Income Inequality + Financialization + Globalization = Destruction of the Middle Class

This equation is a work in progress for me.  I have tried an econometric model but it crashed my computer.  Seriously, we are losing sight of the much bigger picture that is playing out across the country.  Our policy makers are distracted by this financial crisis or intentionally ignore the plight of the Middle Class in the U.S.

This equation was derived from reading a debate between Professors Branko Milanovic and Ashok Bardhan: Two Views on the Cause of Global Crisis (Here and Here).  These two professors debated the causes of the global financial crisis.  Milanovic argued that income inequality was the root cause of the financial crisis while Bardhan argued that globalization and financialization were the causes of the financial crisis.  I argue they are both right.  But they highlight a much bigger problem that is being overlooked by this financial crisis.

Most arguments about what caused the global financial crisis ignore a more insidious problem that is being overlooked in all the discussion and policy proposals: the destruction of the Middle Class.  This global financial crisis has negatively impacted the Middle Class more than any other income group.  A report by Bank of American/Merrill Lynch shows that (via LA Times).  Tom Petruno summarizes the BofA Merrill report this way:

The report hammers home what you might already suspect: The consumer debt problem in the economy really is a debt problem for the middle class. The need to work off a chunk of that debt will sap middle-class families’ spending power for perhaps years to come.

It estimates that middle-class families’ debt as a percentage of disposable income was 205% in 2007, a function of the level of trading-up during the housing boom and of the cash people pulled from their houses via home-equity loans.

By contrast, lower-income families’ debt-to-disposable-income ratio was a much less onerous 133%. And for the wealthy the percentage was lower still, at 116%.

What’s more, on the asset side, BofA Merrill says the middle-class has suffered more than the wealthy from the housing crash because middle-class families tended to rely more on their homes to build savings through rising equity. Also, the wealthy naturally had a much larger and more diverse portfolio of assets -- stocks, bonds, etc. -- which have mostly bounced back significantly this year.

I strongly encourage people to click the LA Times link above to read Tom Petruno's story because he raises a very important policy question.  

The negative impact of this financial crisis on the Middle Class is a symptom of a more larger problem or disease.  As Dr. Thomas Palley points out in his report: "American's Exhausted Paradigm", our economic growth model (which he calls a neo-liberal growth model) is terrible flawed.  The equation - Income Inequality + Financialization + Globalization = Destruction of Middle Class is meant to symbolize the flawed model.  It is this flawed neo-liberal model that needs to be corrected if the Middle Class is to survive.

All this talk and policy proposals of re-regulating the financial sector are just treating the symptoms and not the disease.

INCOME INEQUALITY

The first part of the equation.  This is no surprise that there is income inequality in the U.S: a small number of people earn a lot more money than the rest of us.  What is surprising is the magnitude of the inequality.  This magnitude of inequality is not a good thing.

Branko Milanovic summarized income inequality in the U.S. this way:

In the United States, the top 1 percent of the population doubled its share in national income from around 8 percent in the mid-1970s to almost 16 percent in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1 percent share reached its previous high watermark American income inequality over the last hundred years thus basically charted a gigantic U, going down from its 1929 peak all the way to the late 1970s, and then rising again for thirty years.

Then we got this stunning graph from Professor Emmanuel Saez's updated report on income inequality in the U.S.:

Notice how income distribution really starts to change right around the early 1980's.  That is the time which Dr. Palley rightfully claims that the neo-liberal economic growth model - our current growth model - began to take hold.  And another thing, this graph only shows incomes as low as $109,600 which means that a very large group of Americans making less money have a very small share of total income.  That is why this graph is so startling.

Some people may say that income inequality is not a big deal.  Oh yeah. Well income inequality creates huge inefficiencies in the economy in terms of allocation of resources.  It also creates the potential for an aristocracy (or financial oligarchy) that will do whatever it can to protect its dominate position in society.  A better description would be the creation of a two-tiered economy - kind of like many Latin American countries - what our economy is starting to look like.

Professor Emmauel Saez in his report "Striking it Richer" offers this suggestion for the huge income inequality:

The labor market has been creating much more inequality over the last thirty years, with the very top earners capturing a large fraction of macroeconomic productivity gains. A number of factors may help explain this increase in inequality, not only underlying technological changes but also the retreat of institutions developed during the New Deal and World War II - such as progressive tax policies, powerful unions, corporate provision of health and retirement benefits, and changing social norms regarding pay inequality.

Emphasis is mine.

Interesting, that bold phrase is what Dr. Palley is railing about in his report regarding our flawed neo-liberal economic growth model.

FINANCIALIZATION

Financialization means the increasing position/size of financial assets and the financial sector in the economy.  This financialization was facilitated by de-regulation of the financial sector.  Professor Ashok Bardhan explains financialization:

Over-financialization could be seen in rise in the size of financial assets relative to the real economy as indicated by gross domestic product. Globally, the holdings of financial assets, comprising equities, government and private bonds and bank deposits ballooned way out of proportion to global GDP, the primary underlying measure of real economic activity (see Figure 1). Similarly, the gross market value of outstanding derivative contracts more than doubled between mid-2006 and mid-2008. The share of financial services in GDP has increased dramatically in the US and UK in recent years; in the latter it has doubled in the last decade alone. In many countries, the financial sector grew to a size disproportionate to its primary raison d'etre - to efficiently bring savers and borrowers together, allocate savings to viable investments, and manage diversification of risk. Liquid and deep financial markets are necessary; indeed, they are the lifeblood of economic activity, but to extend the analogy, not if they cause high blood pressure to the economy!

This Financialization was indicative of a much larger problem.  What replaced wage growth was asset price inflation and rising indebtedness.  For example, as the BoA Merrill report points out above, Middle Class families relied heavily on the equity in their homes - this was an important savings vehicle.  Consider this from Dr. Palley's report:

1. Since 1980, each U.S. business cycle has seen successively higher debt/income ratios at end of expansions, and the economy has become increasingly dependent on asset price inflation to spur the growth of aggregate demand.
2. Over the last 20 years, the economy has tended to expand when house price inflation has exceeded CPI (consumer price index) inflation. This was true for the last three years of the Reagan expansion. It was true for the Clinton expansion. And it was true for the Bush-Cheney expansion. The one period of sustained house price stagnation was 1990–95, which was a period of recession and extended jobless recovery.

Financialization is a symptom to the disease that is destroying the Middle Class.

GLOBALIZATION

Globalization can be defined by the free flow of trade and capital from country to country.  The policies implemented since 1980 have precipitated globalization which has forced American workers to compete with much lower-paid foreign workers.  But there is more to it.  Our current, neo-liberal, incredibly flawed, economic growth model depends on CHEAP IMPORTS.  The impact from wage stagnation is covered up by cheap imports - it is a way to pacify Middle Class families.  What better way to make us feel like we have a lot of purchasing power by having access to incredibly cheap consumer goods from a big retailer.

Dr. Palley describes it this way:

The reality is that the structure of U.S. international engagement, with its lack of attention to the trade deficit and manufacturing, contributed to a disastrous acceleration of the contradictions inherent in the neo-liberal growth model. That model always had a problem regarding sustainable generation of demand because of its imposition of wage stagnation and high income inequality. Flawed international economic engagement aggravated this problem by creating a triple hemorrhage that drained consumer spending, manufacturing jobs, and investment and industrial capacity. This in turn compelled even deeper reliance on the unsustainable stopgaps of borrowing and asset price inflation to compensate.

THE EQUATION

Like I said, it is a work in progress but hopeful something that people, especially policy makers, will understand:

Income Inequality + Financialization + Globalization = Destruction of the Middle Class

Together these factors have contributed to the destruction of the Middle Class.  Some economists, like Dr. Palley, argue that our current, neo-liberal, economic growth model is not sustainable.  I would argue that it is not so much that this economic model is not sustainable, because I am sure that the financial oligarchy and corporate aristocracy would keep it going, but it will destroy the most important aspect to any stable economy - the Middle Class.

It is not too late to reverse course but based on current affairs I have little faith that it will happen soon.  Time is running out. 

Oh, BTW, where the hell is the President's Middle Class Task Force.

P.S.  Any suggestion on improving the equation are welcomed.