The Holidays are a great time to unwind and think about longer term big picture issues. One of the topics that has been much discussed in the blogosphere has been the rising level of income and wealth inequality in the United States, so I thought I would write about my thoughts on the topic.
The social justice criticism
There are many different views of inequality. Yves Smith at Naked Capitalism wrote about the uneven nature of the recovery from the Great Recession:
A new Bloomberg story, Americans on Wrong Side of Income Gap Run Out of Means to Cope, is a zeitgeist indicator: the normally-well-insulated-from-realty investing classes have noticed that large swathes of what was once the middle class aren't just downwardly mobile but are struggling.
The top 10 percent in the US captured a biggest share of income in 2012 than any year since 1917
Real median income of college-educated men 25 or older fell 10% since 2007
Of people who lost jobs in 2009 through 2011 that they'd had for three or more years, only half the women and 61% of the men were re-employed by the start of 2012 (and remember, a mere one paid hour of work a week counts as employment)
Only 1/3 of adults 18 to 32 lived in their own household, only marginally higher than the 38 year low set in 2010.
Smith went on to quote the Bloomberg story about how the uneven recovery has caused tectonic shifts in American demographics:
"The middle has really collapsed," said Lawrence Katz, an economics professor at Harvard University in Cambridge, Massachusetts, and a former chief economist at the Labor Department in Washington…
"Wall Street is roaring and Main Street is struggling," Representative Kevin Brady, a Texas Republican and chairman of the Joint Economic Committee, said in an interview. "Quantitative easing has really exacerbated income inequality."
Wall Street kleptocracy
Yves Smith comes at the income inequality issue from a social justice viewpoint. She is ideologically related to the former IMF chief economist's Simon Johnson of "why did we bail out the greedy bankers in the first place" school of thought. Johnson penned an important article several years ago where he compared the oligarchs in emerging market economies to bankers and characterized the U.S. as a kleptocracy run by Wall Street:
[T]o IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess-exports must be increased, and imports cut-and the goal is to do this without the most horrible of recessions. Naturally, the fund's economists spend time figuring out the policies-budget, money supply, and the like-that make sense in this context. Yet the economic solution is seldom very hard to work out...
Typically, these countries are in a desperate economic situation for one simple reason-the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit-and, most of the time, genteel-oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders…
Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or-here's a classic Kremlin bailout technique-the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk- at least until the riots grow too large.
That's what happened in the wake of the Lehman Crisis. Despite all of the wrongdoings (excess leverage piled on top of bad paper being sold by Wall Street, the robo-mortgage approval fraud, which were followed by the robo-foreclosures, LIBOR rigging, credit card abuse, etc.), the TBTF banks were bailed out and no major banking figure has gone to jail over the litany of financial scandals that the market has seen in the last five years.
Indeed, this commentary from an anonymous investment advisor tells the story of the demographics of the top 1%:
I sit in an interesting chair in the financial services industry. Our clients largely fall into the top 1%, have a net worth of $5,000,000 or above, and if working make over $300,000 per year. My observations on the sources of their wealth and concerns come from my professional and social activities within this group.
The bottom half of the 1% are the Horatio Alger stories of the American Dream that are often celebrated:
The 99th to 99.5th percentiles largely include physicians, attorneys, upper middle management, and small business people who have done well. Everyone's tax situation is, of course, a little different. On earned income in this group, we can figure somewhere around 25% to 30% of total pre-tax income will go to Federal, State, and Social Security taxes, leaving them with around $250k to $300k post tax. This group makes extensive use of 401-k's, SEP-IRA's, Defined Benefit Plans, and other retirement vehicles, which defer taxes until distribution during retirement. Typical would be yearly contributions in the $50k to $100k range, leaving our elite working group with yearly cash flows of $175k to $250k after taxes, or about $15k to $20k per month.
On the other hand, the top half of the 1% come almost exclusively from banking:
Membership in this elite group is likely to come from being involved in some aspect of the financial services or banking industry, real estate development involved with those industries, or government contracting. Some hard working and clever physicians and attorneys can acquire as much as $15M-$20M before retirement but they are rare. Those in the top 0.5% have incomes over $500k if working and a net worth over $1.8M if retired. The higher we go up into the top 0.5% the more likely it is that their wealth is in some way tied to the investment industry and borrowed money than from personally selling goods or services or labor as do most in the bottom 99.5%. They are much more likely to have built their net worth from stock options and capital gains in stocks and real estate and private business sales, not from income which is taxed at a much higher rate. These opportunities are largely unavailable to the bottom 99.5%.
No wonder a movement like Occupy Wall Street sprang up.
How much does inequality matter?
Despite some of the concerns raised over rising inequality in the United States, some analysts have suggested that there are distortions in the data and the anger is misplaced. This World Bank study looked at the evolution of income inequality globally and concluded that most of the losers came from the developed market countries and winners came from emerging market economies. In effect, social justice crusaders should be celebrating because vast swaths of humanity have been lifted out of poverty, though the middle class in the developed world has suffered as a result. Is this necessarily a disastrous result?
Ed Yardeni analyzed American demographic data and pointed out that the number of households with singles has been steadily rising and suggested that the apparent rise in income inequality came from demographic shifts:
It stands to reason that these demographic trends might be having a significant impact on income distribution and exaggerating the extent of inequality. On average, a young or senior single is likely to earn less than the combined income of a married couple.
I can confirm the effect cited by Yardeni by analyzing the shift in U.S. demographics in 2012 and 1995 using U.S. Census data. The first bar in the chart below shows the mean number of earners in a household has fallen from 1995 to 2012.
I then normalized the data using the average change in number of earners and found that income inequality by income quintile was virtually identical in 1995 compared to 2012:
So is the income inequality debate a red herring raised by the Left?
When does inequality matter?
I believe that income inequality, when viewed in isolation, does not matter. What matters is the context of the situation. From a social policy viewpoint, you need a way to distinguish the winners and losers in an economy so that it can be dynamic and grow. So rising income inequality may not necessarily be a bad thing if the winners created real value. In a dynamic economy, the Bill Gates and Sam Waltons of the world should be celebrated for creating truly disruptive technologies and business models,
However, my inner investor believes that the social justice campaigners have a point in that the bifurcated recovery where Wall Street feasts and Main Street suffers retards the growth potential of the economy. That is a legitimate criticism of the Fed's many QE programs because they rely mainly on a wealth effect where the benefits from QE are unevenly distributed.
Focus on equality of opportunity, not income
That is not my main concern about income inequality. My greatest concern has to do with how the nature of inequality can fray the social fabric of America. George Friedman of STRATFOR wrote a relatively balanced essay on the topic and highlighted the upward mobility nature of the American Dream when he wrote about the subprime crisis [emphasis added]:
I should pause and mention that this was one of the fundamental causes of the 2007-2008 subprime lending crisis. People below the median took out loans with deferred interest with the expectation that their incomes would continue the rise that was traditional since World War II. The caricature of the borrower as irresponsible misses the point. The expectation of rising real incomes was built into the American culture, and many assumed based on that that the rise would resume in five years. When it didn't they were trapped, but given history, they were not making an irresponsible assumption.
American history was always filled with the assumption that upward mobility was possible. The Midwest and West opened land that could be exploited, and the massive industrialization in the late 19th and early 20th centuries opened opportunities. There was a systemic expectation of upward mobility built into American culture and reality.
The Great Depression was a shock to the system, and it wasn't solved by the New Deal, nor even by World War II alone. The next drive for upward mobility came from post-war programs for veterans, of whom there were more than 10 million. These programs were instrumental in creating post-industrial America, by creating a class of suburban professionals. There were three programs that were critical:
1.The GI Bill, which allowed veterans to go to college after the war, becoming professionals frequently several notches above their parents.
2.The part of the GI Bill that provided federally guaranteed mortgages to veterans, allowing low and no down payment mortgages and low interest rates to graduates of publicly funded universities.
3.The federally funded Interstate Highway System, which made access to land close to but outside of cities easier, enabling both the dispersal of populations on inexpensive land (which made single-family houses possible) and, later, the dispersal of business to the suburbs.
There were undoubtedly many other things that contributed to this, but these three not only reshaped America but also created a new dimension to the upward mobility that was built into American life from the beginning. Moreover, these programs were all directed toward veterans, to whom it was acknowledged a debt was due, or were created for military reasons (the Interstate Highway System was funded to enable the rapid movement of troops from coast to coast, which during World War II was found to be impossible). As a result, there was consensus around the moral propriety of the programs.
Friedman went on to say that the subprime fiasco may have shaken the American Dream and highlighted the concerns raised by Yves Smith and the Bloomberg article about the downward mobility of many American families in the wake of the Lehman Crisis:
The subprime fiasco was rooted in the failure to understand that the foundations of middle class life were not under temporary pressure but something more fundamental. Where a single earner could support a middle class family in the generation after World War II, it now took at least two earners. That meant that the rise of the double-income family corresponded with the decline of the middle class. The lower you go on the income scale, the more likely you are to be a single mother. That shift away from social pressure for two parent homes was certainly part of the problem.
If the social fabric of America is deeply rooted in the American Dream of the possibility of upward mobility, then could such a shock start to fray the mythic culture?
An upstairs / downstairs nation?
My greatest concern about the fabric of America is that the combination of rising income inequality and lack of social mobility has begun to destroy the classless society nature of the American Dream. The Economist highlighted an OECD study in 2009 showing that social (and upward) mobility was higher than Old Europe than the U.S., the home of the American Dream.
Alan Kreuger dubbed this the Great Gatsby Curve, shown in the chart below. The x-axis depicts the Gini coefficient, which is a measure of income inequality (the higher the number, the more unequal). The y-axis shows the correlation of wealth between generations as a measure of economic mobility (the higher the number, the more likely an offspring will have the similar income level as his or her parents).
Kreuger's analysis shows that the United States has a high level of income inequality and a low level of economic mobility. In effect, the American Dream is dying. Why this matters is a culture rooted in class impedes competitiveness and innovation. The FT had a terrific article a number of years ago comparing America and Argentina:
A short century ago the US and Argentina were rivals. Both were riding the first wave of globalisation at the turn of the 20th century. Both were young, dynamic nations with fertile farmlands and confident exporters. Both brought the beef of the New World to the tables of their European colonial forebears. Before the Great Depression of the 1930s, Argentina was among the 10 richest economies in the world. The millions of emigrant Italians and Irish fleeing poverty at the end of the 19th century were torn between the two: Buenos Aires or New York? The pampas or the prairie.
A hundred years later there was no choice at all. One had gone on to be among the most successful economies ever. The other was a broken husk.
What happened? The difference was how the two countries treated the idea of social class:
European emigrants to Argentina had escaped a landowning aristocracy, only to recreate it in the New World. The similarities were more than superficial. In the 1860s and 1870s, the landowners regarded rural life and the actual practice of agriculture with disdain. Many lived refined, deracinated lives in the cities, spending their time immersed in European literature and music. The closest they came to celebrating country life was elevating polo, an aristocratised version of a rural pursuit, to a symbol of Argentine athletic elegance. Even then it took an elite form: the famous Jockey Club of Buenos Aires. By the end of the 19th century some were sending their sons to Eton.
America's move westwards was more democratic. The government encouraged a system of smaller family holdings. Even when it did sell off large tracts of land, the potential for a powerful landowning class to emerge was limited. Squatters who seized family-sized patches of soil had their claims acknowledged. US cattle ranchers did not spend much time boning up on the entrance requirements of elite English schools. And as well as raising cattle, the western settlers grew wheat and corn. By the 1850s, the US was importing a quarter of a million immigrants a year.
Through the lens of literature, we can see how the combination of an entrepreneurial spirit and a classless society allowed America to overtake England in the 19th Century. You just have to read the works of Jane Austen in works like Pride and Prejudice, where the gentry were expected to be gentlemen and dirty their hands with "work" and in "trade". In the BBC series North and South based on an 1855 novel by Elizabeth Gaskell, the hero is a self-made cotton mill owner in the industrial north of England, but he was somehow deemed to be less desirable because he was not a "gentleman" but was in "trade". In America, a self-made man would be celebrated, not the object of social disdain.
Unfortunately, it appears to me that America is going in the same direction. This time, the top 0.5% is banking and the dividing line is education. With lottery-like exceptions, you don't get into schools like Wharton or Harvard without a lot of support from your parents - and that kind of support costs a lot of money.
The Third Way
George Friedman lamented the likely eclipse of American dominance and Pax Americana and wrote that he had no bright ideas:
It would seem to me that unless the United States gets lucky again, its global dominance is in jeopardy. Considering its history, the United States can expect to get lucky again, but it usually gets lucky when it is frightened. And at this point it isn't frightened but angry, believing that if only its own solutions were employed, this problem and all others would go away. I am arguing that the conventional solutions offered by all sides do not yet grasp the magnitude of the problem -- that the foundation of American society is at risk -- and therefore all sides are content to repeat what has been said before.
People who are smarter and luckier than I am will have to craft the solution. I am simply pointing out the potential consequences of the problem and the inadequacy of all the ideas I have seen so far.
I can offer a couple of sensible approaches.
My overriding philosophy is to focus on the equality of opportunity and not the inequality of income.
Therefore the kneejerk reaction of higher taxes, while it may be intuitively appealing from a social engineering viewpoint, is not the shortest path from A to B because it does not address the issue of opportunity equality. There is a role for government in addressing these issues. The proper set of policies allows for and indeed encourages creative destruction to occur. On the creative side of creative destruction, I propose eschewing more traditional approaches like tax credits and holidays and embrace initiatives like the DARPA robotics challenge. The DARPA challenges are sensible ways to encourage innovation, particularly in light of the existence strong technologically based clusters like Silicon Valley.
As for the destruction part of the creative destruction equation, government must create policies that allow enterprises and empires to fail. I believe that the dividend tax breaks enacted by the Bush II Administration was wrongheaded in that it was an unnecessary level of support for the owners of capital and encourages the development of social class in American society. The net effect had little effect on capital formation, but shifted investor preferences between debt and equity.
Having lived both in Canada and the U.S., I can say that some of the Canadian tax policies provide a better framework for a national discussion of tax policy. For example, the Canadian tax code ties the capital gains tax rate and the dividend tax rate to the marginal tax rate. So when the marginal tax rate changes, so does the capital gains rate and the tax rate on dividends. The intent of the Canadian tax code on dividends on individuals is that it makes the tax rate on dividends roughly equal to the tax rate on interest income equal, on a pre-tax basis at the corporate level. That way, a corporation would be indifferent to paying dividends or interest expense in order to finance its business, net of credit risk which are priced by the market.
Having set such policies, Canadians can have a more sensible discussion about tax policy, rather than waste time on fighting useless battles on capital gains taxes because changes in marginal tax rates distorted the difference between ordinary income and capital gains.
I don't comment much on politics, but this is as far as I am willing to venture (for now).
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.