Middle class squeeze: The deep roots of an economic and social transformation

The current recession has stoked deep-seated fears about a declining middle class. A great collective anxiety about such a decline has been floating around for years now, and for good reason. As abundant data make clear, middle class families are being squeezed by stagnant incomes and rising expenses, and have been since the 1970s.

This week, Elizabeth Warren, chair of the Congressional Oversight Panel that is monitoring the TARP bailout funds given to banks, jumped into the debate on the topic. In an interview with The Washington Post, she said: "I believe that the middle class is under terrific assault."

An astute political player, she added: "And I don't want to play this as a capitalism issue." Actually, capitalism has quite a bit to do with the squeezing of the middle class -- but so do other factors, including government policy and deep structural changes in the global economy.
Here is more of Warren's statement on the subject, which provides a good sense of where middle class families stand today.
When we compare middle class families today with their parents a generation ago, we have basically flat earnings -- a fully employed male today earns on average about $800 less, adjusted for inflation, than a fully employed male earned a generation ago. The only way that families could increase their household income was to put a second earner into the workforce, and, of course that's now flattened out because there aren't any more people to put into the workforce. So you've got, effectively, flat income in this time period, with rising core expenses: housing; health insurance; child care; transportation, now that it takes two cars to get everywhere, two jobs to support; and taxes . . . families are spending a lot more on what you describe as the basic nut.
So how did we get here? Today, the top one percent now takes in 16 percent of national income, up from eight percent in 1980. The top 20 percent receive over 50 percent of all income.

This represents a major change from the glory years of the great American post-war boom, when the modern middle class came into its own. Historically, income inequality reached a peak in 1929, just before the stock market crash, and declined all through the postwar boom decades of the 1950s and '60s as progressive tax rates and restrictions on financial speculation limited the income of the upper class. Widespread prosperity in the post-war period raised incomes in the middle and bottom income brackets. But that trend reversed in the early 1970s, and income inequality has again reached the extremes last seen in 1929. By some measures, inequality is now more pronounced than ever before.

What happened?

What changed in the early 1970s to reverse the great postwar income convergence? A number of factors come into play, some more important than others. Three factors stand out: globalization, the emergence of a financial economy, and changes in government policy. Let's look at each one.

Globalization offers capital higher returns, consumers lower costs and employers what is known as "wage arbitrage" -- seeking out the highest value, lowest cost global workforce. Regardless of whether you agree with those who see globalization as the engine of wealth creation or as the force gutting middle class wages, it is capitalism writ large: capital flows to the highest returns.

Capital also flows along the path of least resistance. Contrary to received wisdom, capital doesn't flow to competition -- it seeks to bypass it or find markets which have no competitors. That is, it seeks the maximum risk/return ratio: the lowest risk, the highest return. The ideal risk/return scenario is a monopoly, in which the return can be raised even as the risk is reduced to near zero. A cartel or price-fixing scheme is near-ideal, too.

Though rarely noted, this is a longstanding trait of capitalism stretching back to Renaissance Venice. When trade became less profitable than farming due to rising competition, the Venetian elite stopped funding trade and bought farms on the Italian mainland. As a side effect, Venice ceased to be a military and trading power. But the elite remained immensely wealthy.

In other words, simply seeking out the lowest-risk, highest return can have pernicious consequences -- not just for the citizenry but for the nation.

Another important change in the early 1970s was the increasing flow of capital into the FIRE economy (finance, insurance and real estate), eschewing real-world investments as comparatively unprofitable. Some of this was due to globalization -- steel, for instance, could be produced cheaper in East Asia than in America -- but policies and regulations influenced this capital flow. For example, while the environmental regulations enacted in the U.S. in the 1970s have been a major success in terms of cleaning up the air, land and water we all share, in some cases they raised costs to the point that moving production overseas made financial sense.

The 1970s also saw the first beginnings of a loosening of financial regulations and the growth of credit and financial "innovations," such as securitization and derivatives. Capital increasingly fled real production for finance, which became the key profit-center of corporate America. GM didn't make money manufacturing autos; they made money selling loans to buy their cars. General Electric made more with its GECC finance arm than it did selling light bulbs and generators.

As a result, where finance and banking once generated a mere six percent of total U.S. corporate profits, by the height of the housing bubble in 2006 it was churning out 45 percent of all corporate profits. Indeed, U.S. "financial services and innovations" were the most heralded exports of the nation.

The pernicious result of this rising reliance on financial innovations and real estate was the growing appeal of speculation over the production of goods and services. To mention but one example: the average compensation of the top 10 hedge fund managers in the 2004-6 era was $600 million each. That is not a misprint: $600 million each.

Government policies actually encouraged this sort of risky speculation over actually investing in productive assets. To name but one example: hedge funds were allowed to report much of their speculative income as long-term capital gains, lowering their tax rate to 15 percent. Meanwhile, the tax rate paid by manufacturers of washing machines (for example) was 35 percent. Why invest in jobs, goods and services when playing with leverage and "innovations" was essentially rewarded by government policy?

Where Bill Gates, Michael Dell and Steve Jobs had built billion-dollar companies and fortunes developing real products for the real world, the fortunes made in the last decade resulted in large part from speculation and financial churn. Nothing was produced except an ephemeral kind of wealth that vanished in the meltdown of the very risk-laden "financial innovations" which were heavily touted as "safe" enough for the middle class to join in.

And join in we did, by the tens of millions. Having watched bigshot financiers speculate their way to hundreds of millions of dollars via leverage, the middle class household -- squeezed by flat wages and rising costs -- jumped into the housing and credit bubble with both feet. Millions extracted equity to spend on an upper-middle class lifestyle, while millions more speculated with extreme leverage (no or low down payments) to buy spec houses to flip for quick profits.

Borrowing capital on the cheap to invest in high returns is capitalistic to the core, and the result was the 1990s dot-com stock bubble (fueled by margin borrowing) and the 2000s housing bubble (fueled by low mortgage rates and minimal down payments). But we should note it was government policy which kept interest rates at historically unprecedented low levels.

Alas, the risks -- presented as low in each case -- turned out to be high, and each easy-credit-fueled bubble imploded, wiping out trillions of dollars in middle class wealth. The housing bubble bursting has been far more devastating to middle class wealth than the dot-com implosion of Internet stocks, for the reason that the house has long been the major store of middle class household wealth, not the 401K or stock trading account.

Studies have shown that the top 10 percent of American households own three fourths of all stocks and bonds; most middle class stock and bond holdings are modest. Thus the meltdown of the NASDAQ bubble did not do irreparable damage to middle class household wealth. But the bursting of the housing bubble did do irreparable damage to many household balance sheets. Seduced by cheap, easy credit, middle class households filled the gap between their flat wages and rising bills with borrowed money. While housing was rising, this debt could be offset with rising equity. But once housing popped, then assets receded, leaving only the debt.

Something else changed in the early 1970s: the U.S. government launched a long-term policy of devaluing the dollar. While this is often referred to as "inflation," it is in essence a devaluation of the U.S. dollar. It now takes $486 to equal $100 in 1973. A dollar bought over 300 Japanese yen in 1973; now it buys about 90 yen. The net result of this stealth depreciation of the dollar is that purchasing power has declined even as nominal wages and wealth have increased.

While "inflation" has risen almost five-fold, the cost of many essentials has risen much more than that. Chief among these is health care, which has skyrocketed to 16 percent of the entire GDP. Are we two times healthier than we were a few decades ago? That is hard to pin down, but we certainly pay two times more for medical care, adjusted for inflation.

This tremendous rise in health care costs acts as a hidden tax on the entire U.S. economy, making the nation less competitive and diverting discretionary household income to the health care complex. What's often lost in the current health care debate is that very few are willing to tackle the elephant in the room: skyrocketing costs. Merely shifting the burden from employers to taxpayers is accomplishing very little in the overall picture.

Where do we go from here?

The story of the middle class squeeze is complex, but its effects are not hard to see. Despite an increase in national wealth over the last 40 years, the wages and wealth of most of the U.S. population are flat at best. Owners of capital and the professional class, who make up the top five percent (or less), are the only ones who received the benefits of economic growth over the last few decades.

While some observers point to middle class ownership of stocks and bonds as evidence that this trend benefits the middle class as well as the wealthy, they fail to note that middle class ownership of stocks and bonds is a mile wide but an inch deep. The vast majority of households own less than $10,000 in stocks or bonds, including IRAs.

During the recent speculative mania, elite and middle class interests seem to converge, as everyone appeared to benefit from the real estate bubble except the poor. But this convergence was illusory; while the financial elites and government benefited (via stupendous capital gains taxes), the private-sector middle class was in essence the bag-holder. When the newfound "wealth" in housing and stock market gains vanished, it was middle class wealth which was destroyed en masse.

Both capitalism and government policy have brought the nation to its present financial situation. To blame one and hold the other blameless is missing a lot of history. And just as each contributed to the current recession, so each must be part of the solution.

Charles Hugh Smith writes the Of Two Minds blog and is the author of numerous books, most recently, Survival+: Structuring Prosperity for Yourself and the Nation.
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