There is no clearer example than the course of the 2008 financial crisis. In the years leading up to the crisis, Alan Greenspan and the Federal Reserve kept interest rates artificially low. This enabled bankers to originate subprime mortgage loans and to package those loans into highly rated securities for sale to institutional investors. The bankers made billions of dollars in origination and servicing fees and billions more in underwriting fees and trading revenue. These mortgages and mortgage derivatives were rated AAA in many cases, due to flawed risk models, venality, and malfeasance by the major rating agencies such as S&P, Fitch, and Moody’s. Bank regulators were ignorant of the risks involved because of their own flawed models and obtuse oversight. Inevitably, mortgage default rates rose; the first reports of these defaults emerged in the spring of 2007. This was called to the attention of Federal Reserve and U.S. Treasury officials. Ben Bernanke assured the Federal Reserve Board in March 2007 that the situation was manageable and losses would abate. The U.S. Treasury had no interest in intervening or even requesting information, despite the fact than any distress would land in their lap.
By the late summer of 2007, financial dominoes began to fall. Two Bear Stearns mortgage hedge funds collapsed. Several money market funds sponsored by BNP Paribas closed their doors to stop a flood of redemptions. Markets stabilized by December 2007 as major sovereign wealth funds in Singapore, China, Abu Dhabi, and Kuwait were prevailed upon by the Treasury to bail out major banks, including Citibank, Morgan Stanley, and Merrill Lynch. Then panic reemerged with the Bear Stearns failure in March 2008, the collapse of Fannie Mae and Freddie Mac in June 2008, and finally the Lehman Brothers bankruptcy in September 2008. In late September 2008, stock markets crashed, bank runs began, and the United States was days away from a sequential collapse of all major banks. Intervention by the Federal Reserve and FDIC, including unlimited deposit insurance, guarantees on all money market funds, massive money printing, and multitrillion-dollar currency swaps with the European Central Bank were needed to alleviate the panic. Finally, by March 2009 the stock market bottomed and a long, slow recovery began.
The middle class watched these developments with a mixture of fear and disbelief. Investors knew panics happen from time to time and stock market booms don’t last forever. The middle class might have been resigned to their losses if they had seen some trace of accountability on the part of elite bankers, CEOs, and regulators. That never happened. In fact, no bank CEOs or senior executives were ever held accountable. They kept their jobs or moved seamlessly to other financial firms. After two years of increased scrutiny, the bank CEOs resumed the practice of awarding huge bonuses and options, which rose on a stock market propped up by the Fed. Treasury secretary Tim Geithner secretly communicated with Attorney General Eric Holder at Obama’s Department of Justice with a request to refrain from prosecution of bankers because prosecutions could hurt confidence and destabilize the financial system. Holder agreed. There were no penalties, prosecutions, or terminations related to the crash among the top bank elites at all.
The middle class was decimated. Members lost half their savings and many lost their jobs and homes. It was the worst economic setback since the Great Depression. These financial and career losses for the middle class were on top of emotional stress that resulted in higher suicide rates, increased divorce rates, and a wide opioid epidemic. There was a social and emotional collapse in addition to the financial collapse, a phenomenon rarely discussed on happy-talk financial TV. The middle class might have borne the burden of the financial crisis as they had borne burdens from the Great Depression to the Second World War. Yet this crisis was different. The burden was not equally shared by all. In fact, the burden was placed exclusively on the middle class while elites escaped responsibility.
The leading bank CEOs in 2008 were Jamie Dimon of JPMorgan, Lloyd Blankfein of Goldman Sachs, Brian Moynihan of Merrill Lynch (now Bank of America), John Mack of Morgan Stanley, Larry Fink of BlackRock, and Vikram Pandit of Citi. Every one of them and various of their subordinates are either still in those positions or retired recently with dynastic fortunes in bonuses and stock options. Meanwhile, the middle class is still in shock. It’s true that stocks later rallied to new highs after a ten-year recovery from the lows. Still, ten years is a long time to wait for your money back.
Middle-class investors were not lucky enough even to enjoy the protracted recovery. They sold near the lows in 2009 in a desperate attempt to preserve what was left of their capital. They refused to reenter markets based on a legitimate fear that a new collapse could happen at any time. In short, the rich got richer and the middle class got crushed by the big money.
This scenario of the rich getting richer and the middle class falling behind is playing out in areas besides investing. Inequality is true in college admissions, where the wealthy continue to send their sons and daughters to elite schools while the middle class are restrained by sky-high tuitions and the burden of student loans. It’s true in the housing market, where the rich picked up mansions on the cheap in foreclosure sales while the middle class were frozen in place by negative equity. It’s true in health care, where the rich could afford all the insurance they needed while the middle class were handicapped by unemployment and the loss of job-related benefits. These disparities also affected the adult children of the middle class. There are no gold-plated benefits packages in the gig economy.
The extent of this income redistribution toward the rich and away from the middle class is revealed in recent research from Deutsche Bank. Their work shows the percentage of children earning more than their parents at age thirty by date of birth over time. The research shows that fewer than 50 percent of all children age thirty today earn more than their parents at the same age. This 50 percent figure compares with 60 percent who earned more in 1971 and 80 percent who earned more in 1950. The American Dream of each generation earning more than the prior generation is collapsing before our eyes.
With this and similar data in mind, we repeat the original question. Is the middle class disappearing? The answer is no, but it is struggling and is increasingly disadvantaged in relation to powerful elites. The middle class is getting poorer on a relative basis and it is lagging farther behind the rich, whose incomes absorb an increasing share of total GDP. This result is discouraging for the middle class and creates a headwind for growth, in the form of lower productivity. Why work harder if the gains are not distributed fairly?
The manner in which the rich become rich in the first place is highly variable. It could be simple luck, as when two farmers buy adjacent parcels of land and one strikes oil while the other doesn’t. It could be the result of smart choices in matters such as personal health care, marriage, and higher education. It could be the result of hard work, invention, or entrepreneurship. The initial sources of wealth are not necessarily unfair in a capitalist system.
Problems arise with the way in which the rich stay rich, become more rich, and pass wealth to their children and grandchildren. Techniques for preserving wealth are supported by customs, laws, and regulations mostly promoted by the rich themselves to perpetuate and expand their wealth. This is what gives rise to the rigged system of which the middle class rightly complains.
The first set of abuses arises in the tax code. On paper, the rich pay higher taxes than the middle class. But that’s a mirage based on a quick glance at progressive tax tables. The reality is far more complicated. Much of the wealth of the richest Americans is never taxed because they hold on to real estate and stocks and pass them to their beneficiaries tax-free. When the media points out that Amazon CEO Jeff Bezos is worth over $100 billion, it’s important to bear in mind that most of that $100 billion is in the form of Amazon stock on which Bezos has paid no income tax, except for the shares he has sold. Even when Bezos sells some stock, he is treated to capital gains tax rates, which are lower than normal income tax rates. The same analysis applies to Mark Zuckerberg at Facebook and Elon Musk at Tesla. An average upper-middle-class pro
fessional pays a higher effective tax rate than the richest people on the planet. Holding on to stock is not a cash-flow burden, because billionaires can easily borrow cash using the stock as collateral. There is no income tax on loan proceeds.
The second tax dodge is the use of foundations. The ultrawealthy can donate their stock to a foundation (for which they receive a tax deduction against other income) and then appoint themselves or their spouses as heads of the foundation. They can then remain in control of the money by making the minimal statutory grants to favored causes while investing foundation assets in a portfolio of their choosing. The foundation itself pays no income tax. In effect, the billionaires remain in control of vast fortunes that are effectively tax-free. Middle-class individuals do not have the cash flow and the resources for legal fees to set up similar arrangements.
Other tax dodges abound, including offshore income, deferred income plans, transfer pricing between taxable and nontaxable entities, and inflated valuations on charitable gifts. The result is always the same—the rich dodge taxes while the middle class pay more than their share.
Other preferences include the impact of social networks on opportunities for jobs, school admissions, and investment opportunities. Many of the most profitable new investments of the past twenty years were shared among a tightly knit crew of Silicon Valley and Wall Street insiders who tipped each other off about new companies like Google, Amazon, Uber, Airbnb, and others long before the companies went public (in many cases the companies still have not gone public). Middle-class investors get crashing valuations in companies like Snap Inc. (formerly Snapchat), which has fallen from $20.75 per share in early 2018 to $9.15 per share as of this writing. The Silicon Valley founders captured the higher valuation in the IPO while the middle class is left with the lower valuation today. The best stock tips are passed around by the wealthy at country clubs and private equity firms before middle-class investors are even aware these companies exist.
College admissions at elite schools have always carved out a significant portion of each entering class for “legacy” admissions. If your dad went to Harvard, your chances of admission to Harvard are higher than the typical middle-class applicant. This system is not foolproof or automatic, yet it does give an edge to sons and daughters of the wealthiest Americans and helps their families as a whole to maintain an elite edge. When graduation rolls around, the same network makes sure the graduates who are members of elite families get first crack at top jobs in law firms, investment banks, wealth managers, and other preferred occupations. This passing of the baton from one elite generation to the next helps the elites to keep a stranglehold on wealth and privilege. Middle-class graduates with brains and talent are not shut out completely; they just have a harder time cracking the code.
Finally, the student loan debacle is one of the most powerful discrimination factors between the rich and middle class. The sons and daughters of rich families breeze through college and emerge with little or no debt. The middle-class families borrow extensively from government student loan programs to graduate from the same schools. The difference shows up upon graduation, when the elites enter careers debt-free while the middle-class students may easily have a hundred thousand dollars in student loan debt.
This debt burden in a gig economy quickly results in missed payments. As we’ve seen, bad payment history then impacts the FICO credit scores of the recent graduates. Poor FICO scores stand in the way of good jobs, leases on attractive apartments, or mortgages on starter homes in good neighborhoods. Student loans constitute a form of indentured servitude in the case of middle-class graduates who work hard to pay them off, but fall further behind in doing so. Meanwhile, the rich graduates are getting promotions, raises, and buying new homes with ease. The stage is set for another generation of the rich getting richer and the middle class getting left behind.
Is there a public policy solution to this increasing inequality in income distribution? Walter Scheidel’s book The Great Leveler (2017) examines income inequality since the agrarian age.6 He reached several important conclusions that are critical to understanding the income inequality society faces today.
Scheidel’s first conclusion is there is no shortage of proposed remedies for income inequality. The list of solutions varies with the stage a society has reached. The usual remedies are land redistribution, progressive income taxation, higher estate taxation, free education, greater access to good schools, support for preschool programs, free lunches and improved nutrition, universal health care, an end to preferential legacy school admissions, an end to discrimination in hiring, and greater diversity in the management of large companies.
Scheidel’s second conclusion is that none of these remedies has any chance of becoming law on a large enough scale to have a material impact on income inequality. Reasons for this failure of implementation are diverse, but the most prominent reason is that legislatures and courts are effectively controlled by elite bankers and lawyers who stand in the way of policies that erode their clients’ elite status. In short, the wolves are in charge of the hen house.
This does not mean that income inequality is never leveled or reversed. Periodically society experiences what Scheidel calls a “leveling,” in which income distribution is compressed and gaps between rich and poor are greatly reduced. That’s the good news. The bad news is that leveling is achieved only through death and violence as a result of mass mobilization warfare, extreme revolution, pandemic plague, or a systemic collapse. A classic example is the Black Death in fourteenth-century Europe, in which over one third of the population died. Surviving workers received higher wages because of resulting acute labor shortages. This phenomenon is well documented. Still, plague is a tough way to get a raise.
Prospects for a reduction in income inequality and improvement in the relative well-being of the middle class are dismal absent the appearance of one of these violent four horsemen in the form of warfare, revolution, plague, or systemic collapse. No one is rooting for those outcomes, yet no one should expect a reduction in income inequality without them.
Despite this embedded unfairness, those on the wrong side of the income inequality distribution should not assume all is well with the superwealthy. The rich may not be concerned with paying bills, but they are concerned with survival if, as many expect, current social disorder spreads into social collapse. This is the impetus for luxury bombproof bunkers built in former missile silos, and expansive estates in New Zealand loaded with rations and good wine. Even these precautions don’t ease their minds, because it leads to the next worry, which is how to get to the shelters in a panic and how to insure the loyalty of their guards and private-jet pilots as society unravels. These second-order fears are on full display in this excerpt from an article by theorist Douglas Rushkoff, describing a private encounter with superrich clients:
After I arrived, I was ushered into what I thought was the green room.7 But instead of being wired with a microphone or taken to a stage, I just sat there at a plain round table as my audience was brought to me: five super-wealthy guys—yes, all men—from the upper echelon of the hedge fund world. After a bit of small talk … they edged into their real topics of concern …. The CEO of a brokerage house explained that he had nearly completed building his own underground bunker system and asked, “How do I maintain authority over my security force after the event?”
The Event. That was their euphemism for the environmental collapse, social unrest, nuclear explosion, unstoppable virus, or Mr. Robot hack that takes everything down ….
They knew armed guards would be required to protect their compounds from the angry mobs. But how would they pay the guards once money was worthless? What would stop the guards from choosing their own leader? The billionaires considered using special combination locks on the food supply that only they knew. Or making guards wear disciplinary collars of some kind in return for their survival ….
When the hedge funders asked me the best way to maintain authority over their securit
y forces after “the event,” I suggested that their best bet would be to treat those people really well, right now. They should be engaging with their security staffs as if they were members of their own family …. All this technological wizardry could be applied toward less romantic but entirely more collective interests right now.
Rushkoff’s advice to treat people decently is worthy, yet seems to have escaped the hedge-fund crowd. A more practical answer is to pay your guards in gold or silver, always money good. The fact that this solution never occurred to the hedge-fund mavens shows even the richest are estranged from the concept of real money.
As if to validate elite worries, one need only point out that the 2008 global financial crisis is not over. In fact, it has barely begun. Economic downturns historically run in a V-shaped pattern. Growth declines during the recession stage and then bounces back to the trend line quickly. The lost growth in the recession is made up by a steep rebound. Once growth returns to trend, the lost wealth is recovered and the economy continues on its historic growth path. That never happened in the 2008 crisis. Growth declined, but it never bounced back. Growth never returned to the trend line and never made up the losses. Instead, growth resumed on a new trend line well below the old trend and on a more shallow trajectory.
Not only was there no V-shaped recovery, the new trend falls further away from the old trend over time. The gap between the old higher trend and the new lower trend is referred to as the wealth gap, the difference between how rich we would be if there were a strong recovery after 2008, and how rich we are based on the historically weak recovery that occurred. That wealth gap today is over $4 trillion dollars. What’s worse is the wealth gap keeps getting larger because the new trend line is not as steep as the old one. The old and new trend lines don’t run parallel; they diverge, so the wealth gap keeps growing.
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