I recently published a very (very) long post on the subject of income inequality (which I encourage you to read!). Given its length, I thought it might be helpful to readers to publish a shorter, Cliffs Notes version. Here goes.
The dramatic increase in income inequality over the past several decades is one of the most important issues facing the U.S. and the world today. Rising income inequality has led to the election of President Trump, the Brexit outcome in the U.K. and the growing popularity of populist, isolationist, fascist and socialist leaders around the world. It has also resulted in a backlash against capitalism. And while the topic of income inequality is increasingly at the forefront of both mainstream media coverage and economic study, I believe that neither economists nor journalists have correctly identified its underlying causes.
However before we can get to those causes, we need to recognize that there are two separate trends going on contributing to rising income inequality. The first type of income inequality is what we’ll refer to as the decline of the middle class. This is primarily a phenomenon in the U.S. and Western Europe (globally, the middle class has grown enormously over recent decades). The second type of income inequality is the rise of the wealthy and the super-wealthy, which is truly a global phenomenon. These two aspects of income inequality share many of the same underlying causes, however their stories differ and we will discuss each of them in turn.
What do we mean by the decline of the middle class? For starters, real (inflation adjusted) wages for many workers have declined or stagnated. The middle class’s share of national wealth has also shrunken, while middle class indebtedness has risen sharply. Workers also face far more job insecurity than ever before. And while the headline unemployment number in the U.S. is very low (currently under 5%), this statistic does not reflect the high number of able-bodied people out of the workforce, nor the magnitude of underemployment, further exacerbated by the so-called “gig” or “sharing” economy. Finally, and most scary, these trends are affecting young people more dramatically and leading many to debt, to despair and to drug addiction.
In my view, the decline of the middle class has been caused by a combination of three trends: globalization plus regulation plus monetary policy induced financialization. Here’s our story. Beginning in the 1980’s and 1990’s, China, along with many other countries joined the global economy. With abundant low-skilled labor, they put pressure on manufacturing wages in the U.S. and other developed countries. Due to regulations, unions and legacy retiree compensation, manufacturing companies were not able to lower their costs of labor. Instead jobs were outsourced, off-shored and lost while companies went bankrupt and entire industries disappeared.
Meanwhile, in its naive belief that all inflation is monetary, and seeing no apparent inflation due to the effects of global trade, the Federal Reserve printed money, kept interest rates low, engaged in repeated bank and financial market bailouts and created a three decade long financial bubble. The middle class’s cost of living went up instead of down. Real estate, education and healthcare became unaffordable. The only way for consumers not to suffer in the near-term was to take on debt, debt that can never be repaid. More jobs were lost as technology disruption and automation was subsidized. Wall Street grew at the expense of Main Street. Monopolistic crony capitalism came to rule the economy. And last but not least, long-term productivity and the future prospects of the middle class were even further mortgaged as retirement savings, pensions and insurance policies were bled dry.
As damaging as a declining middle class is to society, the shocking rise of the wealthy and super wealthy is even worse. This trend has the same three causes that explained the decline of the middle class: globalization, regulation and monetary policy fueled financialization. However, here the story is different. The rise of the wealthy is primarily a result of monetary policy and financialization. It was then exacerbated by regulation and exacerbated even more by globalization.
Cheap money, subsidized capital and low interest rates led to rising prices for all financial assets which greatly benefited the wealthy who naturally own these assets. Loose monetary policy also led to a wage/price inflationary spiral for the wealthy as prices of luxury goods and services accelerated leading to higher wages for high-skilled (i.e. 1%) workers, not to mention pricing out the middle class from cities like New York and San Francisco.
Monetary policy also led directly to the dramatic growth of Wall Street and financialization of the economy. As banks and financial markets were subsidized, Wall Street grew, and grew, and grew. Increasing revenue brought increasing profits and increasing profits brought increasing bonuses for investment bankers, traders, institutional salespeople, private bankers, quants and others. Hedge funds minted billionaires even while their performance lagged safer investments. Tech startups also created billionaires as cheap capital subsidized growth and valuations, fostering a winner-take-all mentality and unprecedented consolidation and monopoly power in the technology industry.
CEOs of public companies went from earning 30 times the average worker to more than 300 times thanks to monetary policy, government regulation, tax policies and crony capitalism that together favored and subsidized stock options, short-termism, growth, financial engineering and consolidation. Finally, globalization exacerbated all of these unfortunate trends as central banks throughout the world executed the same easy money playbook. Cheap money flowed across borders, asset bubbles sprung up everywhere and corruption allowed the wealthy to amass not just more wealth, but ever greater political power.
Can we solve the problem of income inequality? In theory the answer is yes. In practice the answer is probably not, as nothing that I am about to suggest is realistic given today’s toxic and corrupt political system. There is absolutely no realization among the economics profession, the mainstream media or the political community of the disastrous consequences of “modern” central banking. Nor is there any reason to believe that those in power who have benefited so much from decades of easy money and crony capitalism will change their viewpoint.
But let’s try anyway. The first thing we must do is to normalize interest rates, or better yet, get central banks out of the business of managing the economy and out of the business of bailing out the financial sector. We must make it clear that risk will no longer be subsidized and financial firms will no longer be bailed out.
If we do this, money will dry up and Wall Street will shrink significantly, along with bonuses and financial services jobs. So too will the technology sector contract as tech valuations plummet. 1% cities like New York and San Francisco will once again become affordable for doctors and lawyers and teachers and police officers. The era of the hedge fund billionaire and the tech mogul will be at an end. Jobs that serve no social purpose will disappear, like most (but not all) investment bankers, consultants, hedge fund analysts and private equity professionals. Technology disruption and automation will be slowed. Companies that don’t make money will disappear. Companies that actually make money will thrive and will relearn how to invest in their own employees. Smart people will once again become doctors and scientists and engineers and teachers.
Meanwhile, while the financial system goes through a reset as almost (and should have) happened in 2009, we must also reduce the massive regulations that hinder hiring, that put a floor on compensation, and that support and subsidize big business, big labor and crony capitalism. We must un-monopolize our monopolistic and failing education system. Ditto for our healthcare system. We must find a way to upgrade our infrastructure and to restructure the promised pensions and retirement costs that will ultimately bankrupt our governments.
What must we not do? We must not give in to the populists, socialists, fascists and isolationists of the far left and the far right. We must not abandon capitalism. We must not give up on global trade, if for no other reason than abandoning trade will lead to war (though there are many other good reasons in favor of trade). We must not turn our backs on immigration for it is the only way to achieve significant economic growth, to afford our (hopefully shrinking) welfare state and to bring back manufacturing. We should not try to fix income inequality through re-distributive taxes, or through more regulation or more unionism. Each of these will make things worse, not better.
In summary, we must let the free market work. Let companies succeed that deserve to succeed. Let companies fail that deserve to fail. Let people work who want to work. While it may take a generation or more to re-orient our economy, it is the only way to increase productivity, to revive the middle class, and to preserve our way of life.