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Tuesday, September 7, 2010
the end of influence

Something very big changed in America between the post-World War II generation and the present time: That particular something was the distribution of the money generated by the growth of the American economy. In the first postwar generation, 1947 to 1973, American labor productivity—average output per hour worked—doubled (growing at a rate of about 2.5 percent per year). Median income—the income of the average American, the American sitting on the fifty-yard line—rose at the same rate; it too doubled. As a society, America marched into prosperity in unwavering ranks, everyone advancing at the same rate. And Americans also managed to save about 7 percent of GDP each year.

Over the next thirty-plus years, from 1973 to 2005, productivity grew at a somewhat slower rate. Nevertheless, the awful decades of the 1970s and 1980s were offset by strong growth in the high-tech boom years of the 1990s, and overall labor productivity still increased by two-thirds or so. But the American middle class got almost nothing of that gain. The incomes of those smack in the middle of the American income distribution increased by only 14 percent over thirty years, and almost all of that gain had come in the late Clinton years of 1995 to 2000. Simultaneously, American savings (income minus spending) dried up completely: a phenomenon not seen since the Depression.

While the median American male's top income stayed flat from 1973 to 2005, the gain went to the topmost reaches of the top 10 percent. The ratio of the top 1 percent to the middle fifth went from 10 to 26 times. What caused the change? A set of forces that include:

  1. An unprecedented rise in asset values: The Dow Jones Industrial Average rose at about 1.3 percent per year between 1960 and 1980 (and that is not adjusted for inflation). Over the next twenty years, 1980 to 2000, it rose tenfold—1,000 percent. Whatever we may hear about America being a nation of shareholders, shareholdings are radically skewed toward the top: The top 10 percent owns 77 percent of all stocks. And the holdings are steeply skewed within the top 10 percent: The top 1 percent of American households owns one-third of all stocks, the next 9 percent owns 43 percent, and the remaining 90 percent of Americans owns 23 percent (including 401[k]s). Housing prices also rose, and the wealthiest families own the biggest houses and benefit disproportionately from the advantageous tax treatment lavished on home ownership.

  2. Government policy: Under Eisenhower, whom no one ever called a radical, top tax brackets extended up to 90 percent (snaring marginal bracket dollars from no more than about three hundred very rich people); in the 1960s, they were about 70 percent; in 1986, they were lowered to 28 percent and have moved around since, but were never pushed back up to the ranges that prevailed during the faster-growth, more equitable America of the first postwar period. They are now about 35 percent. Under George W. Bush, the government cut away at inheritance taxes (and even eliminated them entirely as of 2010, but only until January 1, 2011, when pre-Bush rates are scheduled to return unless the law is changed: The elderly rich are likely to be especially fearful around Christmas 2010). Inheritance taxes affect only the top 1.5 percent.

  3. Immigration: Huge, recent waves of unskilled immigrants, legal and illegal, compete for low-wage jobs, pulling down the bottom of the income scale.

  4. Imports and offshoring: The influx of imported goods pushed down employment and pricing power at American manufacturers, which typically paid higher wages than did the big-battalion service employers, retail and fast-food restaurants, squeezing wages. Moving industrial production offshore—even the threat to do so—holds down demands for higher wages. Offshoring, until recently confined to industrial production, is rapidly extending into white-collar jobs in such diverse industries as finance, insurance, accounting, law, and engineering—the product flows instantly through the Internet, enabling employment to relocate to places such as India and the Philippines, where comparable skills can cost as little as one-fifth of American rates.

  5. Decline of unions: Unions more or less disappeared as a major force in most of the private sector. The Reagan administration was far more successful in its war on unions than in its war on drugs, beginning with the air-traffic controller strike. And of course, increased foreign competition and the weakening of the giant, mass-production, oligopoly industries such as steel (the core of union power) combined to radically reduce unions' ability to sustain wages.

  6. Technology: It is not the production of high-tech goods, but their use in business that is often cited as an important factor that has increased inequality. Whatever the findings of econometric analyses, it is difficult to argue that the U.S. economy uses more technology than, for example, Scandinavia or Germany, where significant increases in income inequality have not been recorded.

  7. Culture: It seems to us that there has been a cumulating and massive cultural change regarding income inequality: CEO pay is a good indicator. In the 1960s, CEOs of large companies were on the top of the income pile, paid as much as thirty times the average worker; by 2000, the ratio had gone up tenfold, to three hundred times the income of the average worker. It would be difficult to argue that CEOs, or their companies, performed better in the twenty-first century—when Congress voted to repeal the inheritance tax—than they did in the postwar period. Furthermore, this increase has been exceptionally high in the United States relative to other OECD countries.
We don't weigh these seven factors for their relative importance.

Is there a connection between rapidly rising inequality, stagnant middle-class earnings, and the collapse of savings in the United States? It is very likely that these trends are all closely linked. Faced with stagnant incomes, seeing themselves falling behind those above them on the income scale, and spending their evenings watching Lifestyles of the Rich and Famous, what did the average American family do?

First, they worked more. By 2005, families in the middle fifth of the income distribution were working 500 hours, or 12 weeks, longer per year than in 1979. Most of this was due to women's entering paid employment: In 1966, 20 percent of mothers of children under three years old worked outside the home; by 1994, it was 60 percent and rising, though child-care arrangements did not improve much.

Second, they borrowed. And they borrowed bigger and bigger. Household debt rose at an annual rate of 10 percent between the end of 1999 and the third quarter of 2003. Between 1966 and 2006, this debt, adjusted for inflation, rose by almost 3,000 percent. A big hunk of the debt was for mortgages on houses; more and more Americans became homeowners, and houses, unlike families, grew bigger. But, though mortgage debt rose from about one-third of GDP in 1990 to over 80 percent now, home equity (the percentage of the house not owed as mortgage debt) fell from two-thirds of GDP in 1990 to one-half of GDP by 2006; it has, infamously, fallen since. From 1979 on, American politics seemed to be making the nightmare of nineteenth-century classical liberals—irrational pessimism—come true, as politician after politician called for caps on taxes and increases in spending, the most recent example being George W. Bush. Up until the coming of the widening of the American income distribution, such borrow-and-spend policies had little attraction to the American electorate. That changed as incomes began pulling apart in the 1970s, starting with Howard Jarvis in California in 1979 and reaching full spate with George W. Bush.

Government deficits went from a brief flirtation with zero and even surpluses (which count as savings) at the end of the 1990s into larger and larger deficits in the new century and new administration. Corporations followed suit: Corporate debt shot up by one-third to about $4 trillion between 1997 and 2007. Household debt—mortgages, credit cards, auto and student loans—went from 64 percent of GDP in 1997, to about 100 percent in 2007. What assets did Americans borrow against? Only Uncle Sam can borrow on a simple obligation to repay, and only Uncle Sam owns the printing press (as long as he borrows in dollars, that is).

They borrowed on rising asset values. Between 1960 and 1980, the Dow Jones Industrial Average rose from 617 to 824—much less than zero, once you take inflation into account. But from 1980 to 2000, the average went from 824 to 11,357—more than a tenfold increase. House prices also rose: in 1980, the average house sold for $62,000; in 2006, in went for $245,000, about a fourfold increase, with the big increases coming after 2000. And nearly everyone knew that house prices would continue to rise. The Federal Reserve, aided by China, did its part to help, cutting interest rates after the 2001 dot-com stock market bust, thereby enabling the same monthly payment to carry much higher debt. If tech stocks could no longer do it for them, Americans could still get rich selling their houses to one another.

And they could buy the houses with money borrowed, ultimately, from China. Given the unbalanced flows of goods from China to the United States, a corresponding flow of money from China back to the United States is necessary. If the Chinese produce more than they consume, someone has to buy the stuff or else production halts. If the United States is to buy more than it produces, someone (China) has to sell the stuff and lend it the money to buy the goods. The flow of goods is direct: from the manufacturer to Wal-Mart to the consumer. The flows of money, however, are indirect. In order for the individual American homeowner or customer to borrow money, someone had to lend it to him or her. And neither the government of China nor Chinese banks nor Chinese manufacturers do that directly. The flow of money is "intermediated" by the US financial system, which decides who gets to borrow and on what terms, whether for mortgages or credit card debt, for new plants and equipment, or for stock buybacks.

Over the past ten to fifteen years, finance—always an important force in the American economy and in policy making—became a dominant force, perhaps the dominant force. It dominated in several reinforcing ways: as the leading growth sector generating swelling incomes and profits; as a substantial contributor to increasing income inequality; as a shaper of business behavior, government policy, and American ideology; and, of course, as the major precipitator of the current financial and economic crisis.

As manufacturing declined as a percentage of what Americans produced—from 21 percent of GDP in 1980 to 14 percent in 2002, finance grew to fill the gap—exactly! As a percentage of what Americans produce, finance rose from 14 percent of GDP in 1980 to 21 percent in 2002. Though manufacturing declined as a proportion of what Americans produce, manufactured goods did not decline significantly as a proportion of what they buy. The difference, of course, is imported, overwhelmingly from East Asia. Finance—not manufacturing, not construction (4 percent of GDP), not the military (5 percent), not even health (16 percent) became the biggest—and fastest-growing—industry in the U.S. economy. And though just about every think tank and politician issued dire warnings about soaring health-care costs, none came forth with programs, or even warnings, to restrain the growth of finance.

By 2002, financial companies had grown to account for over 40 percent of U.S. corporate profits, up from its historical post-war average of between 10 percent and 15 percent. The 40 percent substantially underestimates finance's share of total profits, because significant proportions of the finance industry—venture funds and hedge funds, for example—are typically not organized as corporations. Moreover, the estimates do not usually include profits from the wholly owned finance subsidiaries of industrial firms such as Ford, whose financing division was responsible for all of the automobile company's pretax profits in 2002 and 2003. By 2007, the peak year, finance's profits shot up to represent 47 percent of corporate earnings.

As finance—banking in all its multifarious forms—expanded to become the leading growth sector and the biggest profit generator, remuneration in banking (earnings is the preferred euphemism) zoomed up past the other sectors. This had not always been the case; it hadn't been since the late 1920s. From 1948 to 1980, average pay in finance was pretty much the same as in other industries. By 2005, it had increased to double the average pay in the other industries, and bank tellers, of which there are still many, don't get paid very much. The top "earners" in finance, however, pocketed prodigious sums, and the next two, three, or four tiers down also did marvelously well by any standards. They were the pacesetters in America's rush to ever-greater income inequality.

The basic function of the finance system is to round up savings from all over and to channel them to the most productive use. The American financial system dreadfully failed in the performance of its key function, and it was that failure to prudently and responsibly manage the allocation of capital that transformed the fundamentally unsustainable imbalance in America's foreign trade and debt position into a financial and economic crisis of global and historic proportion.

Everyone who could participated. Top Wall Street bankers, Congress, the chairman of the Federal Reserve, the secretaries of the Treasury, the chair of the Securities and Exchange Commission and other antiregulation government regulators, the press, finance professors at business schools, fresh-grown grassroots mortgage originators, corporate CEOs, and home buyers whose undisguised ignorance rivaled their transparent mendacity. Even honest and often-self-righteous macroeconomists (ourselves as well as the great herd), studying the data that showed productivity in the United States growing far faster than in Europe, grew cautiously convinced that the deregulating, entrepreneurial, free-up-the-market American approach was yielding world-beater results. Recent studies are pointing to the possibility that fundamental difficulties in assigning values for the output of the ballooning financing industry bring into question the data that evidenced much of the superior productivity performance of the U.S. economy in recent, finance-driven years.

Corporations as well as households loaded debt onto equity. New finance theory conveniently explained that nonfinancial corporations could and should borrow money not only for productive investment, but also for buying back their own shares. And they did, in colossal amounts: In 2007, U.S. corporations bought back some $831 billion of their stock, whole-number multiples of their earnings. Of course, the tsunami of corporate borrowings used to buy back stock was a major contributor to rising stock prices and, therefore, to soaring executive incentive-based compensation. It was also a nice business for the bankers, though it left the companies financially weakened should hard times hit and earnings fall.

Finance was the driving force. It had achieved the cultural dominance that so often goes hand-in-hand with economic dominance: its gigantism and ubiquity, its tonic impact on the entire economy, its fabulous success, the sheer gushing of money, its generous funding of elected politicians, its seconding of its top executives to top posts throughout the regulatory apparatus of government, and its simple and powerful message of "let the market work its magic." It was so easy. Nobody had to take responsibility; nobody had to do anything. It all cumulated to finance's full-blown capture of government and culture. How else to explain the tepid opposition to the repeal of the estate tax that hit, at most, the top 2 percent? Though a few tried to sound the alert, day after day, up and down, in and out, in government, in the media, in society itself, no other voices were heard.

There is no limit to the list of what and who went wrong. Incentives were perverse, and this was not totally because of some fit of absentmindedness. Smart, aggressive managers of very big funds of pooled savings were marvelously rewarded by how much they could book as instant profits. This, of course, propelled their decisions toward grabbing for short-term profits and ignoring the costs of longer-term risk. It paid—wildly—to roll the dice on other people's money: One way, you, the manager, win colossal sums. The other way, you take no losses, but other people do, later, after you've cashed out.

The banks were innovative, hiring superbright math students and setting them to create derivatives, derivatives squared, and, ultimately, derivatives cubed. Permitting house mortgages and other debt to be packaged in large bundles and "securitized," the banks made synthetic debt products, thus enabling investors to buy slices (or tranches) of that debt-based synthetic according to taste: higher risk with higher returns; lower risk with lower returns. Mortgages were no longer mainly originated by local banks, which knew the local market, knew the clients, demanded serious documentation of ability to pay on the loan, and kept many of them on their own books. Now, all kinds of new mortgage brokers set up shop, sold mortgages with either insouciance or complicity to buyers who could not qualify under normal scrutiny and who could only pay their debt if the house price would continue to rise and they could flip or finance against a higher notional value. Many traditional banks adopted the new model. Why carefully check out the borrower? It's arduous and, worse, expensive to do. They wisecracked about Ninja loans—no income, no job, no assets—but wrote them, anyway. Wall Street, where the product was stuffed into long, limp casings and then sliced—and the slices were sliced and etherealized into mathematical functions —did little, if anything, to make sure that its product would pass sanitary codes.

No finance "FDA" insisted on carefully examining and testing innovative financial "food and drugs." The regulators did not regulate very eagerly, thoroughly, or energetically; they were, as usual but also by design, understaffed. And now they were run at the top by political appointees who were outspoken in their commitment to cut away the morass of regulators and regulations that inhibited market innovation. The attitude of the regulators mirrored that of political Washington: Cut back interference in the market.

It would take a brave banker to refuse to play and watch competitors rake in vast profits not just for a few quick weeks, but year after compounding, marvelous year. He would not only have to be brave and preternaturally confident, but very well defended. The board would clamor for returns at least comparable to competitor banks, and the market would reward their zeal and, presumably, severely punish any lack of it. Chuck Prince, the CEO of Citi, seems to have understood what was going on. He famously remarked: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

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