These policies worked—often immediately. When low interest rates inflated house prices, for example, households borrowed between 25 and 30 cents out of every dollar of housing price appreciation. Taken all together, the policies transformed the bases of middle-class consumption. The midcentury middle class had financed its rising standard of living with income. But beginning in the 1970s, middle-class consumption began to be financed by debt.
The pattern is unmistakable. Mean income among the bottom 90 percent rose steadily (more or less in tandem with consumption) between roughly 1940 and roughly 1975, at which point income stopped rising almost completely, even as consumption continued its smooth growth. Mean debt, by contrast, rose more slowly than income from 1940 to 1975 and then, just a few years after incomes stopped growing, began a steep rise (again, more or less in tandem with still-rising consumption). Middle-class borrowing, in other words, bent upward just as middle-class incomes flattened out, and borrowing grew on a scale big enough to fill the income gap that middle-class households lost to stagnant wages.* The scale of the borrowing, moreover, approached the shift in wages from the middle to the top.
As the Nobel Prize–winning economist Joseph Stiglitz has observed, “The negative impact of stagnant real incomes and rising income inequality . . . was largely offset by financial innovation . . . and lax monetary policy that increased the ability of households to finance consumption by borrowing. . . . The support for the bubble thus depended on expansionary monetary policy together with financial sector innovation leading to ever-increasing asset prices that allowed households virtually unlimited access to credit.” If the standard of living in midcentury America was funded by income, and the standard of living of the European middle class is increasingly supported by government redistribution, the American middle class increasingly relies on borrowed funds. The earlier observation that household credit has become functionally equivalent to payday lending stated a literal truth.
Finance rode to its current prominence atop this wave of inequality-induced borrowing, scaled to match the U.S. macroeconomy, which pushed new money through the sector not as a trickle, nor even as a stream, but as a geyser. The share of GDP attributable to financial services has roughly doubled since 1970. Finance now contributes nearly a tenth of the country’s total economic output, which is beginning to converge on the share of GDP attributable to manufacturing.
These developments shifted the center of gravity of the American economy away from Main Street and toward Wall Street: economic activities such as agriculture, wholesale and retail trade, and manufacturing that produce directly useful goods and services became relatively less important; while financial activities such as banking, securities trading, investment management, and insurance that create and transfer claims to money became relatively more important. Even traditionally powerhouse industrial firms have come to be dominated by their financial offshoots. The most profitable unit of General Motors in the years leading to the financial crisis was its financing subsidiary, GMAC. At General Motors, Wall Street’s debt-financed middle-class consumption swamped Main Street’s industrial production.
Overall, about a quarter of finance’s exceptional growth came immediately and directly from the inequality-driven rise in household credit, and in particular the explosion of residential mortgages—though consumer credit, including credit card debt, also contributed substantially to this facet of finance. A further half of finance’s growth came from economic inequality’s other side, through the increased output of the securities industry. The securities boom was overwhelmingly propelled by the growth of asset management services—with especially rapid growth in private equity firms, venture capital firms, and hedge funds—which by nature serve the wealthy whose assets they manage. Indeed, the most rapid growth within asset management came from fixed-income assets, typically produced by securitizing loans—securitized home mortgages alone accounted for roughly half of all asset-backed securities issued between 2000 and 2008—which show the flip side of rising household borrowing. (By contrast, the functions that traditionally generated the securities industry’s profits in the more equal midcentury—trading fees and commissions, trading gains, and securities underwriting fees—actually all generated declining shares of GDP over this period.)
It is only a slight exaggeration to say, with one prominent commentator, that by the time of the 2007–8 crisis, the “entire edifice” of the U.S. financial market “rested on the housing market.” The housing market, for its part, rested on debt. And debt, once again, rested on economic inequality.
At almost the same historical moment as the demands on finance exploded, a new, super-skilled labor force came to Wall Street. The new supply of superordinate workers transformed how finance did business, attracting innovations that favored its own elite skills.
When the first wave of super-skilled finance workers reached Wall Street in the late 1970s, old-timers (still cast in the mid-skilled, midcentury mold) called them “rocket scientists.” The reason is that they were. Military imperatives associated with World War II and the Cold War—the invention of radar, the Manhattan Project to build the atom bomb, and the arms and space races—had persuaded midcentury America that highly trained, meritocratic physicists and engineers were essential to the nation’s prosperity and security. The Defense Department and the Department of Energy began liberally funding pure research, and academic faculties grew rapidly in both size and quality through the 1950s and 1960s.
But then the United States won the space race, a détente with the Soviet Union slowed the arms race, and the unpopular conflict in Vietnam roused the public to oppose “science in the service of war.” The tide turned against the military uses that had driven scientific research, government cut back its funding, and research dried up. A generation of newly minted PhDs in physics and engineering found themselves without academic jobs. The new supply of super-skilled workers went looking for demand.
At first, energy and communications companies, including most notably Exxon and Bell Labs, absorbed the new super-skilled workforce. But by 1980, Wall Street recognized that physicists and engineers could profitably develop and deploy new financial technologies and came calling—often literally. A physicist who entered finance early and eventually became a managing director at Goldman Sachs remembers that headhunters offered his cohort jobs “that paid $150,000 . . . a huge amount in those days for an ex-physicist making less than $50K.”
When the rocket scientists arrived on Wall Street, they fundamentally transformed how the sector did business. The new, super-skilled workforce made complex financial techniques—long known in theory but too difficult for mid-skilled workers to implement—suddenly practicable. The match between the workforce that finance needed to reconstruct itself and the labor that physicists and engineers could provide was uncannily precise: the math deployed in finance and in physics closely resemble each other, and the pragmatic work ethic of physicists and engineers rendered them especially willing to step into subdisciplines not quite theirs and to construct makeshift solutions to practical problems and then move on. Finance had found a new type of human capital—“skilled mathematicians, modelers, and computer programmers who prided themselves on their ability to adapt to new fields and put their knowledge into practice”—that almost perfectly suited its growing needs.
This triggered innovations that had long lain dormant. The fundamental theoretical advances that ground modern, sophisticated finance (the capital asset pricing model and the Black-Scholes model that underwrite portfolio allocation and the pricing of options and other derivatives) were made in the 1950s, 1960s, and early 1970s, often a quarter century before finance transformed itself into a super-skilled sector by implementing them. (Indeed, the foundational ideas behind these models, which concern measuring, segregating, and then recombining risks, have been around since Pascal and other French mathematicians invented modern probability theory—an interest aroused by inquiries
put to them when aristocratic gamblers sought to measure and manipulate the odds in their wagers.) Now, after a quarter century (or three centuries) of lying fallow as merely theoretical possibilities, these advances encountered a financial workforce capable of deploying them and a broader society that needed the services they made possible.
Practical innovation followed almost at once, with forty fundamentally new financial products and practices introduced between just 1970 and 1982. The innovators became rich. In the early 1980s, for example, super-skilled workers at Drexel Burnham Lambert pioneered the high-yield bond market: “There wasn’t another firm in the world that knew how to price a junk bond,” a Drexel insider remembers, which made the junk bond business immensely profitable. The profits of course drew competition from other newly minted super-skilled workers, and this competition generated new innovation, including in the mortgage-backed securities that proved so profitable in the early 2000s and in the high-frequency trading platforms that are so profitable today.
The innovations, moreover, drove mid-skilled, middle-class workers out of finance even as they attracted super-skilled replacements. Securitization, once again, encouraged banks to dispense with traditional loan officers, by aggregating and hedging away loan-specific risks, and therefore making the accurate initial lending decisions that traditional loan officers were charged with less valuable. (Indeed, literally all the increase in home mortgage loans over the past three decades was produced without mid-skilled loan officers, using financial technologies, and securitized and sold to shadow banks and other investors. The aggregate household credit issued on the midcentury model and held by banks constituted the same share of GDP in 2007 as it had in 1980, in spite of the massive rise in household borrowing.)
The match between elite education and finance was made. The sleepy, mid-skilled, middle-class model of the sector gave way to rapid growth, constant innovation, and a super-elite (immensely skilled and extravagantly paid) workforce. The transformation was so pervasive that it has changed finance’s culture and language: old craft-based and autodidact practitioners, like chartists and stock tipsters, have been supplanted by new super-skilled, formally trained, university-certified “quants.” Wall Street began to dominate hiring in the Ivy League, and entire groups at major banks came to be dominated by physicists, applied mathematicians, and engineers, many with PhDs. Finance has never been the same.
Finance abandoned its midcentury model of growing by hiring more mid-skilled workers, and even as its share of GDP rose rapidly, its share of employment actually began to fall. As finance used relatively fewer but more skilled workers to produce relatively more output, finance-sector incomes began to rise, and the elite workers who dominated the sector got rich. Today, “talent is the most precious commodity on Wall Street; it’s what [banks] sell, so it’s also what they have to pay for.” Wages now capture nearly half a typical Wall Street firm’s net revenue. The average finance worker now makes 70 percent more than average workers in other sectors (the college wage premium in finance nearly doubles that for other workers). And finance workers dominate the ranks of the really rich. Today, elite finance workers’ enormous incomes exacerbate economic inequality, increasing the needs that finance serves.
This stylized story glosses over many complexities, but it captures an important core truth that applies far beyond finance, across the entire economy. The skill-biased technologies that account for superordinate workers’ enormous incomes did not arise out of the blue—from beyond the meritocratic system. Instead, the appearance of super-skilled finance workers induced the innovations that then favored their elite skills. A rising supply of meritocrats stimulates its own demand.
Meritocratic inequality grows—and meritocracy builds and then reinforces its trap—through a series of feedback loops. The most important connects meritocratic inequality’s two basic building blocks: the exceptional training that rich children receive in school and the extravagant incomes that elite skills sustain at work.
The returns to skill rationalize the elite’s mania for training. Both parents and children accept oppressively intense education in order to secure glossy jobs, avoid gloomy ones, and transmit caste down through the generations. In this way, work remakes the home in its image.
The elite’s exceptional training, for its part, rationalizes the labor market’s fetish for skill. Most obviously, meritocracy promotes innovation. Innovators require training, often lots of it, and the scope and scale of research and development therefore increase where meritocratic education builds an innovator class—the physicists who came to Wall Street—and creates a “research and development sector.” Less obviously, but no less important, meritocracy guides innovation, determining not just how many but which and what kinds of new technologies get invented. Meritocracy biases technological innovation toward skill because elaborately trained and intensely motivated superordinate workers can use skill-biased innovations in especially productive and profitable ways, in stark contrast to the aristocratic elite. (Imagine asking Bertie Wooster to trade collateralized debt obligations.) Meritocratic education both creates innovators and gives them a target to aim at. In this way, the home also remakes work in its image.
The feedback loop between elite training and elite work does not of course account for all economic inequality, or even just for all meritocratic inequality. Nevertheless, it constitutes the master mechanism that dominates social and economic life today. Meritocratic inequality exhibits neither self-correction nor even self-restraint; to the contrary, once it gains a foothold, new inequalities grow inexorably upon prior ones. The workplace fetish for skill induces elite parents to give their children exceptional educations, and superordinate workers bend the arc of innovation to increase the fetish for skill.
The cycle continues, and meritocratic inequality snowballs down through the generations, gathering size, mass, and momentum as it rolls down history’s hill.
REINVENTING MANAGEMENT
The Safeway supermarket chain was founded by the son of a Baptist minister, who promoted cash-and-carry grocery stores because he believed that credit-based grocers raised prices and produced household debt and dependency. The chain’s founder, M. B. Skaggs, would later remark, “In 1919 I had never seen a cash-and-carry grocery store, but the plan made sense. My progress would be measured by the degree to which I could give better service, cut out waste, sell for cash, meet my customers’ needs, and give them the benefit of my savings.” For decades—through expansions, contractions, and restructurings—Safeway did business under mottos such as “Drive the Safeway; Buy the Safeway” and “Safeway Offers Security.”
Throughout this period, the firm functioned on the midcentury model, embracing what Fortune magazine, in a 1940 article for which Ansel Adams provided pictures, called “a simple formula for success: it behaves as if it were operated for the benefit of its producers, employees, and consumers.” The formula, moreover, was no empty slogan. The firm’s 1939, 1940, and 1941 annual reports, for example, all proudly announced that although each year saw a decline in the number of Safeway stores in operation, this had not required the company to fire any of its employees. In 1968, Safeway worked to save a competitor food co-op that served the Bayview–Hunters Point neighborhood of San Francisco. In 1972, it was ranked first among food retailers for “social responsiveness and accountability to the public interest.” And in the early 1970s, it seconded a director and senior vice president to the National Alliance of Businessmen, giving them paid leave to work on a crash program that aimed to create half a million good jobs for underprivileged minority workers.
Safeway’s top managers, in this period, retained close connections to the rest of the firm. The 1965 annual report, in celebrating the company’s fortieth anniversary, proudly declared that Safeway’s president had worked for the firm for all forty years, beginning as a part-time food clerk when Safeway was incorporated in 1926 and working his way up to lead the firm. Safeway’
s policies enabled and even encouraged this trajectory: “We live and preach people development” the company announced; “we systematically forecast needs for trained and experienced managers; we identify them and provide the training and experience to qualify them for today’s complex and demanding conditions; and we create opportunities for them to move up.” Opportunities indeed followed: in 1939, all of Safeway’s division managers save two started with the firm behind the checkout counter. One of these two started out as a bookkeeper and the other as a bakery helper.
Safeway’s payroll was distributed broadly across its workers: a division manager might, with bonuses, take home half the pay of the CEO. And Safeway’s CEOs were paid well but not exorbitantly: in each year between 1956 and 1964, Safeway paid its CEO, Robert Magowan, $135,000, which amounts to roughly $1.2 million in 2018 dollars—still a lot, but profoundly less than CEOs make today. Fortune, summing up the firm’s culture, declared that “Safeway has rationalized its technique with so sound a concept of business that when it behaves in character it performs an act of public relations.”
Finally, Safeway’s approach suited its social circumstances. The nineteenth-century workforce—with low literacy rates, few high school graduates, and virtually no college graduates—had lacked the skills either to take or to give managerial direction, and nineteenth-century firms (like the Durant-Dort Carriage Company) therefore naturally did largely without managers. But by the twentieth century, universal high school education, the postwar college boom, and elaborate workplace training had produced a large class of workers capable of performing basic management tasks. At the same time, the valorization of leisure among midcentury elites and the uncompetitive mediocrity of midcentury universities produced top executives who were neither willing nor able to shoulder exceptional managerial burdens. The dispersed managerial technology and elaborate corporate hierarchies that Safeway (and other midcentury firms, including GM) adopted again matched the skill profile of their workforce.
The Meritocracy Trap Page 31