The Two Economies

The Rich Have Recovered—the Country Hasn’t

In early January, walking in midtown Manhattan on a bitter-cold morning, I saw a crowd of people standing on the sidewalk about four abreast, in a line that stretched almost around the block—I guessed two thousand people, maybe more. They seemed to be all ages, from teens to oldsters, and all backgrounds, white, black, Hispanic, Pacific Rim, South Asian. I asked a man in the line what it was for. He said, “A hotel is hiring.” Ah.

The next Sunday, the New York Times Real Estate section had a glossy summer-rental insert. One ad was for a rental on Long Island Sound—great house, lovely pool, beachfront, dock—only $175,000 for the month of August.

So those are two faces of what many economists are now calling a “recovery.” The mood on Wall Street, indeed, is practically giddy. Markets are up and corporate profits are soaring. The old bonuses are back, expense stubs at top hotels and restaurants are levitating, and thousand-dollar-a-bottle wines flowed freely at the year-end parties.

Things are much less bright in the rest of the country. Hiring is still in the doldrums. The official unemployment rate has gone down a tad, but that’s mostly because large numbers of people are dropping out of the work force. The steep free-fall in housing prices has stopped, but the market has yet to bottom out. Consumers increased spending over Christmas, but it came out of their savings.

While things aren’t necessarily getting worse they’re certainly not getting better. And for ordinary people—the kind of folks who are not in the market for exclusive beachfront rentals—“not getting better” means getting a lot worse. Savings run out, job skills deteriorate, self-confidence vanishes, and fear and panic take over.

The worst of it is that we may have reached the point where our top companies, the global banks and global corporations that pay huge sums and provide lavish benefits on their top employees, are untethering themselves from the rest of us—floating away into a moneyed nirvana all their own.

The global crash of 2007, which is still unwinding, was a most unusual one. It was a financial collapse. It wasn’t caused because crops were wiped out, or companies produced floods of unwanted cars. It happened because banks created far too much credit, so all varieties of people, and companies, and countries, got much too deeply into debt, to the point where trillions in loans could not be repaid. The last time that happened on such a scale in the United States was during the Crash of 1929.

 

The Crash & How It Happened

The roots of the 2007 crash can be found in the three-decade-long campaign, under the Reagan, the Clinton, and both Bush administrations, to dismantle the old banking regulatory regime. The new policies were premised on the conviction that financial markets had become so efficient, and so quick to punish missteps, that prolonged episodes of bad lending were impossible. Former Federal Reserve chairman Alan Greenspan and current chairman Ben Bernanke heartily endorsed that view. The consensus cut across party lines. Former Treasury secretaries Robert Rubin and Larry Summers, primary economic advisers to both Clinton and Obama, are strong deregulation advocates.

Almost every important restriction on banks’ activities was dropped outright or severely weakened. The biggest banks were free to ratchet up their borrowing, almost without limit, to fund more and more lending. They were allowed to employ murky devices to hide their true liabilities, and to exploit exotic new derivatives that shifted, or appeared to shift, the risks of bad credit to investors all around the world.

As supervision was relaxed, the banks behaved with almost inconceivable recklessness and outright criminality, yet there has been little federal prosecutorial follow-up. In the quest for higher yields, almost all the larger banks acquired fly-by-night subprime mortgage originators, who specialized in financing doubtful properties at unrealistic valuations, while skipping reviews of borrowers’ income and assets. They also lured poor buyers into the market with very low initial payment requirements, which quickly jumped to levels that virtually guaranteed default.

Mortgage bankers didn’t care about losses, because they held loans only for weeks before shipping them to bigger banks, to be bundled into big-ticket instruments sold to institutional buyers throughout the world. Because the majority of such securities were awarded high AAA and AA investment-grade ratings by the official rating agencies, supposedly sophisticated investors bought without hesitation.

The rating agencies freely stamped their seals of approval because, like the banks, they made huge profits on the deals. Similar patterns occurred in commercial real estate, credit cards, automobile, and company-takeover lending. The Federal Reserve cooperated by making interest rates so low that almost anyone could afford to borrow, and almost everyone did. Financial-sector profits grew to more than 40 pecent of all corporate earnings.

But this was, at bottom, a Ponzi scheme—and at some point, as Charles Prince, erstwhile CEO of Citigroup, admitted, “the music stops.” In the summer of 2007, a hedge fund with a large portfolio of shaky securities tried to sell them back to the banks. But no bank would buy them, except at steep discounts. That triggered a ripple of nervousness that gradually escalated into a full-scale panic. Investment funds, pension funds, and market analysts finally realized that they had been buying paper that would probably never be repaid. And the big banks had hundreds of billions of dollars worth of similar paper in their sales pipeline that they could never unload, and billions more on trading desks that senior managers didn’t even know about.

Bank after bank—Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, Washington Mutual, Citigroup, the insurer AIG, and many others in Europe—either failed outright or were put on government life support. Almost all lending ground to a halt, and the entire world looked over the edge into a 1930s-style abyss.

 

Bailout & Recovery

Two numbers capture the workings of the federal bailout of the banks. From 2008 through October 2010, the nation’s banks reduced their liabilities by a stunning $2.7 trillion. At the same time, the federal government increased its debt—you guessed it—by $2.7 trillion. Arrangements to heal the great and good almost always come out of the pockets of the rest of us.

The bailouts did work in the limited sense that they prevented global financial markets from slipping into terminal cardiac arrest. European governments, whose bigger banks were similarly reckless, responded much the same way. The recession that ensued was the worst since 1929, but not nearly as bad as the Great Depression.

There was a path not taken. In principle, governments might have simply seized the banks, wiped out the creditors, fired the managers, and restarted the banking system on a duller, quieter, less risk-prone basis.

In the real world, any such attempt would have been hopelessly bogged down by lawsuits and other delays. A messy process, and weeks or months of uncertainty, could easily have frozen all global financial markets and precipitated a rerun of the Depression.

So we have the recovery we have, and it’s not much to brag about. The bankers are back in the catbird seat, the art auctions are booming at Christie’s, and financial markets are feeling that old mojo. But official unemployment is stuck in the 9.5–10 percent range, while the true rate, including “discouraged” and part-time workers, is much higher. Most employed workers have not had raises for years, and essential costs, like health care, tuition, and gasoline, keep rising. Retirement nest eggs have been devastated, and older people will need to stay employed years longer than they planned in a hostile market.

A chorus of market analysts, however, claims the worst is over. The country has “de-leveraged”—that is, reduced debt—as consumers have learned the joys of thrift and savings. So it’s now time to resume spending.

That is pure fantasy. Neither the country nor its consumers have de-leveraged. Total debt—consumer, business, and government—is higher than it was in 2007. Total consumer debt is down a tad since 2008, by about 3 percent, but that’s mostly because of defaults, not because consumers have been paying their bills early. The big uptick in federal debt, as we have seen, was roughly offset by the drop in bank debt, but all other debt categories—business, state, and local government, debt to foreigners—are still going up. And the new stimulus programs and tax deal will ensure that federal debt will keep rising. De-leveraging—everyone agrees we need to do it—has not even started. All the hard work is yet to come.

That sounds pretty gloomy. Is the United States really turning into a creaky, debt-ridden, class-based, postimperial society? The sad and bitter answer may well be yes.

 

The Two-Tier Economy

The most portentous, and dangerous, economic development of the past thirty years is the very sharp rise in income inequality. The tax authorities have good records of taxable income since 1913. For a quarter-century after World War II, the reported taxable income of the top 1 percent of taxpayers, including capital gains, toddled along at about 8–10 percent of all taxable income. That share started to rise steadily in the late 1970s, and continued to rise right through the 1990s and 2000s. By 2007, the top 1 percent of taxpayers were reporting 24 percent of taxable income, the highest share ever, except for 1928. We know what happened after 1928, and now we know what happened after 2007 as well.

Another way to look at those data is to calculate how much of income growth was captured by the top 1 percent. During the “Bush Expansion” of 2002–07, the top 1 percent of taxpayers captured about 65 percent of the growth in taxable income, including capital gains. Conservative economists object that the IRS data leave out most transfers like welfare and Social Security payments. Well, yes, but it also excludes the huge amount of tax-sheltered incomes, legal or not, that benefit only the very wealthy.

In other words, we have witnessed the creation of a new financial aristocracy with a very powerful grip on the economic machinery. How powerful? Consider perhaps the most scandalous of tax breaks. The partners at the Blackstone Group and other private equity funds, who are among the richest of all Americans, pay only a flat 15 percent rate on the massive fees, bonuses, and most other compensation they receive for managing their funds. Even a new Democratic Congress, with large majorities in both houses, could not muster the votes to return these powerful investment managers to a normal tax schedule. Similarly, passing extended aid for the long-term unemployed required bribing the very rich by extending the Bush tax cuts, cuts that are responsible for a good portion of the federal deficit.

In 1933, when FDR swept into office, he was able to flatten income distribution by a stricter and more progressive tax regime and tougher regulations against financial chicanery. The near-term chances of a progressive movement replicating Roosevelt’s triumph seem very low. Indeed, there are forces in place that will inevitably tighten the new plutocracy’s grip.

Few people will have heard of the “carry trade” in finance. But our financial aristocrats began to exploit it in a big way in the 1990s. In order to escape a long-term recession, the Japanese government drove yen interest rates to zero and even slightly below. The smart-money guys borrowed yen by the ton—it was free, right?—converted it into dollars, and rode the American dot-com stock bubble until it collapsed in 2000.

In the wake of the 2007 financial crash, the dollar has become the carry-trade currency of choice. A big player can borrow in the United States at money-market rates—say 1 percent—and invest in a government bond paying 5–7 percent in a high-growth overseas economy like China, Taiwan, or Brazil. Hard to lose on that one. No one knows how big the carry trade is, but the annual flows must be in the trillions. (It abated a bit over the last few months of 2010, as fears over the euro made traders more anxious to keep their dollars.)

American companies benefit from a kind of national carry trade of their own. Headquartering a company in the United States ensures a corporate-friendly legal environment, a minimum of government meddling, a stable political setting, and access to the largest and most liquid financial markets in the world. But there’s no requirement that you have to invest here. About 60 percent of all big-company revenues—at the IBMs, GEs, Caterpillars, Boeings, HPs—come from overseas, and the world’s fastest growth areas are newer markets like China, India, and Brazil—so that’s where investment flows.

On top of that, the Internet is writing a new chapter in hyperglobalization. Early waves of outsourcing involved highly standardized operations that could be easily monitored from a distance. Increasingly, high-level services, like software, legal research, even medical analysis that typically require close communication between vendor and customer, can be relocated as well. In effect, the available workforce has doubled or tripled, with most of the benefits flowing to owners rather than to workers.

In the meantime, the productivity of U.S. workers has been leaping ahead. American labor productivity grew by 7.7 percent in 2009, by far the fastest growth among nineteen advanced industrial countries tracked by the Labor Department—faster even than Asian powerhouses like Taiwan, Korea, and Singapore. But that sparkling outcome is not the result of massive new productivity investments, for U.S. companies are mostly sitting on their mountains of cash. Instead, they are fattening their bottom lines by holding down pay, cutting health care and other benefits, and squeezing more and more work out of employees who are desperate to hold on to their jobs.

 

The Plutocracy’s New Rules

If you’re confused about who now runs the country, consider some recent straws in the wind. Since the financial crisis broke in 2008, the federal government has run a huge slug of taxpayers’ money through the banks, possibly as much as $12 trillion cumulatively—buying up banks’ dicey securities at nearly full price, or lending oceans of money nearly for free so banks can make large profits from safe exercises like purchasing Treasury notes.

Since the bankers blew up the world, you’d expect them to be humbled by their sins and grateful for their rescue. Not at all. Instead they have brazenly exacted more or less the same outrageous levels of pay they received at the height of the financial bubble, essentially for processing the paperwork of their own rescues. Literally hundreds of billions of taxpayer money that was supposed to rebuild bank capital has been siphoned off into the financial barons’ pockets. No one in our government, under either the Bush or Obama administrations, seems especially upset.

American corporations earned a blowout $1.7 trillion in 2010, much of it from the stellar productivity of their workers, but they’re still cutting pay and benefits, not because they need to, but because—in this wintry job market—they can. And they have better things to do with the cash, like buying other companies. Big new mergers, with fat Wall Street fees, are bruited on a nearly daily basis, many of them overseas. There is in fact a large body of evidence showing that such mergers rarely produce better companies. But they certainly produce bigger companies, which allows all the top executives to ratchet up their pay accordingly.

The bank rescue, of course, has ballooned the federal deficit by nearly $3 trillion and counting. The plutocracy and its minions, having stuffed their pockets with taxpayers’ cash, now view federal deficits with alarm. Their taxes are too high! (Federal income taxes as a percent of GDP are the lowest since 1948.) Time to cut entitlements! Working people should save their own money for retirement and medical care, and stop sponging off the rich! Above all, repeal the new health-care bill, which would benefit no one but the bottom 60 percent of workers!

The business writer Chrystia Freeland, in her forthcoming book The Super-Elite, quotes a wealthy investor, who had supported Obama, telling a Democratic legislator, “Screw you.... The government won’t get a single penny more from me in taxes.... My money isn’t going to be wasted in your deficit sinkhole.”

Leaving aside the bank bailouts, the “deficit sinkhole” results from military spending, Medicare, and Social Security—everything else is comparatively trivial. The first two of those produce huge cash flows for the elite’s transportation, oil, computer, hardware, pharmaceutical, medical-device, hospital, and insurance companies. (The real opposition to health-care reform is based on the fear that it may succeed in reining in medical-cost growth, which mostly stems from runaway introduction of feebly tested new medical technologies.)

Besides, the “sinkhole” didn’t exist before the multiple rounds of Bush tax cuts, which primarily benefited the elite. The plutocrats might have sent a thank-you note. Instead, their message to America’s battered middle class is: “We’ve gotten our tax breaks and had our bailout; now you have to fix your deficit.”

Americans have always been relatively undisturbed by sharp income differences between the wealthy and the rest of the country. But as Alexis de Toqueville documented in the 1830s, it was because most Americans believed that they, too, could become very rich with a little luck and a lot of work. And in that era it was true. Not anymore.

The degree to which parental incomes determine the income of their adult children is a good measure of mobility. The higher it is, the less mobility. Among nine rich countries, the United States and the United Kingdom, which both have very high income inequality, rank last in income mobility. In both, parental income has a 50 percent weight in predicting children’s income. In “high mobility” Canada, Norway, Finland, and Denmark, it has only about a 20 percent weight. Germany, France, and Sweden are in between.

Sadly, America’s spectacularly rich new elite seem determined to keep their money and pass it on to their privileged children. The narrow concentration of wealth, and the elite’s tendency to distribute it globally, leave little hope of a broadly based U.S. recovery, or even a modest leveling of current financial inequality. That is not likely to change in the medium term, or even well beyond.

But a decade or so from now, most Baby Boomers will find that they are too old to work, or can’t find jobs, have little in the way of pensions and savings, and can’t make it on Social Security alone. Dreary prospect though that may be, it may be our best hope. For it could possibly generate the kind of severe political and economic crisis that can finally lead to thoroughgoing reform.

 


Related: The Wall Street Meltdown, by John W. Weiser
Peter Steinfels's review of Winner-Take-All Politics, by Jacob S. Hacker and Paul Pierson

Published in the 2011-03-11 issue: 
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Charles R. Morris’s most recent book is The Rabble of Dead Money, a history of the Great Depression (PublicAffairs).

Also by this author
Measuring Inequality

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