Few topics have gotten more economic press in recent years than income inequality. The issue of income inequality was the driving factor in last summer’s shocking (or not so shocking) Brexit vote and last fall’s shocking (or not so shocking) election of Donald Trump. Income inequality is also responsible for the rising popularity of socialists like Bernie Sanders and the growing power of populist leaders around the world.
Ever since Thomas Piketty’s Capital in the Twenty-First Century was published in 2013, trying to explain the rise in income inequality has been on the forefront of economists’ minds. Yet, mainstream economics has offered no comprehensive or satisfactory explanation for why income inequality has increased, nor has it offered comprehensive or satisfactory remedies.
I believe the underlying causes of increased income inequality are relatively clear and relatively simple. And the remedies too are clear and simple. Of course, as with most of the world’s economic woes, implementing these remedies is practically and politically impossible.
But first things first. Has income inequality even increased, and if so, in what ways? The short answers are yes, no and yes. Let me explain.
Has income inequality really increased?
Income inequality is typically measured statistically by economists as a metric called the Gini coefficient. Loosely, the Gini coefficient measures in a single number between 0 and 1, how evenly distributed income is within an economy. A coefficient of 0 means that everyone’s income is equal (perfect equality). A coefficient of 1 implies perfect inequality, that all income is earned by a single person. And yes, the Gini coefficient has increased in most countries, including the U.S., over the past few decades (in the U.S. from approximately 0.35 in 1970 to at least 0.45 today).
And now that I’ve briefly mentioned it, forget about the Gini coefficient. It’s not very helpful in understanding the root causes of increased income inequality.
As Piketty correctly describes in his book, there are two aspects of income inequality that are happening simultaneously. The first is the decline of middle class income and wealth. Let’s call this Type 1 income inequality. This trend is occurring most prominently in the U.S., but also in Western Europe and other developed countries. The second aspect of increased income inequality is the dramatic rise in the income earned and wealth owned by the rich, e.g. the 1%, more so the 0.1%, and even more so the 0.01%. We will refer to this as Type 2 income inequality. And this second trend is truly global.
Now let me explain why I said the answer to whether income inequality has indeed been rising is yes, no, yes. As I said above, the decline of the middle class (Type 1 income inequality) is mostly a developed world, and most prominently a U.S. phenomenon. When measured globally, the middle class has increased dramatically over the past 30 years, thanks to the equally dramatic rise in economic freedoms in formally socialist economies including China, India, Southeast Asia, Eastern Europe and elsewhere. China itself is responsible for adding perhaps 600 million people to the ranks of the global middle class.
In short, Type 1 income inequality has increased in the U.S. but decreased globally. On the other hand, the rise of the wealthy (Type 2 income inequality) is manifested everywhere. Hence the “yes, no, yes” answer. These two aspects of income inequality, the decline of the middle class and the rise of the super-wealthy, are not unrelated, and they share many of the same underlying causes. However, their stories do differ and we will discuss each of them in turn. But before we do that, let’s discuss something else that is important. Does rising income inequality even matter?
Does rising income inequality matter?
Yes, it does. Very much. But in a manner different from which most economists believe. The rising inequality that the U.S. and the world is currently experiencing is a SYMPTOM of a poorly operating economic system. Income inequality matters in the sense that it is telling us that economic incentives are screwed up. Income inequality in and of itself is NOT, as mainstream economics believes, a CAUSE of economic dysfunction, poor GDP growth, or financial crises. This confusion of cause and effect is perhaps more than anything else the reason why mainstream economics is so wrong about…well…pretty much everything.
In short, rising income inequality is telling us that the world is messed up but it does not, by itself, cause economic woes. On the other hand, it can, and often does cause political woes, as history teaches. When the masses see the quality of their livelihoods reduced whilst they see the rich get richer, political unrest often follows. And sometimes revolution. We’re seeing warning signs of that in the U.S. right now, in the success of what would normally be fringe political candidates like Trump and Sanders, as mentioned above, and in Europe with Brexit.
So, while increasing inequality does not directly cause economic upheaval (remember, it is a symptom not a cause), it certainly can, and likely will cause political upheaval. And political upheaval tends to be very, very bad for the economy, not to mention to the theretofore rich and powerful (guillotines, anyone?).
At this point we’re almost ready to return to the promise of this article – the root causes of inequality. But if you will, please indulge me for another moment, for there is one more topic we need to discuss. Is there an ideal level of inequality?
Is there an ideal level of inequality?
I don’t know that there is an ideal level of inequality but there probably is a natural level of inequality that would occur in a properly working free market. Pretty much everyone understands that fair or not, some people have more skills, abilities, intelligence, wisdom, work ethic, opportunities, risk appetite and (perhaps most importantly) luck than others. Whether this is fair or not and whether these attributes are innate or not are interesting questions, but immaterial to our present focus. These are the undeniable facts of life here on Earth, and probably everywhere else in the universe.
Equally true is that in a free market where everyone is able to rent out their skills and abilities to the highest bidder, the disparity of skills and abilities will naturally lead to some disparity of income and wealth. Very few among us would disagree that a LeBron James should earn more than the average basketball player, that a Brad Pitt should earn more than the average actor, that a Bill Gates should earn more than the average businessperson.
Why is that? Because most people recognize that, whether fair or not, whether through luck or not, these three individuals 1) have more skill in their domains than their average peers, and 2) that these skills have helped increased societal utility and economic growth. LeBron James through the sales of basketball tickets and basketball jerseys and television viewership, Brad Pitt through the sale of movie tickets and Bill Gates through the productivity enhancements due to Microsoft software (PowerPoint excluded).
Is it fair that LeBron James is a better basketball player than me? Not a relevant question here. Is it fair that because LeBron James is a better basketball player than me that he deserves to be paid more for playing basketball than me? A good question. Given that playing basketball (at a very high level) is economically valued in our society for its entertainment value, the answer is plainly yes.
So clearly, in a free market, some level of income inequality is both natural and desirable. But how much inequality? How much more should Lebron James be paid than the average basketball player? How much more should Lebron James be paid that the average postal worker, or teacher or bartender? How much more should Bill Gates be worth than the average CEO or entrepreneur or computer programmer? This is a much more difficult question, and one that I will not attempt to answer here directly. Sorry.
Conceptually however, we can state that in a free market, one’s income should be directly related to the economic value of one’s labor. This is no more than the basic principle of supply and demand. If my labor is worth more to someone (i.e. to help generate business profits), they will pay me more, or I will take my labor elsewhere (I will be “in demand”). If my labor is no longer helping to generate profits at my current level of income, I will be paid less or replaced by someone more productive. Long story short, in a properly functioning free market, my (and everyone else’s) income should approximate my (and respectively, their) societal productivity.
Type 1 income inequality: the decline of the middle class
Now, finally, we’re ready to discuss the symptoms and root causes of the rise in income inequality. Let’s start with the first type, the decline of the middle class in the United States.
When we talk about the decline of the middle class, especially in the U.S. what do we really mean? Economically we mean several things. In the direct context of income inequality, we mean that middle class real wages have declined. Real wages represent the amount you are paid adjusted for inflation. Real wages are not the amount (ignoring taxes) that is paid to you by your employer. Those are called nominal wages.
To be clear, when economists talk about middle classes wages having declined they don’t actually mean that the amount of money that employees receive (on average) has declined. What they mean is that wages have declined taking inflation into account. For example, wages might have increased 5% over a period of time, but if inflation has been 10% over that same period, then we say that real wages have actually declined. Equivalently, we could say that the average (lower and middle class) worker’s purchasing power has declined. That is, the amount of goods and services that they are able to purchase with their wages has gone down.
Have middle class real wages declined over the past few decades, at least in the U.S.? Actually no, they have risen. But, they have more or less stagnated. Wages have risen slower than the overall economy and much less than mainstream economists think they should have, given overall labor productivity. In other words, given that upper class wages have increased significantly (as we will discuss when we get to Type 2 income inequality), the middle class accounts for a shrinking piece of the economic pie, one of the reasons for the so-called decline of the middle class.
As an aside, however, the picture is a little muddier if you look at total compensation, which would include the present value of promised benefits such as retirement income (e.g. social security and/or pensions) and especially healthcare. But let’s ignore that wrinkle.
Now, when we speak of the decline of the middle class in the context of income inequality, there are a few other economic factors that come into play that make the picture look even worse than just the income data. For one, the middle (and lower) classes have much less savings and are much more highly indebted than ever before. In other words, the middle class’s portion of national wealth has declined even more so than its portion of income. We could just as easily, and perhaps more accurately, be writing about “wealth inequality.”
Second, there is much less job security than in decades past, so whatever income workers are receiving is more volatile. Lifetime employment is clearly a thing of the past. Companies, especially those publicly traded or private equity owned, are quicker to lay off, to restructure and to outsource. Moreover, as established companies are continuously “disrupted” by cheap-money financed and venture capital backed upstarts, they face constant pressure to cut labor costs. Not to mention the high failure rate of those upstarts naturally leads to employment volatility.
Third, 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. This is exacerbated by the so-called “gig” or “sharing” economy. People are working fewer hours and at lower skilled jobs than they desire. When one is reasonably highly educated, working 30 hours a week at a Wal-Mart or driving for Uber is not the stuff that the American dream is made.
Fourth, and most scary is that the aforementioned factors of stagnating real wages, high indebtedness and job volatility affects young workers more than anyone else. Young people are graduating college with enormous debt loads and poor job prospects. Plus, the retirement and healthcare benefits generously provided to their parents are less likely to be there for them. Politically, masses of unemployed young people with few economic prospects are the stuff of which revolutions are made.
In summary, while middle classes real wages haven’t exactly declined, it is very true to say that real wages have stagnated, that the middle class has received less of the total economic pie, and that young people face even more dire prospects than other demographics.
The real causes of middle class decline
That the middle class in the U.S. is “not winning” is denied by few, and as I stated at the top of this article, has been the centerpiece of both the populist Trump and populist Sanders presidential campaigns (regrettably if you were a Hillary Clinton fan, she did not take the baton from Sanders on this issue). Trump blamed immigration, free trade, bad deals, Mexico and China. Sanders, during his campaign, blamed free trade, unfettered capitalism, lack of union power, and greedy Wall Street. Mainstream economists tend to blame some combination of globalization, technology and the declining power of labor movements.
As we shall see, while there are kernels of truth in both the Trump and Sanders viewpoints (as well as that of mainstream economists) the root causes are different and very much misunderstood. In a nutshell, the real cause of U.S. middle class plight over the past few decades is an aggregation of three enormously increasing trends: globalization plus regulation plus monetary policy fueled financialization.
Causes of middle class decline Part 1: Globalization
Remember at the top of this article, when we said that while the middle class in the U.S. has declined, the middle class in China and other fast growing countries has exploded? Our story starts here.
Starting in the late 1980s and early 1990s and accelerating thereafter, somewhere between 1 and 2 billion people entered the global workforce. What do we mean by the global workforce? We mean employees of companies making tradable goods and services, or those manufacturing products (and services) which can be sold globally. Where did they come from? As we’ve already stated, primarily from China and Southeast Asia, from India and from Eastern Europe (after the fall of the Berlin Wall). Especially in Asia, and especially at first, these were primarily relatively low skilled jobs.
Aha! So Trump is right? China stole our jobs? Not exactly. Globalization, or more specifically global trade, absolutely has winners and losers. Clearly, the Chinese middle class are better off. And very likely, former U.S. textile workers are worse off. Simplistically, there are a lot more Chinese that have been elevated from abject poverty to middle class than former U.S. textile workers that have lost jobs. In fact, far more Chinese have become middle class over the past two decades than the entire U.S. population. This is thanks to the workings of capitalism and is why Type 1 (middle class) income inequality has enormously decreased GLOBALLY. Humanity as a whole has clearly won.
Of course, that U.S. workers lose jobs or see their real wages decline for the benefit of the Chinese is unpalatable to U.S. presidential candidates and to U.S. voters. But this is not the whole story of globalization. While globalization has had a negative impact on some U.S. workers, it has had a positive impact on others. Who are those others and what are the benefits?
The Chinese like to watch Hollywood movies. They buy Boeing airplanes. They use Microsoft software. They consume Texas beef. Globalization has benefited those workers in export oriented industries, since the market for those products (exports) is obviously far larger globally than it is only domestically.
The second benefit of globalization to the U.S. dwarfs the first. Companies import goods rather than produce them domestically because they are cheaper. ALL consumers benefit from goods that are less expensive to produce, and therefore less expensive to purchase, whether these goods be T-shirts or iPhones. That imported goods are cheaper if wages are sufficiency lower is obvious, but is also a key part of our story explaining the decline of the middle class. We will return to it shortly.
Globalization’s third benefit, hardest to quantify, yet probably most important, is a reduction in the risk of war. Simply put, countries that trade with each other, tend not to go to war with each other. It is safe to say that there are few in the U.S. who would be better off under the circumstances of war with China, or any other (presumably former) trading partner. Regrettably, this is a point that President Trump and his administration seem not to appreciate.
Alas, we’ve digressed a bit. Let’s return to the connection between globalization and middle class decline. Think back to Econ 101, to supply and demand. When there is a big increase to the supply of something, what should happen to its price? Its price should go down. So what should have happened to global low skilled wages if there was a significant increase in the supply of low skilled labor? Wages should have declined. And of course that is what happened globally. Abundant Chinese (for example) labor put pressure on low-skilled U.S. wages.
Aha again! So, globalization caused middle class wages in the U.S. to decline. That explains the impact on middle class income inequality. And this is indeed the narrative told by the likes of Trump and Sanders and others. End of story, right? Not so fast.
Causes of middle class decline Part 2: Globalization plus Regulation
Yes, U.S. manufacturing wages should have fallen. Supply and demand dictates as much. But as we said earlier, they did not fall (on a nominal or real basis). Why not? As economists like to say, wages were “sticky.” Or in other words, there were frictions to the market that prevented wages (more accurately, total compensation) from falling. What were these frictions? There’s a whole bunch. Minimum wages, unions, inflexible work rules and especially the fixed costs of long-term retirement benefits and pensions. Plus disincentives to work (and accept lower wages) due to government provided welfare and unemployment benefits. There’s also one additional very important friction that we will come back to later (no spoilers!).
Said differently, government regulation and unions made it more expensive to hire workers. Naturally, businesses responded in several ways. They went out of business, they moved production overseas, they outsourced production and they switched their production inputs from regulated and expensive labor to unregulated and less expensive capital (machines and robots). All of which cost untold domestic jobs.
To make matters even worse, regulation (and tax policy) nearly always favors large companies over small companies, for the simple reason that large companies can afford lobbyists who write the regulations, whereas small companies cannot. Hence, regulations tend to protect large incumbents from competition, rather than consumers or the general populace to which they purport to “protect.” The end result is the kind of pervasive and monopolistic “crony capitalism” that dominates the U.S. economy. Moreover, by favoring large companies, regulation and tax policy subsidizes outsourcing and offshoring, since large companies can much more easily deal with such complexities than can small companies. Finally, large (especially public) companies are much more apt to layoff and restructure than are small private companies and less likely to make long-term investments (including investment in their employees, so-called “human capital”).
Let’s again return to Econ 101. Regulation, unions, welfare benefits and the like effectively set a floor on wages. And what happens when you set a floor on the price of a good but the true market price is below the price floor? Instead of the price falling to the market price and the quantity adjusting accordingly, the price is not allowed to fall. Instead the quantity falls. This is exactly what happened to middle class jobs.
Because of wage rigidity (more accurately, total compensation rigidity), and other (very significant) regulatory costs, the quantity of domestic jobs fell. The U.S. lost not just a few manufacturing jobs, but entire industries, like apparel, textiles, furniture and steel. And decimated were cities like Detroit and entire regions like the rust belt.
Instead of manufacturing workers earning, say 20% less in order for a factory to be cost competitive with China, the entire factory was closed or exported and the workers were laid off. Now those same manufacturing workers are either long-term unemployed or earning, perhaps 60-80% less working in the service sector or the “gig” economy. What were once steady and long-term careers have been replaced by short-term, unstable and much lower paying jobs.
Before we go any further, let’s quickly review. Competition from overseas led to pressure on U.S. manufacturing wages. But since wages weren’t allowed to adjust downwards, many jobs were lost instead. What should have happened in a free-er market? We should have seen somewhat lower (manufacturing) wages but significantly more (and better) jobs.
If you are perceptive, you might be wondering the following: wouldn’t even lower wages than we have now have increased income inequality even more? No. For two primary reasons.
First, unemployment went up more than it should have. Some of the workers never found new jobs and became part of the welfare state. Others found jobs, for example in the service sector that, as we mentioned above, tends to pay far lower wages than manufacturing jobs. So while manufacturing wages should have fallen some amount, those workers would have been much better off than not working at all, or having their wages fall much more working in the service sector.
To understand the second reason, we need to turn our attention to monetary policy and the resultant unprecedented growth of the financial sector.
Causes of middle class decline Part 3: Globalization plus Regulation plus Financialization
Back again to basic economics. Whether due do importing cheaper Chinese (and other country’s) goods because of cheaper Chinese labor (as primarily happened) or due to cheaper domestic goods because of cheaper domestic labor from the threat of Chinese imports (as should have happened much more), or both, domestic prices should have declined. In economic-speak, the U.S. was, and should have been, importing deflation.
Of course, the prices of many goods did decline, most notably of course, those imported from low-wage countries and most of the stuff sold at Walmart. However, the combination of lower priced goods and wage pressures should have caused the overall price level of the economy to decline. It did not. In fact over the past decades price levels as measured for example by the CPI, have increased somewhere around 2% per year. In other words, we had inflation when we should have had deflation. Why?
The answer is the Federal Reserve. Economists and officials of the Federal Reserve in their infinite un-wisdom believed (and continue to believe) in three myths: 1) that deflation is always bad, 2) that positive inflation (i.e. 2%) is necessary for a healthy economy and 3) that inflation is always a “monetary phenomenon.” In light of these erroneous beliefs, the Federal Reserve implemented what is known as “inflation targeting.” Simply put, they kept interest rates low and printed money in order to engineer a 2% (more or less) rate of inflation.
The model that most simply encapsulates the central bank’s thinking is known as the “Phillips curve,” which posits that there is an inverse relationship between unemployment and inflation. In essence, central bankers believe that inflation is caused by what is known as a wage/price spiral. When the economy is at full employment (everybody who wants a job has a job), additional monetary stimulus will lead to workers demanding higher wages, which will cause employers to raise prices, which is inflationary. They also believe the natural corollary, that as long as the economy is not at full employment, monetary stimulus cannot lead to inflation.
Here’s the rub. How do we know if the economy is at full employment? Does that mean 6% unemployment (keep in mind there are always people who are changing jobs for various reasons so 0% unemployment is not practical)? 5% unemployment? 4% unemployment? Should we count people who are long-term unemployed and too frustrated to be looking for a job? And how about workers that are employed but underemployed, either working fewer hours than they’d like or for lower wages than their skills would indicate?
The short answer is that there is no way to know what level of unemployment represents “full employment.” (This theoretical level is know as the “NAIRU” or “non-accelerating inflation rate of unemployment”). In other words, central bankers cannot stimulate the economy until the economy reaches full employment because full employment is unknowable. Instead, central bankers (in their minds) do the next best thing. They assume that as long as there is no significant inflation, the economy must NOT be at full employment (there is, as they say, “slack” in the economy). Hence, they believe central bankers are free and justified to pursue loose monetary policy.
This is exactly what has been happening over the past three decades or so. The Federal Reserve saw low inflation and therefore assumed that: 1) the economy was not at full employment and 2) loose monetary policy was both warranted and essentially cost-less.
As we’ve stated a number of times, due to globalization and the resultant competition from low-wage countries, U.S. wages should have declined and prices should have declined. Deflation should have been the correct outcome. However, the Federal Reserve, believing that no significant observable inflation meant less than full employment, stimulated the economy by keeping interest rates low and printing money, in an attempt to engineer positive (i.e. 2%) inflation.
The result of this Federal Reserve policy has been disastrous in a large number of ways, but let’s focus for now, on its impact on the middle class. In at least seven ways, Fed policy over the past few decades along with the resultant growth of the financial sector (what we’ll call “financialization”) has helped to crush the middle class.
1. Real wage decline and loss of purchasing power
Instead of falling wages and falling prices (as should have happened), workers experienced falling wages and rising prices. In other words instead of no change to real wages and purchasing power (assuming wages and prices declined the same amount) or even an increase in real wages and purchasing power (if prices fell more than wages), workers were hit with the double whammy of falling wages and rising prices, thus a decline of real wages and a substantial loss of purchasing power.
To be fair, I have no idea if the wage decline would have been greater or less than the price decline, but I am certain that either way, the impact would have been far better than the loss of purchasing power that occurred in the Fed created inflationary environment. My guess is that significantly more people would have experienced increasing purchasing power since everyone in the middle class could benefit from declining consumer goods prices but not everyone faced competition from foreign labor.
Before we move on, recall that when discussing why wages did not fall in light of global wage pressures, we mentioned that there were frictions that prevented wage adjustments (such as minimum wages, regulations, unions and long-term fixed benefits). At the time, I mentioned an additional reason to which we would return later. That time is now. Another important reason why wages were not flexible is because of the Fed-induced rising cost of living.
Workers would have been much more apt to accept lower wages if the overall price level had also been allowed to decline, as it should have. But the mismatch between wages and prices helped lead to what economists call long-term or “structural” unemployment. In a world of increasing cost of living, workers would rather be unemployed and hold out for a job that pays more than accept a job that pays less. Unfortunately, that higher paying job rarely comes along and unemployment tends to persist.
2. Inflation in non-tradable goods
The decline in real wages might have been the most obvious injury to the middle class caused by Fed monetary policy but it was by no means the only one. We’ve already stated that the price of many tradable goods (i.e. consumer goods) declined given globalization yet the overall price index (i.e. CPI) increased. So what did increase in price? The answer is non-tradable goods (that is, goods and services that cannot be manufactured overseas).
Most prominent of these non-tradable goods are three: real estate, healthcare and higher education. These three categories of spending have experienced inflation over the past few decades far, far in excess of 2% per annum. And in fact, all three are likely under-represented in the CPI. When the central bank prints money (or equivalently, keeps interest rates low to encourage banks to print money), the money must go somewhere. And some of that somewhere has clearly been real estate, healthcare and higher education.
Remember that the decline of the middle class is not simply a story of falling wages. It is also a story of despair, hopelessness and a fear that future generations will be worse off than previous generations. That fear is not only reasonable but playing out now as young people, thanks to the Federal Reserve, face not only poor job prospects but unaffordable housing, unaffordable education and unaffordable healthcare.
3. Subsidies to consumer debt
One of the most obvious (and intended) results of low interest rates is to encourage (and subsidize) debt. Naturally, the past few decades of loose monetary policy has seen an explosion of debt, including consumer debt. To be clear, there is nothing wrong with debt, per se. But there is something wrong with too much debt. What is too much debt? Too much debt is when a significant portion of debt cannot be repaid. In other words, when a lot of debt becomes “bad debt” we’ve had too much debt.
We saw exactly this happen in 2008 and 2009 as the consumer real estate debt market cratered. This debt market implosion was the proximate (though not root) cause of the subsequent financial crises. Clearly, too much debt can (or will) cause an asset bubble, and when the bubble bursts a financial crises and recession can (or will) follow.
In addition to creating an asset bubble and its subsequent financial crises, too much consumer debt has had other deleterious effects, specifically on the middle class. Most notably, the middle class is – wait for it captain obvious – over-indebted. In order to maintain their standard of livings in light of falling purchasing power, many people borrowed in order to consume. Many others were forced to borrow to cover the rising cost of medical expenses and rising cost of college education. Recall again that when we talk about the decline of the middle class, we’re not just discussing straight income inequality. We’re also factoring the sense of hopelessness that many (especially among the young) feel, brought upon in large part by debt that can never, and will never be repaid.
The substantial growth of consumer debt also reflects a transfer of consumption from the future to the present. By subsidizing consumption over savings (which is what both low interest rates and inflation do), economic output is pulled forward and there is under-investment. So not only are consumers over-indebted, but future productivity is likely to be lower, making it even harder for the middle class to escape their debts. It is no wonder why, for the first time in U.S. history, the current young working generation will almost certainly be worse off than their parents.
4. Technology “disruption” and automation
In addition to subsidizing consumer debt, Fed monetary policy has had the effect of subsidizing high growth/high risk companies (something I wrote about in more depth here) and enabling them to “disrupt” lower growth/lower risk companies. The primary stated purpose of low interest rates is to spur investment that would not otherwise be made, in the hopes of increasing employment and wages. However, since at least the mid-1990s, much, if not most, of this “extra” investment has been made in the technology sector.
This might sound good, since we are all trained to believe that technology is the future, and that technological innovation is the key driver of productivity growth and long-term economic growth. Unfortunately, because of extraordinarily loose monetary policy, this has not been the case. The vast majority of investment in technology has been wasteful and unproductive, and has destroyed rather than created middle class jobs.
The example I like to use is Amazon, the e-tailing behemoth. Amazon is a company that, thanks to virtually unlimited amounts of cheap capital courtesy of the Fed, has been able to under-price and decimate traditional brick-and-mortar retailers. And yet after 20 years of being in business, and despite its scale, despite its smart employees and brilliant CEO, despite its amazing technology, despite its sales tax advantage and despite its low cost of capital, it has never shown an ability to make a profit from its retail operations. Simply put, Amazon is a company that absent Fed policy would not exist. And absent Amazon, there would be hundreds of thousands more retail jobs in the U.S.
Of course it is not just in the retail sector where middle class jobs have been “disrupted” by easy money fueled technology companies. Virtually no industry has been unaffected. Not only do the disruptees tend to employ significantly more workers than the distruptors (as in the case of traditional brick and mortar retail vis a vis Amazon), but naturally companies facing ongoing threats of disruption are reluctant to hire and disincented to invest in the future.
In addition, this reluctance of companies to hire combined with the enormous regulatory costs of employing full-time workers (for example, providing healthcare insurance) has led to more and more workers being independent contractors and to the so-called “gig” economy. Proponents of the “gig” economy cite flexibility as a benefit to the working masses, but this is nonsense. A good job is one that is stable and offers opportunity for advancement in both compensation and responsibility. Being an independent contractor offers neither.
The uncertainty of employment, generally lower salaries, nonexistent benefits and lack of opportunities for advancement is clearly damaging to the middle class worker. But to add insult to injury, long-term productivity suffers too. Employers have zero incentive to invest in the development and continuing education of their non-employees and those non-employees have zero incentive to invest in their non-employers. All in all, a lose-lose for the economy and for the middle class.
Moreover, the same trends of cheap money and high regulatory costs that have resulted in today’s “gig” economy have also caused the enormous trend towards job automation. Whereas originally automation was a phenomenon affecting low-skilled jobs, more and more it is impacting high-skilled jobs. Contrary to the view of many technophiles in Silicon Valley (and elsewhere), humans are not obsolete. They have just been made too expensive by government regulation intended to help them. Like virtually all government action, it is the unintended consequence that dominates. In today’s world that means we are penalizing companies that employ humans and subsidizing companies that “employ” robots.
We see more evidence of the enormous amount of cheap money in the technology sector when we look at how the business model of venture capital has changed. Prior to the era of cheap money, investors in startups would actually perform due diligence on a company’s business model and path to profitability. Moreover, founders were required to have actual experience in their industry and with the products they were going to sell. Investment exits, whether by IPO or acquisition were almost always predicated on actual profits and cash flow generation.
Today’s model of venture capital is very different. The idea of investing in viable businesses has morphed into the mentality of buying a lottery ticket. Venture capital firms put money into, say 15 companies with the full expectation that 14 of those will be absolute failures and represent total investment losses. Only one of the 15 investments needs to be successful. Which one? Who knows. And what do we even mean by the term successful? Not profits nor revenue nor even a business model but simply an exorbitant valuation, and a liquidity event or exit.
And what of all the so-called “investment” that went into the 14 losers? Can we consider that productive economic investment? Of course not. These companies shut down. Websites turned off. Code deleted. Employees moved on. They leave no productive legacy. Yet, economically it is even worse than a waste of resources. For in their short existences they’ve likely disrupted and done irreparable damage to real companies with productive businesses.
Finally, I would argue that the enormous subsidies to technology companies over recent decades which has fueled the rise of the internet has actually made our economy less productive rather than more. And remember that ultimately it is productivity that results in rising wages. Economic data seems to agree with me. More than three decades since the birth of the personal computer and two decades since the commercial adoption and widespread usage of the internet, we have yet to see rising productivity. Perhaps it is too soon to tell whether or not the internet will lead to productivity enhancements as other new technologies have. But so far, the story is not good.
Moreover, other measures of our societal health seem worse-off, our future mortgaged just like it is when we take on too much debt. For “free” can have a cost, and that cost can be huge.
We can now be entertained 24/7 yet we seem less happy, and more distracted. We can connect with anyone in the world at virtually zero cost yet we seem more lonely, and less able to communicate. We have instant and free access to high quality information yet we are far more susceptible to “fake news” and far more politically polarized than ever before. We have shunned relationships for transactions. We have lost virtually all privacy. We have allowed high quality (and especially local) journalism to be decimated, itself the fourth branch of government, and government’s most important check and balance. We have granted an enormous mouthpiece to fringe politicians, to populists and racists, to conspiracy theorists and last but not least, to terrorists.
5. Growth of Wall Street and the financialization of the economy
As much as monetary policy has spurred the growth of the technology sector, it has even more so been the cause of the growth of the financial sector and Wall Street. This is a topic to which we will return when we discuss the second type of income inequality, the explosive growth of the wealthy and the wealth of the wealthy. For now, however, let’s discuss how Wall Street’s rise has helped drive the middle class’s fall.
But before we do that, let’s make sure we understand the nature and purpose of the financial sector (I’m using “Wall Street” and the “financial sector” interchangeably). The financial sector includes banks, insurance companies, pensions, asset managers such as mutual fund companies, hedge funds, venture capital funds and private equity funds and exchanges where stocks, bonds, commodities and other financial assets can be traded.
Broadly speaking, the purpose (and economic value) of the financial system is twofold. The primary purpose is to efficiently match up the extra money that people, businesses and governments have (what we call “savings”) with those people, businesses and governments that need extra money for good purposes (what we call “investment”). The financial system’s (specifically, the banking system’s) secondary main purpose is to regulate the supply of money.
For a long time, the government has not trusted the banking system with regulating the money supply for fear of bank panics and their subsequent deleterious effects on the economy. This sentiment was most pronounced after the Great Depression when a slew of new banking regulations (not to mention a weakening of the importance of a gold standard) transferred significant control of the money supply from private sector banks to the Federal Reserve and to the government. Over the past three decades, the Federal Reserve’s influence on the money supply has grown enormously after the final withdrawal from a gold standard and the rise of the monetarism school of economics (essentially, the belief that the Federal Reserve can and should manipulate the money supply and/or interest rates to avoid recessions).
As we’ve mentioned a number of times, the disastrous reliance on the Federal Reserve and on banking regulation to manipulate the value of money has led to a world of far too much money, far too low interest rates, and enormous subsidies to risk. The natural upshot of this is a financial sector that has grown far, far beyond its economic value. A financial sector that having been neutered of its second purpose of managing the money supply, does a miserable job at its first purpose, allocating savings to productive uses.
We’ve already discussed three unfortunate trends that go hand-in-hand with the growth of Wall Street: the explosion of consumer debt, the funding of the unproductive (or worse) tech industry and the creation of financial asset bubbles and their subsequent crises. In at least four additional ways, the growth of the financial sector has hurt the middle class. First, by subsidizing speculation and short-termism. Second, by encouraging growth over all other considerations. Third, by vastly increasing systematic risk and decreasing economic stability. And fourth, by providing huge incentives for employment in the financial services sector at the expense of jobs in more productive industries.
Short-term focus
To reiterate, the primary function of finance is to efficiently allocate capital to productive uses. And since most productive uses of capital take a while to become productive, inherently, financial markets should have a long-term focus. However, by massively subsidizing risk, central banking policy has led to a paradigm where the primary function of Wall Street is speculation, and the emphasis, by far, is on short-term results.
We can see this very clearly in the stock market, the primary function of which is supposed to be to allocate money, in an IPO for example, to growing companies that need capital. Instead, the stock market has become dominated by trading of already issued shares by computers and held for micro-seconds (bringing new meaning to short-term results!) and trading volume has exploded. For what good purpose? Not the benefit of “liquidity” espoused by mainstream economists, which encourages short-termism. No, such activity represents an enormous waste of resources.
The emphasis on short-term results does more damage to the economy than just to waste resources. The rise of activist hedge funds leads public companies to focus almost exclusively on quarterly financial results and on financial engineering at the expense of long-term investment. Similarly, the business model of private equity, through leveraged buyouts, leads to excess cost-cutting, more financial engineering, under-investment and frequent bankruptcies. Hedge fund and private equity moguls make billions while the middle class lose their jobs (a topic we will return to when we discuss Type 2 income inequality).
Moreover, by subsidizing Wall Street and public equity markets, the Federal Reserve, along with government regulation, has fostered a compensation system that is inherently biased towards short-term incentives. CEO’s paid with stock options naturally focus on short-term stock performance rather than long-term investment. Likewise do Wall Streeters who receive the bulk of their compensation in the form of annual bonuses. In the old days when Wall Street firms were private partnerships (as they should be), there was incentive for investment bankers to focus on long-term client relationships rather than one-off transactions, as well as an incentive to limit risk since partners’ compensation was illiquid and partners faced capital calls if things went bad. But thanks to the Fed, it became irresistible for firms to go public, and a culture of enormous risk taking took shape.
“I’ll be gone, you’ll be gone,” as the saying goes. In other words, I get the bonus. Someone else takes the risk.
Growth at all costs
In addition to the focus on short-term results, the Federal Reserve’s massive subsidy to risk has also led to a massive emphasis on growth at all costs, since subsidizing risk is essentially equivalent to subsidizing growth. We’ve already seen how this works with tech startups and the venture capital industry where revenue, profitability and cash flow mean nothing. All that counts is growth. But this is true as well in the public markets.
Companies that don’t grow see their stock prices punished by the market. CEOs of companies that don’t grow see their jobs go to someone else. If you can’t grow organically, then grow via acquisition. Why focus on hard things like long-term research and development when you can do easy things like an M&A deal? As CEO I might not be around when the R&D pays off years or decades in the future, but I’ll be around to benefit when the deal happens and I’m a higher paid CEO of a bigger company (and if not, I’ll have received my golden parachute).
These incentives promote highly questionable (read: stupid) M&A transactions that not only destroy shareholder value (as the majority of M&A transactions do), but destroy jobs due to “redundancies.” Moreover, excess cash is not returned to investors, as it should be, and where it can be invested more efficiently. No, it is kept on the balance sheet, for to return cash is an admission that the CEO has no way to grow. And as we stated above, no CEO wants to make that admission.
Systematic risk
The third negative impact of financialization on the middle class has been by vastly increasing systematic risk of the financial system and resulting loss of economic stability. Such financial disruptions have enormous impact on the economy. We experienced such a crises in 2008-2009 and its aftermath, as bankruptcies, layoffs, defaults and recession hit the middle class. We will surely see this happen again. The Federal Reserve believes that it has been making the world safer by backstopping financial markets, mitigating downturns and smoothing out economic activity. On the contrary, the Fed’s efforts have led to an enormous increase in underlying risk.
Increased systematic risk in the economy is manifested in a large number of ways. Massive financialization has fundamentally changed the basic business model of banking from one based on relationships to one based on transactions. This change (which has also happened throughout the economy) is not for the better, contrary to the view of mainstream economists. For hundreds of years, the basic business of banks was simple and unchanging. Banks knew their customers, performed due diligence and kept their loans on their books. In short, they behaved “prudently.” The fear of bank runs, not regulators, led banks to limit risk and keep adequate capital.
Today, incentives are vastly different. Regulation of banks is dramatically higher yet so is the banking system’s underlying risk, as well as leverage. Banks sell off their loans rather than keep them, booking immediate revenue and profit, and obviating the need to perform proper diligence. That debt then gets securitized, “sliced and diced,” often backstopped by the federal government in the process, and then sold to institutions that have no idea what they are buying. Rinse and repeat. The net effect is substantially more debt, especially consumer debt, than the economy can support, and as we so painfully witnessed during last decade’s financial crises.
The financialization of the economy and securitization of debt markets has increased systematic risk in other ways as well. Large companies began funding their day-to-day operations with extremely short-term (overnight) debt which they roll over daily, rather than much longer term loans or lines of credit. Being dependent on debt markets each and every day to make payroll and pay vendors introduces enormous risk into the economy, as again we witnessed when debt markets seized up during the financial crises.
Finally, the perceived reduction of risk due to lower interest rates and the implied backstop of central banking activity coupled with an overriding emphasis on growth of financial institutions led to the explosion of the derivatives market. In fact, the derivatives market dwarfs the underlying debt markets perhaps by an order of magnitude or more. The size of the derivatives market and its inherent counterparty risks turns a bank’s balance sheet into an irrelevant joke and increases the risk of bank (and financial system) insolvency to astronomical levels.
The lure of Wall Street
The next of the seven damaging impacts of the growth of Wall Street of which we’ll discuss is the incentive for people to be employed in the financial services sector rather than put to more productive use. The best and brightest among us are encouraged by enormous compensation to become bankers and traders and hedge fund managers and venture capitalists, instead of becoming engineers and scientists and doctors and teachers. Yesterday Einstein changed the world as a physicist. Today’s Einsteins become hedge fund quants, seduced by money. The benefit to society? Zero. At best.
The bottom line is that when smart people are put to unproductive uses, only they benefit. But when smart people are put to productive uses everyone benefits. And since long-term GDP growth depends on productivity growth, and the long-term health of the middle class depends on GDP growth, until the best and brightest return to productive uses, the middle class is screwed.
In short, Wall Street has become a parasite. Its size vastly exceeds its value. It destroys economic productivity in the short-term by sucking resources that would be better allocated to Main Street. And it kills economic growth in the long-term by mis-allocating capital, leading to over-investment in short-term and unproductive uses of money and under-investment in long-term and productive uses.
Crony capitalism
Fed monetary policy has also led to the very unfortunate rise of crony capitalism. How, you might ask? By fostering a focus on short-term results and growth, by subsidizing public equity markets, by encouraging financial engineering and M&A activity, and by subsidizing valuations, and therefore the value of employee stock compensation, and consequently the quality of employees.
Of course, as companies get larger they have more money to lobby government (they become “special interests”) for various subsidies and tax incentives and protections (regulations, patent protection, tariffs and trade protection) for their businesses. These subsidies and protections work to keep out new entrants, and limit the competition from typically smaller competitors. Now you’ve got a positive feedback loop as these subsidies and protections from the Fed, from Wall Street, and from government make the company larger and more able to lobby for more subsidies and protections.
It is the essence of crony capitalism that companies become larger, industries roll-up and become more concentrated and less competitive, and governments work hand-in-hand with these large companies. A revolving door develops between government and big business. Small businesses are at an enormous disadvantage and suffer. They face disadvantages in funding due to their higher cost of capital, if they can get funding at all. Regulations (sponsored by the larger companies) act as barriers. Licensing requirements multiply, as does paperwork. Small business faces disadvantage in hiring because they cannot offer overvalued stock options.
We are experiencing this throughout the economy in virtually every industry. Local banks disappear as they cannot afford the regulatory costs that large financial institutions can. Small doctors offices disappear as they cannot afford the paperwork that large hospital networks can. Mom and pop retailers and restaurants disappear as they cannot afford the rent increases that large chains can. Small business struggle to survive, or go out of business. The lucky ones perhaps get bought out by the large companies. Moreover, many businesses cannot get started (outside of the tech industry) as they cannot get funding.
The middle class suffers too, for a number of reasons. As we’ve mentioned previously, large public companies are more likely to outsource and offshore jobs. Moreover, large public companies are less likely to invest in their employees. Innovation tends to fall, hurting productivity. Competition falls, raising prices. We wind up with monopolies which are the true enemy of capitalism. Remember that the foundation of capitalism and rising standards of living is innovation. And most of innovation comes from new business. Innovation is not occurring outside of technology sector, and within the tech sector, as we’ve discussed, it is mostly unproductive.
Special interests are an unavoidable byproduct of democracy. They have always been, and will always be. For there is an inherent risk/reward asymmetry between the entity that benefits from the special interest and the majority of the population that is hurt by the special interest. There will always be substantially more incentive for an entity to deploy resources to fight for a large payout than there is for the general population, each receiving a proportionally small payout by fighting against it. However, in recent decades, the power of special interest, the power of big business and the level of crony capitalism has become unprecedented. More than any other reason, for this we can thank the Federal Reserve, whose policies have favored large businesses and monopolies.
Mortgaging the future
As much as monetary policy has been damaging to the middle class over the past three decades, its impact on the future will be even worse. Unfortunately, the damage has already been done.
We’ve already mentioned the fact that low interest rates have subsidized consumer debt causing the middle class to consume when they should saved, and shifting consumption forward. The result being an indebted middle class that will have to consume less in the future. We have also discussed how much of the easy money fueled investment made over recent decades was unproductive and wasteful. We’ve talked about how Wall Street and the Federal Reserve allowed crony capitalism and monopolistic behavior to flourish at the expense of innovation and future productivity. We’ve discussed how short-term focused companies are under-investing in their employees, under-investing in basic research and development and pursuing financial engineering, acquisitions and share buybacks instead of long-term innovation. Add the fact that our monopolistic education system is failing to train the middle class. Put all these trends together and the inevitable result is lower economic growth in the future.
But there’s one additional impact of monetary policy of which we have not yet discussed. And this, unfortunately, will have an even greater impact on the middle class in the future. Whatever little savings of the middle class that does exist will likely be gone.
Government and the Federal Reserve have already done the middle class an enormous disfavor by encouraging people to use their houses (the primary form of middle class savings) as piggybanks during an enormous real estate bubble. Now Fed monetary policy decimates middle class savings even further because of exceptionally low interest rates. These low interest rates slowly destroy the basic business model of the middle class’s other two primary forms of savings, pensions and insurance policies.
Pensions and insurance companies, needing to match assets with future liabilities, cannot do so with safe investments because of low interest rates and low returns. So they must resort to much riskier investments. Sooner or later, the gap between asset and liability widens too much, and/or asset valuations plummet (which eventually they must) and the middle class suffers without the financial assets they assumed (and government promised) were safe.
Meanwhile, public pensions are in far worse shape as they were so over-promised to public unionized workers to make it inevitable that nearly all local and state governments will sooner or later become insolvent. Of course before that mess happens, another mess will ensue as basic services (police, fire, education, infrastructure maintenance etc.) are cut to try to stave off the inevitable but politically impossible need to reduce pensions. This process has already happened in a handful of municipalities around the U.S. but will become prevalent at some point. The middle class will suffer more than just reduced pensions as crime rises and infrastructure crumbles.
Recap of the causes of middle class decline
This has been a long argument, so before we leave the topic of the decline of the middle class, let’s really quickly recap our story. Starting 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 as economics 101 would dictate. 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, creating a 30+ year financial bubble and laying waste to the middle class. The 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, the future prospects of the middle class was even further mortgaged as retirement savings, pensions and insurance policies were bled dry.
To comprehend the causes of the decline of the middle class, we require little more than an understanding of basic supply and demand, something covered in the first week or two of economics 101. And yet, this all happened not just in plain sight of, but was for the most part instigated and directed by the economics profession. Baffling, don’t you think?
So that’s our first story in our explanations of the dramatic rise in income inequality. Now onto story number two. What has caused the dramatic rise in incomes and wealth worldwide for the 1% and even more so for the .1% and even more so for the .01%?
Type 2 income inequality: the rise of the 1%
As damaging as a declining middle class is to society, the shocking rise of the wealthy and super wealthy is much worse. For one, it is a truly global phenomenon. But more importantly, it is the fuel of revolution. History teaches that the masses don’t revolt simply because they are struggling and experiencing a decline in their standard of living (Type 1 income inequality). They revolt when they are struggling YET AT THE SAME TIME, their political and business leaders, the so called elite, are prospering wildly. And the upper class is truly prospering, in terms of wealth and in the political power with which wealth brings. And this, more than anything else going on today, is causing a backlash against capitalism leading to the growing popularity of populist, fascist and socialist leaders.
Just like we did for Type 1 income inequality, we must now ask ourselves why. Why has the level of income and wealth been increasing so drastically for top earners? And why has the level of income and wealth been increasing even more astronomically for the top earners among the top earners?
This insidious trend has three main causes. And in fact, they are 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 explanation of middle class decline was a combination of the three trends, and all three are required. The rise of the wealthy is primarily a result of monetary policy and financialization. This is the great cause. It was then exacerbated by regulation and exacerbated even more by globalization.
Asset valuations
Let’s start our story with the most obvious result of easy monetary policy, higher asset valuations. As we learn in Finance 101, lowering base interest rates (other things equal) reduces the cost of capital of all financial assets, and raises the valuation of all financial assets. What do we mean by the term “financial assets?” Stocks, bonds, private companies, real estate and anything else that has scarcity, at least a minimal amount of liquidity and can be used as a store of value including art and fine wine and any other collectibles.
Equally obvious, raising the value of such assets benefits those who own those assets by increasing their wealth. And most obviously, it is the wealthy who owns most of the world’s private wealth. Clearly, increasing the value of financial assets makes the wealthy even wealthier, and this is our first example of how central banking activity has led to Type 2 income inequality.
Wage/price spiral
The second most obvious impact of loose monetary policy on Type 2 income inequality comes out of the Economics 101 textbook, yet goes unrecognized by those teaching economics. This is the wage/price spiral whereby wages (and the number of jobs) increase so more workers can afford to pay more money for goods and services. At the same time, providers of those goods and services experience rising demand and thus raise prices. Workers seeing higher prices demand even higher wages, which leads to even higher prices, which we call “inflation.”
The middle class has not experienced such a wage/price spiral and the price index that more or less tracks middle class cost of living, the consumer price index (CPI) has not risen past the Federal Reserve’s target of 2% per year. However, the wealthy as a group have experienced such a wage/price spiral and such inflation, something that does not show up in the CPI, and seems to be completely beyond the view-port of economists at the central bank.
For example, as Wall Street compensation (both per person and the number of jobs) has increased dramatically over recent decades (which we will discuss shortly), New York real estate prices have also dramatically climbed. As have the prices for other goods and services sold in New York, luxury restaurants, for example. We see the same trends, for instance, in San Francisco where the total compensation of technology workers has increased equally if not even more dramatically, as has real estate, restaurant and other prices. We see the same trend occurring throughout the world in major metropolitan cities dominated by finance or technology or some other industry that has experienced dramatic (and inflationary) growth such as oil.
That this wage/price spiral is occurring only for the already high income segment of society clearly exacerbates income and wealth inequality. This is also why luxury good inflation is much higher than regular good (i.e. middle class) inflation.Whereas the CPI has averaged about a 2% per annum increase, I would surmise that inflation of luxury goods and inflation in major metropolitan areas has been closer to 6 or even 8 percent per year. And the higher up the luxury good food chain we go, the higher the inflation rate. In other words, the inflation rate for millionaires is high. The inflation rate for billionaires is even higher. The price of a BMW up. Collectable Ferrari up more. The price of a two bedroom apartment in New York City up. Upper East side townhouse up more. The price of a bottle of non-vintage champagne up. 1982 Chateau Petrus up more. You get the idea.
Growth of Wall Street
So far we’ve discussed how monetary policy has fueled the rise in asset prices owned by the wealthy and the inflationary wage/price spiral of the upper class. Next, I want to discuss how monetary policy has led to the rise of specific segments of the 1%. Let’s start with what is probably the largest segment of the increased 1% over the past three decades of easy monetary policy, Wall Street and the financial sector. Of course, bankers have always been among the highest paid workers in the economy. But over the course of the last 30 years, the number of high-paid finance workers expanded dramatically, as did the level of compensation given to those workers.
Decades of Fed monetary policy, with its below market interest rates and through repeated financial bailouts acted as a direct subsidy to banks and other financial institutions, encouraging these banks and financial institutions to grow and to take on more risk. This was further bolstered by a regulatory environment (spearheaded by the Federal Reserve as well as other regulatory agencies) that has favored large financial institutions over small ones because of the erroneous yet widespread view that big banks are less risky.
With ballooning balance sheets thanks to easy money, Wall Street grew, and grew, and grew. Increasing revenue brought increasing profits and increasing profits brought increasing bonuses. Moreover, every time the industry took on too much risk and got in trouble, the Federal Reserve bailed it out. The lesson learned? Take on even more risk. Use more leverage.
Financial institutions grew virtually all aspects of their business and invented new businesses as well. Low interest rates, high asset valuations, an expansive risk appetite and tunnel vision for growth resulted in dramatically increased activity in mergers and acquisitions, securities trading, structured products, asset management and other revenue producing areas of large banks. The prime benefactors? The likes of investment bankers, traders, quants, institutional salespeople and private bankers.
Finally, it is worth noting that the massive growth of financial institutions and compensation would never have occurred had those financial institutions remained privately held partnerships, as they had been for centuries. Having one’s own money on the line naturally limits the amount of risk one is willing to take. However, the enormous subsidy to financial markets provided by the Federal Reserve and the regulatory environment favoring large institutions made it irresistible for banks to go public. So not only did banking partners become massively rich and liquid overnight, directly feeding income inequality, but the prudence developed over hundreds of years went out the window.
Hedge funds
While the growth of Wall Street, more than any other industry, resulted in the drastic expansion of the income and wealth of the 1%, a certain subset of Wall Street is probably most responsible for the increase of the wealth of the 0.1% and 0.01% – hedge funds.
Hedge funds are essentially unregulated pools of money that can be invested with few, if any restrictions. Most notably, they differ from mutual funds in that they use leverage and can short stocks. Because what they can invest in is essentially unregulated, and because these investment can be risky, the government limits who can put money into hedge funds. And as we’ll see, just who are the investors in hedge funds is they key to understanding how hedge fund managers became so wealthy.
Hedge funds have been around since the late 1940s but until the past few decades reflected a tiny subset of asset management. Originally, hedge funds were designed to be investment vehicles only for wealthy individuals. However, beginning in the late 1980s and especially 1990s, hedge funds began attracting money from a vastly different type of investor, not the wealthy individual but the institutional investor: pension funds, insurance companies and endowments.
Historically, these kinds of institutions invested in relatively safe investments, most notably bonds, in order to ensure they had the future income to meet anticipated liabilities (i.e. pension payouts and insurance claims). However, because of easy monetary policy and the low interest rates that go along with easy monetary policy, the return on relatively safe bonds became insufficient to meet future liabilities. In order to make the returns necessary to remain solvent, these institutions had no choice but to take on more risk. They began to invest in riskier (i.e. high yield) bonds, stocks and so-called alternative investments such as hedge funds.
Given the enormous amount of money controlled by institutions such as insurance companies and pensions, along with low interest rates and the decades long Fed-fueled bull market, it is no wonder that the hedge fund industry grew wildly. But we have not yet explained why the hedge fund industry minted so many billionaires and contributed to the rise of the super-wealthy. To understand this, we must look to the hedge fund fee structure.
Over the past few decades, other types of investment vehicles have also seen dramatic increases in assets under management. For example, there are many mutual funds that have grown to manage billions of investors’ dollars. And while mutual fund managers are certainly well paid, and are card-carrying members of the 1%, they are not billionaires. That is because mutual fund fees are a very small percentage of total assets under management, typically (and often significantly) less than 1%. Hedge funds, on the other hand, have a very different fee structure.
As the hedge fund industry grew, the typical fee structure for hedge funds became more or less standardized at what is known as 2 and 20. That is to say, 2% annually of assets under management and 20% of investment profits. A handful of high profile funds even charged substantially higher fees. To illustrate the difference in fees, let’s consider a mutual fund and a hedge fund that both had $10 billion of assets under management and produced an investment return of 20%. If the mutual fund charged a reasonable 1% fee, it would be entitled to $100 million annually (1% of $10 billion). On the other hand, the hedge fund charging 2 and 20 would earn $600 million (2% of $10 billion plus 20% of the $2 billion of profit). Whereas mutual funds tend to be part of large organizations with substantial overhead, hedge funds tend to be small, with only a handful of partners sharing the profits. It is easy to see how the fee structure of hedge funds has made some hedge fund managers very, very rich.
Of course, if hedge fund fees are so high, and if hedge funds are minting billionaires, one would expect their investment performance to be stellar. Alas, this is not the case. While a handful of hedge funds have indeed performed well over time (whether due to luck or skill or both), most have not. In fact, that vast majority of hedge funds have under-performed a broad stock index such as the S&P 500, especially on a risk-adjusted basis.
The obvious question remains. If hedge fund performance has been weak, and if hedge funds as an asset class add little economic value, how have hedge fund managers been able to get away with charging their exorbitant fees? To answer this we must return to the question of who are the primary investors in hedge funds and what are their incentives.
Recall that the original investors in hedge funds were wealthy individuals. Note also that the investors in mutual funds are individuals, wealthy and middle class. In either instance, individuals have strong incentives to monitor performance and limit fees if performance does not justify those high fees. In other words, people tend to watch their own money.
The managers of institutional money have very different incentives. Remember that institutions with large pools of money are pensions, insurance companies and endowments. Most pensions funds are state run (The California Public Employees’ Retirement System “CalPERS” being the largest in the U.S.), most endowments are either state run or not-for-profits (universities for example) and most insurance companies are highly regulated public companies (though they used to be owned by their policyholders – another casualty of central bank induced financialization).
There are few incentives for institutional money managers to maximize performance, to minimize fees or to limit risk. Instead the incentive is first and foremost to keep one’s job, and the way to keep one’s job is to do what every other institution is doing. To invest in the same asset classes and same funds, use the same consultants and benchmarks. Moreover, as a public, not-for-profit or highly regulated employee, compensation is typically limited and not tied to investment performance. Instead fund managers are “paid” by hedge funds in “soft dollars” or perks such as dinners, shows and golf outings. Why complain over fees if you’re being entertained with fancy dinners, shows and more? The larger the hedge fund, the more dollars and clout they have to entertain institutional fund managers, so the rich get richer.
Long story short, most hedge funds have poor performance, yet hedge fund founders and partners make millions each year, if not billions because they “take care” of their clients, the institutional managers. Not only does this feed income and wealth inequality but hedge funds are effectively and legally skimming off money from middle class pensions and insurance policies. From the standpoint of their value to the economy and to society, it is hard to imagine a less deserving member of the wealthy than the hedge fund billionaire.
Before we leave the discussion of hedge funds, it is worth noting that other alternative asset classes, for example private equity and venture capital, exhibit the same trends as hedge funds. They too have institutional investors. They too charge high fees (also often 2 and 20). They too suffer poor performance, especially risk-adjusted performance as an asset class. They too have minted many a billionaire because of the misaligned incentives of their investor clients.
Tech moguls
If the finance sector has been the largest beneficiary of decades of easy monetary policy, the technology sector is surely second, and not too far behind. As we discussed when explaining the decline of the middle class, monetary policy, by subsidizing growth and risk, has had enormous impact on the tech sector and on the valuations of technology companies. And just as the financial sector has vastly expanded the wealth of the 1% and created a significant number of billionaires, so too has the technology sector.
In nearly every sector of the economy, easy money and the Federal Reserve’s subsidy to risk and to growth coupled with the crony capitalist regulatory advantage for large companies has led to industry consolidation. In no industry, however, has this been as blatant as in the technology sector. We are conditioned to think of technology as the most competitive of sectors given the low barriers to entry, the endless parade of startups and the very notion that technology is “disrupting” established industries. And in some superficial ways this is true.
However, when we dig a bit deeper we realize that no industry is as concentrated and no supposedly unregulated industry has as many companies with as much monopolistic power as technology. Intel for computer chips. Microsoft for software. Google for search. Apple for phones. Amazon for internet retail and cloud computing. Facebook for social media. And newer near-monopolies such as Uber and Airbnb.
How did this happen to what was, and is supposed to be a highly competitive and unregulated industry?
An economist would probably say this concentration is a result of economies of scale, either because the cost of business is reduced as revenue grows, or because of so-called network effects that result in significant concentration. No doubt that certain sectors of the tech industry do exhibit economies of scale. For example, the high gross margin nature of the software business (software that is expensive to create and then virtually free to replicate) exhibits increasing marginal returns. And businesses such as eBay do exhibit network effects whereby more sellers attract more buyers and more buyers attract more sellers.
However, there is no way that traditional economies of scale can justify the level of concentration in technology. Something else is going on. And that something else is money. Too much money. Too much money has created a winner-take-all game in technology. To some extent this has happened in every industry as nearly every industry has experienced consolidation over the past few decades. However, this has happened far more in technology because of the industry’s generally low startup/growth costs and because the Federal Reserve’s easy money subsidy is greater for high growth/high risk companies, leading to extremely high valuations.
We can see this trend clearly when we examine the business model of startups and venture capital. For startups, the goal of course is to raise money. In the old days, to raise money required significant experience in the same industry or same type of business. You needed to convince lenders, bankers and investors that you had the wherewithal to create and run a profitable business. Today relevant experience means little, and the ability to build a profitable business means even less. What matters is your access to money. Go to the right schools (Stanford), work (briefly) at the right companies, be from the right (wealthy) family. Its all about pedigree, not experience. A breeding ground for inequality and certainly not what we think of as the American way.
If the first goal of startups is to raise money, the second is to grow. That, of course requires more fundraising and more money. And raising money requires a high valuation. And it also requires more employees. And to attract those high quality employees we need to give stock options. And to make those stock options attractive we need a high valuation. And to keep our high valuation we need to grow. And so on. We’ve got a cycle with which only a very small number of companies can keep up. Most cannot. And in the end, the winner takes all. Not because of a better business or higher profits or economies to scale. But because of money.
The third and final goal is to exit, through IPO or more likely sale to one of the larger tech monopolies, fostering even more industry concentration. Exit with a high valuation. With a billion dollar valuation, as a so-called “unicorn.” The winner-take-all, lottery-like startup model jives with the winner-take-all, lottery-like venture capital model. Throw gobs of money at 15 companies with the full expectation that 14 will fail and with the hope and prayer that 1 will succeed. As long as that single success has an exit or liquidity event at a large enough valuation, the venture model works. And with one huge winner and many losers we’ve just described one of the textbook definitions of income inequality.
In the end, we wind up with Googles and Apples of the world, the Bezoses and the Zuckerbergs. The easy money that fosters the “winner-take-all” mentality, that encourages industry concentration, that subsidizes company valuations and stock prices, ultimately creates the tech millionaires and billionaires that are a large part of the income and wealth inequality story. And just as financialization and the growth of Wall Street creates a wage/price inflationary spiral and exacerbates income inequality in financial centers such as New York, so too does the growth of tech valuations and tech monopolies create the same inflation and inequality in places like San Francisco and Silicon Valley and Seattle.
Finally, it is important to point out that while the Federal Reserve is the primary factor responsible for technology sector concentration and the income and wealth inequality stemming from the tech sector (not to mention creating asset bubbles in the technology sector), it is not the sole cause. Federal government policy and regulations play a role here too in the consolidation of the tech industry, by fostering monopolies and crony capitalism, and by treating the internet and related technology as a “public good” which it should not be (for example net neutrality legislation), thereby subsidizing directly technology companies and picking winners and losers.
For example, in the U.S. we’ve got a ridiculous patent system that favors large companies who can afford expensive lawyers and lawsuits at the expense of smaller businesses who cannot. Similarly, companies with very deep pockets can fight, lobby against or even ignore and violate local laws and regulation in order to grow their businesses, as companies such as Uber and Airbnb have done. And once such companies get to a certain scale and size, they can then spend marketing money to affect public opinion and lobby to change the laws to their benefit. Smaller competitors cannot afford to take the same risks, play by the same rules, hire the same lobbyists or spend on marketing to change public opinion.
Public company CEOs
So far in explaining the rise of the wealthy, we’ve talked about Wall Street, we’ve talked about hedge funds and we’ve talked about technologists. The next group to discuss is the public company CEO. In the 1970s, public company CEOs made less than 30 times the average worker’s salary. Today, CEOs of public companies earn upwards of 300 times the salary of the average worker. Yet corporate profitability is not any higher, nor is there any significant correlation between long-term company performance and CEO compensation.
So why have CEO salaries skyrocketed? The answers to this question will be familiar from our previous discussions. Throw in perverse monetary policy and some government regulation, put them together and you get some messed up economic incentives and enormous income inequality.
To understand why CEO compensation has exploded we must first understand how CEOs are compensated. Historically, the bulk, if not all of CEO compensation was paid in cash. However, beginning in the 1980s more and more of a CEO’s compensation has come in the form of stock and stock options. And it is now the stock component that represents the majority of the average CEO’s pay package. And it is the stock component that is mostly responsible for the dramatic increase in total CEO compensation.
The idea behind compensating executives in stock rather than cash is an obvious one: to align management’s interest with that of shareholders. When stockholders do well, the CEO does well. However in practice, this compensation structure has done the opposite. It has served to enrich CEOs at the expense of shareholders. Given the the vast amount of riches a CEO can earn if their company’s stock price rises and through their golden parachutes upon a liquidity event, CEOs have enormous incentive to take risk and to grow at all costs especially through mergers and acquisitions. CEOs are also incentivized to focus on short-term results by managing earnings, to appease activist investors by cutting costs, buying back stock and through other forms of financial engineering. The short-term nature of equity markets also acts to discourage CEOs from making long-term investments in capital, investment in basic research and development, and investment in the training and development of employees.
The next question to ask is how CEO compensation is the fault of monetary policy. The answer is mainly, because low interest rates and subsidized risk led to a 30+ year stock market bubble which directly impacted the value of those stock options, and hence CEO compensation. Moreover, ever higher stock prices naturally led CEOs to demand that more and more of their compensation be paid in stock and stock options rather than in cash, leading to what is essentially a momentum based feedback loop. Owning more stock led CEOs to take on more risk, do more M&A and focus more on growth in order to keep stock prices high. High stock prices led to more CEO demand for stock and stock option compensation. And so forth.
High stock valuations also had the ability to mask poor performance since, as they say “a rising tide lifted all boats.” In other words, many CEOs benefited enormously from an overall bull market and from multiple expansion rather than from higher profits or better company performance. In addition, the Fed’s subsidy to equity markets, to growth and to M&A activity led to larger companies, and hence larger CEO pay packages since it is easier to justify higher compensation for running larger companies. Lastly, just as we discussed with hedge funds, low interest rates forced pensions and insurance into riskier investments like stocks, which further increased stock prices.
In addition to monetary policy, regulation and tax policy also plays a significant role in explaining the significant rise of CEO compensation. SEC regulation stipulates that CEO (and other executive’s) compensation packages are publicly disclosed. This leads CEOs and the compensation consultants they hire to benchmark compensation towards the high range of competitors, an ever escalating game of leapfrog. Moreover, until recently accounting rules allowed companies to ignore the expense of stock options (but not cash salaries) in calculating profits. The advantageous tax treatment of capital gains versus ordinary income rates also served to encourage compensation in stock, as did regulations that limited a company’s ability to deduct from taxable income non-performance based compensation. Lastly, as we’ve noted many times, crony capitalist regulation favors larger companies over small ones, encourages M&A activity and hence, stock compensation.
Before leaving the topic of CEO compensation, we would be remiss in not asking ourselves the following question. Why haven’t investors put a stop to exorbitant CEO compensation? For the same same reason investors haven’t put an end to exorbitant hedge fund fees. That is to say, there is little incentive for owners of stock to do so. Just like with hedge funds, most owners of stock are either institutions (insurance companies, pensions funds and endowments) or mutual funds. Neither institutional fund manager nor mutual fund managers are managing their own money, and therefore have few incentives to go against the grain and fight the battle to bring executive pay under control.
The global 1%
We have talked about how monetary policy, and to a smaller extent how regulation have fueled the rise of Type 2 income inequality. We have not yet mentioned the third contribution to this unfortunate trend, globalization. Unlike with the decline of the middle class, where globalization set off our story, here globalization is more the icing on Mary Antoinette’s cake. And whereas in the story of the middle class, globalization took the form of tradeable (and mostly manufactured) goods and services, here we’re talking about the international flow of money.
In this article when we’ve discussed central banks, we’ve primarily focused on the U.S.’s Federal Reserve. However over the past few decades, all of the major central banks of the world have used the same Keynesian and monetarist models, and executed the same easy-money playbook. So, for the past few decades it hasn’t been just the Fed printing trillions of dollars and subsidizing U.S banks and U.S. financial markets. It has been all of the major central banks of the world, including the European, Japan, China, UK and Swiss doing the same thing, propping up banks and financial markets all over the world.
And over the past few decades with only a few exceptions (China, for instance) capital has been more or less free to flow across borders to seek the highest return. For example, take the “carry trade” which Japan made famous. Since the Japanese were the first to try zero interest rate policies in the 1990s in response to the crash of their real estate and stock market bubble and their ensuing depression, it became profitable for investors to borrow very cheaply in Japanese Yen and then invest that money in higher yielding projects, perhaps in emerging markets or in U.S. real estate.
Remember from when we discussed the decline of the middle class, we talked about how the Fed believes (erroneously) in the idea that they can control inflation through monetary policy. Recall also that one of the key implicit and completely unrealistic assumptions that the Fed makes is that the money printed by the Fed (or by banks spurred on by low interest rates set by the Fed) stays in the U.S. That is, that the new money remains within the U.S. economy and helps creates U.S. jobs.
However, as we said when discussing the carry trade just a moment ago, in a global economy, this is not at all the case. In the international system we have, money can easily flow to wherever it might have the highest returns. So money printed in the U.S. by the Fed or by U.S. banks might not spur U.S. employment but may very well spur investment outside the U.S. Similarly, money printed by the Japanese central bank, given lack of good investment opportunities inside Japan, can easily flow into the U.S. spurring economic activity, employment and ultimately inflation in the U.S.
In either case, in a world of massive central bank money printing AND free capital flows (whether U.S. money flowing overseas or overseas money flowing into the U.S.), the link between monetary policy and domestic economic activity, employment and inflation is severed and broken. Regrettably, the Federal Reserve and other central banks of world seem not to understand this key point.
Now let’s bring the discussion back to income inequality and the rise of the wealthy. In essence, everything we’ve talked about how monetary policy feeds the rise of the wealthy in the U.S. gets increased even further when we add global central banking and the rise of the international financial sector.
We already mentioned how easy monetary policy from the Federal Reserve led to increased asset prices which benefited the wealthy who own far more financial assets than the middle or lower classes. We’ve also discussed how loose monetary policy was a direct subsidy to Wall Street and the financial sector. Very simply, since all the world’s central banks have been subsidizing banks and financial markets, since nearly all large banks have global operations, and since money flows easily across borders these affects on asset prices and the world’s financial sectors were dramatically magnified.
We also discussed how enormous amounts of money have led to high inflation for “wealthy” goods. Naturally, free flowing global capital further accelerates this trend. Its not just domestic hedge funders or tech moguls that compete to own New York real estate or fine wines or modern art or sports teams. So do Russian oligarchs. And Chinese billionaires. And Arab oil princes. Moreover, this inflationary trend is significantly exacerbated by the need for those wealthy people from less free and less democratic countries with their authoritarian governments to get money out of their own countries, even if it means paying inflated prices for assets.
Recall that when we discussed CEO compensation, we discussed how CEOs benchmark their pay packages to the highest comparable CEOs. Globalization has led to even larger companies through international M&A activity and international consolidation. This has had the effect of raising executive compensation in at least two ways. Rather than benchmark pay to only domestic companies, CEOs can now compare pay packages to international and multi-nationals competitors. Second, since executive pay is correlated with company size, today’s larger multinational companies have led to correspondingly larger executive pay. It is worth noting that the rise of CEO compensation used to be primarily a U.S. phenomenon. However in recent years thanks to global monetary policy, the rest of the world has now adopted such “best practices” in compensation. CEOs of the world unite!
Another contributor to global Type 2 income inequality is what we’ve referred to as crony capitalism, at least in developed countries like the U.S. More accurately and less politely, we can call this “corruption,” especially in less developed countries. Whereas the subsidies to large and public companies in the U.S. has led to vastly inflated CEO salaries, in developing countries corruption has caused the rise of oligarchs who were allowed and/or encouraged to essentially steal the assets of their country. This trend was furthered exacerbated by a decades long commodities boom fueled by easy money that led even more so to the rise of billionaires in emerging markets (since emerging markets tend to be heavily commodity focused), not to mention the dramatic wealth of oil producing countries and their ruling families.
Finally, it is worth mentioning that vast wealth buys not just real estate, wine, art and sports teams, but also politicians and political power. And with political power brings a vicious cycle that enhances income inequality. The wealthy benefit from crony capitalism and corruption and gain even more political power. They can then put in place laws and regulation which begets more wealth and more political power. All to the detriment of the lower and middle classes. This trend is most obvious in less developed and less democratic countries but is also quite powerful in the U.S. where the wealthy have gained enormous political power to influence elections through lobbying and through organizations such as Super PACs.
Of course it is not new that money corrupts democracy and that people can buy elections. This has always been the case. But what is new is how much money there is out there and how easy and politically acceptable this type of corruption has become. Just as the rise of the wealthy is a truly global phenomenon so true is their political influence.
The free market and the 1%
As I stated at the top of this section, the dramatic rise of the wealthy and the wealthy’s power is a primary reason why capitalism is under siege. CEOs get paid a hundred or even a thousands times the salary of an average worker for making value-destroying acquisitions and under-investing in the future. 25 year old college dropouts become billionaires overnight for creating products that have zero revenue and zero business model. Hedge fund managers take home nine or ten digit compensation each and every year for speculating with the public’s money and under-performing an index.
Popular disgust is justified. But placing the blame on capitalism is not. What we are witnessing is not capitalism running wild. What we are witnessing has nothing to do with a free market. No, what we are witnessing is a world afloat in too much money thanks to the money printing and risk subsidizing policies of central banks. What we are witnessing are the perverse incentives and crony capitalism that naturally spring from an enormous government sector that allows gains to be privatized but socializes losses.
Finally, to those who believe that the rise of the super-wealthy is an inevitable outcome of capitalism, I point to 2008 when the fundamental forces of the free market were desperately trying to reassert themselves. After decades of easy money and government support, Wall Street was imploding under its own leverage. Global banks were failing. Wall Street jobs were disappearing. Valuations were plummeting. Money was being extinguished. In short, the exorbitant wealth of the wealthy was diminishing, and diminishing drastically.
Scary? Yes. Painful? Yes. But allowed to continue, the world would have eventually returned to one of much greater equality, higher productivity and stronger economic growth. This was the economic “reset” the world desperately needed. Of course as you know natural events were not allowed to continue.
Like every other time over the past three decades when financial markets hiccuped from too much money and too much risk, the market was not allowed to correct itself. Understandably but short-sighted, fearing both economic depression and the loss of power and wealth rapidly being extinguished, the central banks of the world led by the Federal Reserve, and the central governments of the world led by the United States, printed massive amounts of money, lowered interest rates drastically, and bailed out the financial system. Once again, doubling down (in a exponential sort of way) on the causes of the financial crises, leading us to the next and even larger financial crises, and exacerbating even more income inequality.
What can we do to reduce income inequality?
Income inequality is a problem. It will lead to political unrest. It will lead to more politicians of populist persuasion. It will lead to isolationism. It will lead to protectionism and trade wars. It will lead to cold wars and hot wars. Sooner or later, as it gets worse and worse, it will lead to revolution, even in democratic countries like the U.S. What can we do?
The largest contributor to Type 2 income inequality, and a very significant contributor to Type 1 income inequality is the Federal Reserve, and its monetary policy. 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. Of course, this message will not sink in right away. The financial sector will have to learn the hard way through failure and bankruptcy. It will painful for them, and for all of us. But it must happen. And in fact as we just noted, it almost happened in 2009, but we didn’t let it.
If we stop subsidizing risk and let interest rates be set by market forces, asset prices will fall immediately and substantially. This too will be painful, but it will also have an immediate and substantial impact on income and wealth inequality. As money dries up, 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, with their outrageous real estate prices will suffer, but 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. Speculation will never disappear for it is perhaps the world’s second oldest profession and yes, necessary. But it will go back to being the small and unrespected backwater that it has been for most of recorded history. On the flip side, banking will once again be respected and be boring, and that will be good.
Technology disruption and automation will be slowed, though never stopped. Companies that don’t make money will disappear, as they should. 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. Productivity, and the entire middle class will benefit.
Meanwhile, while the financial system goes through a reset, 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. No, we do not want to return to the days of child labor and toxic rivers. But a consenting adult who is willing to work must be allowed to, at any wage, and in any industry. It will take time, but manufacturing will return. Quicker too if we allow immigration, as we should.
Ending the experiment with socialized monetary policy and reducing regulation is most of the battle for reducing income inequality, helping the middle class and returning our economy to healthy growth. Of course there are other things that must be fixed too. Our monopolistic education system is appalling. It is wasteful, inefficient and poor in results. Ditto for our healthcare system. Our infrastructure is falling apart. Our governments at all levels are bankrupt with pensions and retirement costs that they will never be able to afford.
Simply put, 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. We need to relearn the enlightened lessons we learned a long time ago. It is the only way to preserve our way of life. This will take time, maybe a generation, and there will be pain in the process. For more than 30 years, we’ve become addicted to cheap and abundant money and financial bailouts courtesy of central banks. And since the New Deal in the 1930s, we have also grown dependent on increased government regulation. Only a return to market forces will allow the middle class to be revived.
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. Plus it is moral. 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.
Appendix: The 7 incorrect arguments for income inequality
Before we leave this very long post (and vitally important topic), I want to briefly (I promise) list the various explanations that mainstream economists and politicians have provided for increasing income inequality, and discuss why they are wrong.
1. Globalization
Yes, globalization is part of our story behind increasing income inequality. Yes, globalization has winners and losers (though the winners vastly outnumber the losers). Yes, the world (and the U.S. in particular) likely experienced more global trade than it should have. However, it was not globalization that hurt the middle class. It was the inability to allow the free market to adjust to the effects of globalization that hurt the middle class.
Manufacturing wages should have fallen, but they were not allowed to due to government regulations and unions. Prices should have fallen but they were not permitted to by the Federal Reserve. Tax policies, cheap money and regulation all favored and subsidized big business which had the means and incentives to outsource and offshore. In short, government and the central bank ensured that the losers of globalization were not a few steel or auto or garment workers, but the entire middle class.
2. Skills and automation
Yes, high skilled workers have fared much better than low skill workers. Most of the U.S. jobs lost to globalization over the past few decades were low-skilled jobs, whereas high skilled jobs were mostly unscathed. For a while, mainstream economists tried to explain increasing income inequality by maintaining that the modern “post-industrial” or “service” economy favored high skilled workers, and that low-skilled workers would have to adjust (more education and training) or be left behind. However, today even very high skilled workers seem to be at risk of having their jobs automated away.
The implicit assumption that economists are making when blaming income inequality on skill discrepancies is that today’s post-industrial or service economy is somehow natural or evolutionary, the next stage of capitalism. I believe this is nonsense. The makeup of today’s economy (in the U.S., for example) is simply the outcome of government and central banking policies that for decades have favored capital at the expense of labor. It is too expensive to hire workers and at the same time, cheap money subsidizes technology and automation. Put another way, there are massive incentives to invest in software and robots and massive disincentives to invest in people.
Moreover, many of those high-skilled jobs that have been created have been in finance and technology, those two vastly unproductive sectors of which we’ve discussed previously. And of course, it doesn’t help low-skilled workers that the K-12 education system stinks in the U.S. due to it being a government run monopoly, nor that the price of college education has skyrocketed and become unaffordable due to Fed money printing. Long story short, it is no doubt true that the gap between low-skilled wages and high-skilled wages has grown. But there is nothing natural about this. It is due to the perverse policies of governments and central banks.
3. Decline of unions
Yes, the number of private sector union jobs has declined significantly over the past several decades, as has the power of unions. Yes unions fight for their own workers which typically results in rising wages and compensation. Yes, over the past few decades, the decline in the number of unionized workers has been correlated with the rise of income inequality. As we know however, correlation is not causation. In fact, the relationship between the two trends is exactly the opposite of what most economists not to mention left-leaning politicians believe.
As we discussed previously, unionization was one of the factors that helped cause middle class decline. Like any other special interest, unions served the few and hurt the many. By protecting the wages and compensation of a small number of workers, they helped make entire industries uncompetitive. Had unions been even more powerful or protected, the U.S. would have lost even more jobs. Just look to the automobile industry, where manufacturing thrives in “right-to-work” (anti-union) states like South Carolina and has been decimated in pro-union states like Michigan.
It is crucial to get the message across that to be anti-union is NOT to be anti-worker. Quite the opposite. Being pro-worker (and pro-middle class) requires one to advocate against unionization, against stronger labor laws and against minimum wages. To paraphrase Star Trek’s Mr. Spock, the good of the many must outweigh the good of the few.
4. Mercantilist China
Yes, China has been mercantilist. Yes, China has intervened in currency markets to keep the value of its currency from rising too fast, and thus aided its export oriented industries. Yes, China has subsidized many of its domestic industries with government directed financing and made it difficult for foreign companies to do business in China. Yes, the Chinese government has been reluctant to enforce international copyright laws and has helped Chinese businesses engage in blatant intellectual property theft.
If all this is true, why isn’t China mercantilism that cause of increasing income inequality? For the exact same reason that globalization isn’t the root cause. U.S. policy was just as complicit as the Chinese. By not allowing domestic wages and prices to fall, and by subsidizing consumer debt, government and monetary policy encouraged Chinese imports as much as did a weak Chinese currency. As we’ve mentioned previously, for a while U.S. consumers benefit from cheap Chinese goods, but as jobs and the middle class disappear, over the long-term it suffers.
Before we move on, keep in mind a few more things about China and Chinese mercantilism. First, as I’ve mentioned previously, by moving from a socialist to quasi-market based economy over the last 30 years, China has elevated more people out of poverty than any country in the history of the world. Second, one must keep in mind that the U.S. (and other Western countries) employ many of the same protectionist policies, such as import tariffs and export subsidies, as does China. Third, the U.S. in its very early days employed many of the same mercantilist tactics such as state-sponsored intellectual property theft of British technology and protective tariffs as China does today with the U.S. Fourth, understand that the Federal Reserve’s low interest rate policy as as much a manipulator of exchange rates as is Chinese monetary policy (other things equal, low rates weaken the Dollar).
Finally, for those of you with schadenfreude on your mind, know that China will have it coming. By suppressing its currency to aid exports, China has effectively been engaging in massive vendor financing (the Chinese government has to buy U.S. bonds). Sooner or later (either through higher U.S. interest rates or default) the value of these bonds will be reduced, leaving China with a substantial loss on its holdings. In addition, China has crammed probably three generations of economic growth into one, with unprecedented financial stimulus and an enormous debt bubble. Corruption and crony capitalism is rampant and the government is increasingly totalitarian. Pollution is horrific and demographics are terrible. The Chinese bubble will burst and it will be painful. It’s just a matter of time.
5. Greedy Wall Street
Yes, Wall Street, or more accurately, Wall Streeters, are the epitome of greed (I tell MBA students all the time that there is only one reason to go into a finance career – for the money). Yes, Wall Street has become parasitic to Main Street, to the overall economy and to the middle class. And yes, Wall Street is the conduit through which the enormous amounts of money that contributed to income inequality and the rise of the 1% has flown.
But Wall Street is not to blame. It is simply, and legally, taking advantage of the rules and incentives set up by government and by the central bank. Those rules and incentives are perverse, absurd and detrimental, and the fault must lie with those that make and enforce the rules and incentives, not those that follow them for their own gain.
For decades now, the Federal Reserve has subsidized risk through low interest rates and through the implicit (e.g. the “Greenspan put”) and repeatedly explicit bailouts of the stock market, banks and the financial system. Time after time, the financial system has taken on too much risk and has been bailed out by the central bank. Each time this happens, the lesson is enforced that risky behavior has no cost, that government will always come to the rescue. Profits are privatized and costs are socialized. Next time, take even more risk.
But it’s not just the Federal Reserve. Federal (and to a smaller extent state) government plays a role too in making the rules that distort incentives. Among other things, government has institutionalized a “too big to fail” banking policy, backstopped risky consumer debt (i.e. mortgages and student loans), socialized risk through FDIC insurance and directly invested enormous sums of money, through pensions, in dubious asset classes including the stock market, private equity and hedge funds.
The upshot of constant and ever-increasingly subsidized risk is one financial bubble after the next (each one larger than the previous), a financial sector vastly larger than its social role justifies, and the massive income inequality of which we’ve discussed. Vilify Wall Street all you want, but understand that Wall Street would have, and should have failed at least a half-dozen times over the past 30 years, if not for the bailouts, subsidies and upside-down incentives created by the Federal Reserve and the federal government.
Lastly, there are many out there who do blame government for the failings of Wall Street. Not because of the bailouts but because of a lack of regulation. To this I say two things. One, the free market is a far better regulator than government, IF it is allowed to work. Second, complex regulation (and financial regulation is certainly complex) CANNOT be effective when the regulators are paid a fraction of what is paid to those they are regulating.
6. Capitalism
Yes, capitalism inevitably leads to some level of income inequality. As we mentioned at the top of this article, people have different skills and experiences. Some are smarter, some work harder, some take more risk, some are luckier. Moreover, capitalism has never started at time zero. That is, in any country where capitalism has been introduced, there was already at least some legacy inequality, whether in business, in wealth, in land, in education, or in power.
Life is unfair and will always be unfair. But capitalism is the least unfair of any economic system ever tried, and I would argue, the least unfair of any economic system that will ever be tried. Capitalism cannot guarantee equality of results, nor would we want it to, but it is the only economic system that leads to anywhere near equality of opportunity. It is the only economic system that has raised masses of people out of poverty and the only economic system that has increased average life expediencies for those masses.
Unfortunately, capitalism is under siege by both the political right and the political left, by the mainstream media and even by mainstream economists. More than any other reason, it is under siege because of increasing income inequality. However, in criticizing capitalism, the mistake that is being made is to assume that Wall Street represents capitalism, that big business represents capitalism, that giant technology companies represent capitalism. Nothing could be further from the truth.
The United States is less a free market (less capitalistic), than it has ever been in its history. While the trend towards more socialism (i.e. welfare state) and less capitalism has been going on since at least the New Deal in the 1930’s, the past three decades have seen an enormous increase in both the size of government and in government regulation.
We’ve privatized gains and socialized losses in real estate, finance, banking and healthcare. We’ve subsidized big businesses and giant, monopolistic technology companies creating the essence of crony capitalism. We’ve rewarded greed and punished responsibility. We’ve screwed up incentives so badly that is has become cheaper for money-losing, job destroying companies to raise money than it has for money-making, job creating ones.
But more than anything else, we’ve allowed our central bank to play God. We’ve let a central agency determine interest rates, the single most important set of prices in the economy. Think about it slowly. A central agency setting key prices. In a nutshell, more than any other, this is the reason we are living in less and less a free market economy and more and more a socialist one.
Interest rates, you see, are the lever that determines the trade-off between consumption and savings, the trade-off between the present and the future. After 30 plus years of low interest rates, we’ve mortgaged the future. We’ve consumed instead of saved. We’ve transacted instead of built relationships. We’ve gone for the quick profit at the expense of long-term investment.
Capitalism only works if you allow it to work. We don’t. Instead we let government set prices, subsidize monopolies, reward failure, and punish savers. Simply put, and contrary to popular belief, today’s U.S. economy is nothing at all like a free market. Nor is any other economy in the world. Consequently, the current level of income inequality (especially at the wealthy end) is vastly greater that it would be, and should be, in a free market, and vastly greater than what is politically healthy.
Don’t blame capitalism for income inequality. Blame the lack of capitalism.
Before moving on, two final points. First, inheritance. There are those historical figures like Marx, and those contemporary figures like Piketty that have a fundamental distaste for inheritance, viewing it as unfair and perpetuating inequality. Such social commentators tend to favor a steep, if not 100% inheritance tax. No doubt one can make the case that inheritance is unfair. No doubt one can make the case that inheritance perpetuates inequality.
However, inheritance is necessary to both a democracy and to a free society. This is something that wise students of the enlightenment, such as the U.S.’s Founding Fathers, understand, and the unwise do not. As we discussed a moment ago regarding the importance of interest rates, the fundamental trade-off of life, and society, is that between now and later, the short-run and the long-run. Spend or save. Consume or invest.
In a democracy, there are crushing forces that favor the short-term at the expense of the long-term, most notably the desire of politicians to be elected and re-elected. The most vital, and often only constituent of the long-run is the owner of assets, assets that can be passed down to heirs. And most important of those assets are not cash or stocks or land but businesses. Here is another sad example of how government and monetary policy has mortgaged the future. By favoring and subsidizing public companies at the expense of private ones, especially in the most reputationally oriented industries such as banking and insurance, we’ve lost one of the few vital proponents of the long-term view and one of the crucial “checks and balances” on government.
Finally, socialism. There are those idealists or utopians that believe that all men and women should be equal, that there should be no such thing as income inequality. As a method of achieving their dream they turn to the idea of socialism. Such people seem not to have ever read history. For each and every time socialism has been tried it has failed. Whether in the former U.S.S.R. or Eastern Europe under the Iron Curtain, whether in Mao’s China or North Korea or Cuba or most recently in Venezuela, the outcome is the same. For the masses: misery, famine, starvation, corruption, low life expectancy, fear, repression, limited freedom. For the small political class: power and luxury. In short, the most extreme form of inequality one can imagine. Ironic.
How any sane and educated person can believe socialism to be desirable is beyond my comprehension.
7. Income inequality is justified by productivity
This last erroneous explanation for the rise in income inequality is different from the others. Whereas proponents of the first six explanations view increasing income inequality as both damaging and unjustified (as I do), those who accept this line of reasoning view today’s level of income inequality as a natural, desirable and justified consequence of free market activity. They view the decline of middle class wages as a result of declining productivity, and the increase of upper class wages as a result of increased productivity.
The arguments go something like this. Middle class wages have declined because they do not have the technical skills, creativity or work ethic to compete in a modern, technologically advanced, global economy. Upper class wages have increased because they do have the technical skills, creativity and work ethic to compete in a modern technologically advanced, global economy. Moreover, the economics of scale of both a technological and global economy make high skill workers even more economically productive. In short, middle class productivity has declined so middle class wages have declined and upper class productivity has increased so upper class wages have increased.
This is wrong, and believers of such a narrative have as wrong an understanding of the free market as do those on the political left. While both skill disparity and globalization play a role in explaining both types of income inequality (as we’ve seen), changes in productivity cannot explain the increases in inequality. This is especially true of the Type 2 (upper income) income inequality trend. For instance, there is absolutely no way to justify the enormous increase in the ratio of CEO pay to average work pay over the past few decades using any sensible metric of CEO productivity. Moreover, among public companies, there is no correlation between CEO compensation and company performance. Finally, there is no evidence that low-skilled workers have suddenly become less productive.
In short, it is erroneous to credit (or blame, depending on your biases), the free market with causing increased income inequality of either type over the past few decades. It is also an error to view this increase in income inequality as either natural or desirable.
