded over apprehensions about social unrest and political paralysis.
In light of these challenges, it is imperative for central banks and financial regulators – who bear the responsibility of ensuring financial stability – to consider how socio-economic inequalities can pose micro- and macro- financial risks to the resilience of the financial system. This becomes even more crucial in the midst of a ‘polycrisis,’ where climate change, biodiversity loss, health crises, and geopolitical tensions are converging.
UNDP, together with the Predistribution Initiative and a group of institutions, has released a paper, From Fragmentation to Integration: Embedding Social Issues in Sustainable Finance, that aims to generate momentum within the financial system to tackle inequality and social risks. The paper provides key recommendations for governments, regulators, and financial institutions to support research on the systemic risk of socio-economic inequality to financial stability; adopt and improve social disclosure standards and risk management tools; and rethink the macroeconomic determinants of sustainable finance.
This paper highlights how addressing inequality can also unlock needed pathways to address climate risk and nature loss. Resistance to climate solutions in developed markets often comes from a sense of economic insecurity, for instance with legitimate fears that a carbon tax will increase fuel costs for middle class households or that clean energy jobs will lack protections. Other dynamics manifest in developing markets, where the promise of economic growth often depends on consumption of natural resources and access to regenerative financing. Addressing inequality means a more balanced consumption of resources across all stakeholders globally – not so much by some and so little by others – so that human beings everywhere can thrive on a healthy planet.
UNDP and the Predistribution Initiative are part of the Informal Working Group of the Taskforce on Inequality and Social related financial disclosures (TISFD). In the process of developing recommended disclosures, metrics, and targets, TISFD is being designed to help private sector actors and their stakeholders understand socio-economic inequality as a source of system-level risk. More broadly, the framework is expected to help investors, companies, and their stakeholders (including policy makers and regulators) understand private sector impacts, dependencies, risks, and opportunities relating to social issues. This can help enable structural changes in the way finance is channeled.
The paper outlines a number of additional opportunities which we will continue to explore, and we invite the Business Fights Poverty community to join us. For more information, please contact Camille Andre and Predistribution Initiative