Aftershock

by Robert B. Reich

  In the 1920s, richer Americans created stock and real estate bubbles that foreshadowed those of the late 1990s and 2000s. The Dow Jones Stock Index ballooned from 63.9 in mid-1921 to a peak of 381.2 eight years later, before it plunged. There was also frantic speculation in land. The Florida real estate boom lured thousands of investors into the Everglades, from where many never returned, at least financially.

  Wall Street cheered them on in the 1920s, making a ton of money off gullible investors, almost exactly as it would in the 2000s. In 1928, Goldman Sachs and Company created the Goldman Sachs Trading Corporation, which promptly went on a speculative binge, luring innocent investors along the way. Four years later, after the giant bubble burst, Mr. Sachs appeared before the Senate.

  SENATOR COUZENS [Republican from Michigan]: Did Goldman, Sachs and Company organize the Goldman Sachs Trading Corporation?

  MR. SACHS: Yes, sir.

  SENATOR COUZENS: And it sold its stock to the public?

  MR. SACHS: A portion of it. The firm invested originally in 10 percent of the entire issue.…

  SENATOR COUZENS: And the other 90 percent was sold to the public?

  MR. SACHS: Yes, sir.

  SENATOR COUZENS: At what price?

  MR. SACHS: At 104 …

  SENATOR COUZENS: And at what price is the stock now?

  MR. SACHS: Approximately 1¾.

  Meanwhile, National City Bank, which eventually would become Citigroup, repackaged bad Latin American debt as new securities, which it then sold to investors no less gullible than Goldman Sachs’s. After the Crash, National City’s top executives helped themselves to the bank’s remaining assets as interest-free loans, while their investors and depositors were left with pieces of paper worth a tiny fraction of what they had paid for them.

  Yet however much Wall Street’s daredevil antics in the 1920s and in the 2000s were proximate causes of the giant bubbles of these two eras, the bubbles also reflected the deeper problems Eccles identified—the growing imbalance between what most people earned as workers and what they spent as consumers, and the increasingly lopsided share of total income going to the top. In both eras, had the share going to the middle class not fallen, middle-class consumers would not have needed to go as deeply into debt in order to sustain their middle-class lifestyle. Had the rich received a smaller share, they would not have bid up the prices of speculative assets so high.

  The biggest difference between the two eras was in what happened next, after the bubbles burst. In the wake of the Great Crash of 1929, the economy went into a vicious downward cycle. Unemployed workers, with little or no access to credit, were unable to purchase much of anything. This caused businesses to lay off even more workers, which further contracted spending, leading to even more layoffs. The resulting Great Depression shook America to its core. The magnitude of that crisis forced the nation to seek ways to overcome both the widening economic divide that had contributed to it and the economic insecurities it fueled. The undeniable reality that almost all Americans shared the ravages of the Depression resulted in an unusual degree of social cohesion, giving the nation the political will to make the needed reforms.

  Government policies in the wake of the Great Depression led to a new economic order, including many of the programs Marriner Eccles proposed on the eve of Roosevelt’s inauguration—social insurance, and improvements in the nation’s infrastructure, schools, and public universities. Initially, these were financed by government borrowing. They made the American middle class in subsequent years vastly more secure, prosperous, and productive. As we shall examine in more detail, unemployment insurance, Social Security in old age, disability benefits, and, eventually, Medicare and Medicaid propped up incomes even when misfortune struck. After World War II, a vast expansion of public higher education, interstate highways, and defense-sponsored research and development of sophisticated technologies improved workers’ productivity and wages. And support of their rights to form labor unions, work at a base of forty hours and get time and a half overtime, and receive a minimum wage improved their bargaining power. During the war, government spending reached unprecedented levels. The nation put its full industrial capacity to use, employing almost all working-age Americans. And even though that capacity was largely dedicated to military demands, the sheer volume of production also met civilian needs. By the end of the war, most surviving Americans were better off than they had been at its start, and the Great Depression had irrevocably ended. America’s debt was huge, to be sure, but in subsequent years a buoyant economy enabled government to repay a substantial portion.

  The Great Recession that started at the end of 2007, however, has produced no new economic order. Instead, the government stepped in quickly with enough money to contain the downward slide. America had at least learned the superficial lesson Marriner Eccles had offered to deal with downdrafts of this magnitude: When demand evaporates, government must act as purchaser of last resort, temporarily filling much of the vacuum created by fast-retreating consumers, and it must make borrowing so cheap as to keep banks solvent and credit moderately available. In 2008 and 2009, the Obama administration and the Federal Reserve played their parts with $700 billion in bank bailouts, a subsequent stimulus package of similar magnitude, and a massive expansion of the money supply.

  The government thereby averted what in all likelihood would have become another Great Depression. No rational person could wish for a repeat of that. Yet, ironically, President Obama’s success in forestalling economic collapse reduced the urgency of dealing with the larger challenge. Apart from extending health insurance coverage, little was done to reduce the underlying, cumulative problem of widening inequality—Eccles’s insight into what caused the Great Depression. After the stimulus and loose money wear off, therefore, it is unlikely that growth can be sustained. We are almost certainly in store for many years of high unemployment. The underlying trend of the last thirty years will continue: Median incomes will remain flat or decline, and most families will stay economically insecure. Inequality will continue to widen. Consequently, the middle class will not be able to buy nearly enough to keep the economy going. Neither richer Americans nor foreign consumers will fill the gap. All of this will constitute the Great Recession’s aftershock. From it will emerge either a political backlash—against trade, immigration, foreign investment, big business, Wall Street, and government itself—or large-scale reforms that reverse the underlying trend.

  * There is no strict definition of the “middle class.” For the purposes of simplicity and clarity, I define it broadly to include the 40 percent of American families with incomes above the median family income and the 40 percent below.

  3

  The Basic Bargain

  On January 5, 1914, Henry Ford announced that he was paying workers on his famously productive Model T assembly line in Highland Park, Michigan, $5 per eight-hour day. That was almost three times what the typical factory employee earned at the time. In light of this audacious move, some lauded Ford as a friend of the American worker; others called him a madman or a socialist, or both. The Wall Street Journal termed his action “an economic crime.” Ford thought it a cunning business move, and history proved him right. The higher wage turned Ford’s autoworkers into customers who eventually could afford to plunk down $575 for a Model T. Their purchases in effect returned some of those $5 paychecks to Ford, and helped finance even higher productivity in the future. Ford was neither a madman nor a socialist, but a smart capitalist whose profits more than doubled from $25 million in 1914 to $57 million two years later.

  Ford understood the basic economic bargain that lay at the heart of a modern, highly productive economy. Workers are also consumers. Their earnings are continuously recycled to buy the goods and services other workers produce. But if earnings are inadequate and this basic bargain is broken, an economy produces more goods and services than its people are capable of purchasing. This can lead to the vicious cycle Marriner Eccles witnessed after the Great Crash o
f 1929 and that the United States began to experience in 2008. (Global trade complicates this bargain but doesn’t negate it, as I will discuss later.)

  In his time, Ford’s philosophy was the exception. From the 1870s to the 1930s, during what might be termed the first stage of modern American capitalism, most workers didn’t share in the bounty. Large factories, mammoth machinery, and a raft of new inventions (typewriters, telephones, electric lightbulbs, aluminum, vulcanized rubber, to name just a few) dramatically increased productivity. But most working people earned far less than five dollars a day. America’s burgeoning income and wealth was concentrated in fewer hands. Consequently, demand couldn’t possibly keep up. Periodic busts ensued. The wholesale price index, which had stood at 193 in 1864, fell to 82 by 1890. Sharp downturns continued to jolt the economy. By the first decades of the twentieth century, the economy had stabilized, but productivity gains continued to outpace most Americans’ earnings. The rich, meanwhile, used their increasing fortunes to speculate—making the economy more susceptible to cycles of boom and bust. Eccles saw this pattern eventually culminate in the Great Depression.

  British economist John Maynard Keynes also understood the crucial connection between the level of wages and the demand for what workers produced. A tall, charming, self-confident Cambridge don, Keynes was born in Cambridge, England, in 1883, the same year Karl Marx died. Yet his writings probably saved capitalism from itself and surely kept latter-day Marxists at bay. During the depths of the Great Depression, when many doubted capitalism would survive, Keynes declared capitalism the best system ever devised to achieve a civilized economic society. But he recognized in it two major faults—“its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” Until these were corrected, Keynes argued, capitalism would continue to be highly unstable, vulnerable to economic booms that would often be followed by catastrophic collapses. Yet if government worked to correct these faults, he felt confident that future generations could inherit a stable and prosperous world.

  Classical economists had viewed markets as self-correcting. They had supposed that full employment would always prevail in the end. Any spate of unemployment would cause wages to drop until employers found it profitable to hire workers again. By this view, persistent unemployment was the result of stubborn resistance on the part of workers who insisted on keeping their old level of wages even though they didn’t work hard enough to justify them. The only answer was to make them experience joblessness long enough to accept lower wages. This view fit nicely into the prevailing Social Darwinism of the era: Only the fittest should survive, and any effort to make the less fit more comfortable was bound to inflict harm on the greater society. After the Great Crash of 1929, Herbert Hoover’s secretary of the Treasury, millionaire industrialist Andrew Mellon, reflecting this prevailing view, cautioned against government action. He advised that wages and prices should be allowed to fall, thereby clearing the system of waste and lassitude. “Liquidate labor, liquidate stocks, liquidate the farmer, liquidate real estate. It will purge the rottenness out of the system.… People will work harder, lead a more moral life.” This was the same nonsense Marriner Eccles had come up against, leading Eccles to conclude that people in power were trying to justify the status quo by invoking a dubious morality.

  Like Eccles, Keynes did not view unemployment as a moral failing. He saw it as a failure of demand. Average workers lacked enough purchasing power to buy what they produced. Keynes’s big idea was to use macroeconomic policy to maintain full employment. Policymakers should expand the money supply to permanently lower interest rates, so that consumers and businesses could get lower-cost loans, and government should increase its own spending to make up for the shortfall in consumer demand, so that more jobs would be created.

  Part of Keynes’s answer was also to spread the benefits of economic growth. Keynes recognized that growth depends on the incentives of the rich to save and invest. But he noted that until an economy reaches full employment, additional savings don’t help; in fact, they cause harm by reducing the demand for goods and services. The central problem isn’t too little savings; it’s too little demand for all the goods and services an economy can produce. This logic led Keynes to conclude that “measures for the redistribution of incomes in a way likely to raise the propensity to consume may prove positively favorable to the growth of capital.”

  Keynes thereby offered a theoretical explanation and a practical justification for doing what Marriner Eccles thought government should do under the conditions Eccles witnessed: maintain aggregate demand so that the productive capacity of an economy doesn’t outrun the ability of ordinary people to buy, which would give businesses less incentive to invest. Equally important, enforce a basic bargain giving workers a proportionate share of the fruits of economic growth. The two went hand in glove. When the basic bargain is maintained, the entire economy is balanced. When the basic bargain breaks down, government must step in to reinforce it, or the economy will shrink.

  America learned this lesson in the Great Depression. We also learned it in the Great Prosperity that followed. After that, we forgot it. Now and in years to come we must remember it.

  4

  How Concentrated Income at the Top Hurts the Economy

  The economic problem Eccles identified and Keynes formalized arises not because the rich live too well relative to everyone else but, paradoxically, because they live too modestly—at least compared to what they can afford. When income is concentrated in relatively few hands, the overall demand for goods and services shrinks because the very rich do not nearly spend everything they earn. Their savings are hoarded, circulated in a fury of speculation, or, especially these days, invested abroad. Some savings find their ways into new domestic investment, but, as Eccles observed, usually only “when the purchasing power of the masses increases their demands for a higher standard of living.” Without adequate consumer demand, investors won’t foresee enough return to make the investments worthwhile.

  Rich Americans may sometimes be conspicuous consumers, but overall they simply do not spend enough. Warren Buffett is an extreme example. The richest man in the world in 2008, with a net worth estimated to be $62 billion, Buffett called money “little pieces of paper that I can turn into consumption.” But to a remarkable extent he chose not to consume. In 2008 he still lived on Farnam Street in the central Dundee neighborhood of Omaha, Nebraska, in the same gray stucco house he bought in 1958 for $31,500. His children attended public schools and shared the family car when they were old enough to drive. He paid for his grandchildren’s college tuition but gave them nothing more. Buffet’s one indulgence was a Gulfstream IV-SP jet that cost $10 million, which he sheepishly named The Indefensible.

  Buffett’s parsimony might be considered admirable, but, paradoxically, it contributed to the larger economic problem. “If I wanted to,” Buffett once said, “I could hire ten thousand people to do nothing but paint my picture every day for the rest of my life. And the [gross national product] would go up. But the utility of the product would be zilch, and I would be keeping those ten thousand people from doing AIDS research, or teaching, or nursing. I don’t do that, though.… There’s nothing material I want very much.” Buffett’s economic logic missed a significant fact that John Maynard Keynes emphasized: Every dollar that’s actually spent in an economy has a multiplier effect. Not only does it go to the person who first receives it, but also, indirectly, to other people whom the recipient of the original dollar pays for the things he needs. They, in turn, buy from others. Had Buffett spent more of his income, he would have sustained more jobs. Each of the ten thousand people he hired to paint his portrait would spend the money he paid them, thereby generating employment and income for many others. All of them, painters included, would also pay taxes. And their spending and tax payments might well support, directly or indirectly, AIDS research, teaching, nursing, and other endeavors more socially useful than the ten thousand port
raits of Warren Buffett.

  Consider the nearly $100 million Kenneth Lewis earned as CEO of Bank of America in 2007, as he was leading the bank toward collapse (and absorption by Merrill Lynch). To spend it all, Lewis would have had to buy $273,972.60 worth of goods and services every day that year, including weekends. If he had devoted twelve waking hours a day to the task, he’d have had to spend $22,831 every hour, $380.52 every minute.

  In the year prior to Lehman Brothers’ catastrophic inability to pay its bills, its then CEO, Richard Fuld, collected $500 million of compensation in salary and shares of stock. Fuld had a penthouse on Park Avenue then valued at $21 million; an estate in Greenwich, Connecticut, worth an estimated $25 million; and an art collection valued at $200 million. Steve Schwarzman, head of the private equity firm the Blackstone Group, was another free spender. He held a sixtieth birthday party for himself that cost $5 million. Paul Allen, cofounder of Microsoft, owned two 757s and a helicopter. But these and other high rollers—the modern equivalents of the Vanderbilts, the Carnegies, and the Rockefellers, who built mansions, threw grand parties, and owned their own railroads and oil wells in the late nineteenth and early twentieth centuries—still manage to spend only a modest portion of their yearly incomes.