- Capitalism requires a balance between economic growth and wages so workers can pay for what they make.
- Economic growth without wage growth can occur if financed by debt.
- Debt-financed growth can happen for a long time, but is unsustainable and eventually leads to financial crises.
- The U.S. is at historically high levels of income concentration, even as income in the middle stagnates.
- Whenever such extreme inequality occurred in the past, markets crashed.
Henry Ford rightly deserves a place in history as a champion of American capitalism. Not only did he pioneer organizational technologies, such as the assembly line, but he was also an astute businessman. When it came to compensating workers, he adopted a commonsense yet revolutionary principle: pay workers enough so that they can buy what they make.
The benefits of this idea were simple. If workers' paychecks were large enough, they would buy cars and ultimately boost Ford's bottom line. This could then finance wage hikes for workers, along with expanded production, which would again boost revenues. This virtuous cycle could theoretically go on forever, because there would always be a growing market for cars.
American capitalism seems to have regressed from this insight. Since the early 1980s, wages have largely stagnated, especially for low-income households and the middle class. All of a sudden, workers did not have enough money to buy what they made. Policymakers responded to this problem by liberalizing the financial sector, which seemed to solve two related issues:
1.) Workers could buy more than what they earned by taking on debt. Rising debt levels could finance the difference between wages and production, and growth was maintained.
2.) Investors faced with slack demand in the real economy could now engage financial speculation as an alternative source of returns. Financial gain partially decoupled from the business of making stuff that people wanted and instead turned to flipping electronic paper.
This strategy seemed to work out well for about 30 years, but as we all know, growth financed with debt and fueled by financial speculation is not sustainable. By the late 2000s, the American economy's debt capacity reached its limit:
In 2008, total debt reached the astronomic level of 370% of GDP, and we reached a point in which many households, banks, and business simply could not service their massive obligations. Fortunately, since 2008, we have been slowly deleveraging, particularly in the household and financial sectors, but we still have a long way to go. So while some commentators believe that rapid credit expansion in the private sector is the key for getting growth back on track, it seems clear to me that such low-quality growth leads to economic distortions and risks depression.
So how do we get sustainable, balanced growth without risking depression? I think we should take our cue from Henry Ford: American workers need a raise. We need to get back to an economy in which consumer demand derives from worker wages, not the machinations of the finance industry.
This will require addressing the problem of inequality, because high-income households tend to be savers that are looking to invest rather than consume their resources.
Now, I understand that inequality has its benefits: if everyone has the exact same income, then there is little incentive to work harder or innovate. But is anyone really talking about total equality? I think a more productive way to think about the issue is a matter of degree: what level of inequality best balances the need for a dynamic economy without fostering debt-fueled speculative growth?
The key point is that we want "creative destruction," with an emphasis on "creative" rather than "destruction."
Well-intentioned people will disagree on the optimal level of inequality, but here's a starting point for the conversation. The figure below shows the income share of the top 1% over the last 100 years:
The connection between income concentration at the top and financial instability is uncanny. The income of the 1% reached its peaks as a share of the total in the 20th century in 1928, 1936, 1999, 2007, and 2012. The first four episodes turned out to be warning signs for workers and investors alike: when too much concentrated wealth chases too few investment opportunities in the real economy, capital allocation becomes undisciplined, and both investors and workers will suffer. Now, we are at another income peak for the super-affluent, who now take home 20% or more of all income, even as median wages have hardly budged.
If history is any guide, this will not end well.
In summary, there is a clear theoretical and empirical connection between inequality and financial instability. For economies to have sustainable growth, there needs to be a balance between what workers can afford and what they produce. If workers cannot pay out of wages, then the problem can be temporarily "solved" by lending them the difference. But such low-quality, debt-induced growth introduces all sorts of distortions and eventually leads to a financial crisis. And unfortunately, it appears that the U.S. economy remains extremely unbalanced: until workers get a raise, growth will have to be financed by debt. This leaves two undesirable choices: more debt bubbles and financial crises, or economic stagnation. Unless we see median income growing, investors should be skeptical of any "economic recovery" and remain cautious about owning risk assets.