Who Destroyed the Middle Class?

June 24, 2012

(This item originally appeared at Forbes.com on June 24, 2012.)

http://www.forbes.com/sites/nathanlewis/2012/06/24/economic-forensics-who-actually-destroyed-the-middle-class/

Who destroyed the U.S. middle class?

The difficulties experienced by the great middle in the U.S. can be, in my opinion, traced to the delinking of the U.S. dollar from gold in 1971. Now, I know a lot of people are going to say that is ridiculous. But, one reason I say that is, even by the U.S. government’s own statistics, the income of the median full-time male worker begins to stagnate at exactly that point, after rising by huge amounts during the 1950s and 1960s.

The median U.S. full-time male income was $47,715 in 2010. In 1969, it was $44,455. The 1969 numbers are of course “adjusted for inflation,” and you know that the government’s inflation adjustments are thoroughly low-balled. With slightly more honest statistics, the trend would not be flat, but instead downward over the past forty years.

Another way of looking at it is in terms of ounces of gold. After all, gold was the monetary basis of the United States for 182 years, from 1789 to 1971, so why shouldn’t we use that as a measure of how much people are really getting paid?

Our median worker, in 1969, made $8,668 nominal. But, in those days, the dollar was worth 1/35th of an ounce of gold. It works out to 248 ounces of gold. In 2010, the dollar’s value was, on average, about 1/1224th of an ounce of gold, and the full-time male worker was making only 39 ounces of gold. This figure exaggerates the situation somewhat, due to the rapid decline of the dollar vs. gold in recent years, but it describes, I would say, the economic reality of the situation.

Think of it like this: what if, in year 1, the average Mexican full-time male worker was making 8,668 pesos per year, and the peso’s value was one peso per dollar. The Mexican worker is making the monetary equivalent of $8,448. In year 40, after four decades of “easy money” and currency deterioration, the average Mexican worker is making 47,715 pesos, but the peso’s value has fallen to 35 pesos per dollar. We can see that the Mexican worker is making only $1,363, and no amount of government statistical tomfoolery or “purchasing power parity” arguments will change that fundamental fact.

The fact that you can buy an iPad in Mexico City today, while forty years ago you would have to make do with a television set based on vacuum tubes, doesn’t change the fact that the Mexican worker is making less. For some reason, we are able to see these things easily when I take the hypothetical example of a Mexican worker, but Americans are prone to states of denial when asked to consider that maybe a similar thing has been happening to them.

This is why you “can’t devalue yourself to prosperity.” “Prosperity” mostly means higher wages. But, each time you devalue the currency, wages tend to go down in real terms, even if they go up in nominal terms.

The Keynesians are quick to argue that their “easy money” policies will lead to a reduction in unemployment. Sometimes, this works (though not always). It often works because, when wages have been lowered via currency devaluation, then there is more demand for labor due to the lower price. Currency devaluation might help the unemployed, but it hurts the employed – always a much larger number – because their wages have been effectively cut.

Not only do things line up perfectly in terms of timing, but it makes sense on a theoretical basis too, because stagnation and indeed a real decline in wages is exactly the outcome you would expect from a funny-money policy.

However, that is not the only thing that happened to the U.S. middle class in those years. In general, we have a slightly better tax system now than then, at least for upper incomes. I would like to see a much better tax system, more like an 18% flat tax of the sort that Steve Forbes and others have long promoted.

Reducing taxes on upper incomes may make the rich richer. However, I don’t see how they make the middle class poorer – and that is the problem we are talking about here — unless perhaps the tax cuts reduce funding for government services. That has not been the case at all: tax revenue as a percentage of GDP has been about as pancake flat as anything can be for the last sixty years. The variation which does exist (notably the large decline in the last few years) is mostly related to economic performance, not tax policy changes. Government spending as a percentage of GDP is at historic highs today.

However, one thing that has happened over the past forty or sixty years is that taxes on lower incomes have increased. The payroll tax was 3% in 1960, or 6% if you consider both the employer and employee portions. Today, it is 6.2%, or 15.3% taking both sides and also considering Medicare. That’s a big increase.

Sales taxes have risen from an average of 7.0% in 1983 to 9.6% in 2010. Unfortunately, the data becomes murkier going farther back, but it appears that this trend higher in sales taxes has been taking place since the 1950s.

Also, the basic exemption has been driven lower and lower, mostly due to inflationary “bracket creep.” In 1950, a married couple was exempt on its first $1,200 of income. That might not sound like much, but in 1950, per-capita income was about $1,510. In 2010, per-capita income was $40,584, and a married couple was exempt on only the first $11,400 of it.

Overall, we’ve seen a gradual increase in the tax rates on the first $50,0000 of income. Today, for a family of four that makes over $36,900 — not exactly a high hurdle — you’ll be paying 15% on marginal income, plus 15.3% in payroll taxes (directly or indirectly), plus about 10% in sales taxes, plus additional state-level and possibly city-level income taxes, plus property taxes (directly or indirectly), plus additional fees and taxes on your phone, gasoline, and whatnot. A single taxpayer hits this level at $14,650. That is, in my opinion, much too heavy a burden at this income level.

Another theme of the past four decades or so has been “outsourcing,” first to South Koreans or Mexicans, but especially to Chinese or Indians in the past fifteen years or so. The problem is that a huge new supply of labor has been introduced to the world market economy. This tends to favor capital, i.e. business owners, which is one reason why U.S. corporate profit margins have been recently near their highest in decades.

This has been a problem that we have been trying to deal with for literally the entire history of industrial capitalism. In general, I like to think of the “capital:labor ratio.” This is more of an idea than an actual number. All economists agree that rising incomes are basically a reflection of rising productivity. You can’t have it until you make it. Think of a person with “little capital.” We tend to like hole-digging for these examples, so let’s give them a stick. The person can’t dig many holes with a stick. Their productivity is low. Now we give them more capital, such as a hand shovel. Their productivity increases. Now we give them still more capital, in the form of a mechanized backhoe. Their hole-digging abilities take a huge leap skyward. Now we give them a huge amount of capital, in the form of a giant excavator found in some mining operations. Their hole-digging abilities increase again. They have become much more productive.

In practice, “capital” usually doesn’t take the form of these simplistic examples. It could be education, or investment in software research and development, or investment in a high-end hotel resort, instead of these outdated “man with big machine” notions. But, the basic idea still holds: when there is a lot of capital and relatively little labor, then individual wages tend to rise. The investment of a billion dollars in a high-end hotel resort allows several hundred people to provide high-end hotel resort services, in a similar fashion that investment in a billion dollars of digging equipment allows several hundred people to provide excavation services.

Although capital does flow internationally somewhat, I find that, in general, places with high levels of capital creation (i.e. a high savings rate and low taxes upon capital and income) also tend to have high levels of domestic investment. China takes all the awards here, as it has a savings rate of about 50%, which is extraordinary. Chinese people are climbing the ladder from stick to shovel to backhoe to giant excavator very quickly as a result. The U.S. has a very low savings rate, commonly under 5%, which contributes greatly, I think, to the capital-starved character of the U.S. economy today.

In short, “labor” has effectively increased dramatically in the U.S. due to “outsourcing,” while “capital” is scarce due to a low savings rate and some of the worst treatment of capital, in terms of taxes, in the developed world.

None of the things that we have enumerated thus far really has much to do with the so-called “1%.” However, particularly in the last few years, the character of U.S. policy has become distinctly corporatist, favoring large-scale theft (“bailouts”) particularly by the financial sector, although also by the defense, education, and healthcare sectors in my opinion. Many corporations have also used their political influence to allow themselves to engage in behavior that is destructive to the middle class, such as predatory or just plain excessive lending, for homes, autos and education, which might otherwise have been curtailed. The U.S. healthcare system has also become effectively predatory upon the middle class, claiming 17% of GDP to provide what costs 5-8% of GDP in other developed countries.

In short, certain businesses are using their influence of the political system to take the government’s money. And, since it is mostly the “99%” who provide this money, via their tax payments, this constitutes theft from the middle class by the oligarchical class. So far, this theft has been financed essentially by debt, so the effect on the middle class has not been felt directly. But, debt will need to be paid, and it is the taxpaying “99%” that will do the paying.

Those four elements – devaluation of wages by currency mismanagement; mediocre tax policy including a gradual increase in tax rates on lower incomes; the deteriorating capital:labor ratio; and crony capitalist theft and predatory activities – constitute the basis for the deterioration of the U.S. middle class today. How could they be resolved?

1)   A policy of stable money, in practice returning to a gold standard system as was used for most of U.S. history until 1971.

2)   Major tax reform, including both a reduction in top rates and a dramatic reduction in taxes on lower incomes

3)   The intent to improve the capital:labor ratio, mostly by way of removing obstacles to capital accumulation, and promoting a much higher savings rate. Note that this is completely contrary to Keynesian notions focusing always on increasing “consumption.”

4)   Ending all “crony capitalist” payoffs, and regulating corporate activity that tends to be destructive of middle-class welfare.

Unfortunately, we aren’t anywhere near having a rational discussion about any of these topics. Democrats, for the most part, don’t even understand them. Republican thinkers often do understand them, but rarely talk about them as it tends only to result in an explosion of Democratic angst.

I think it would be nice if Republicans could focus their attention a little more on the median and less-than-median workers and families in the U.S. Explain how policies such as the ones above will help them more than any tax-and-spend scheme devised by the Democratic party. Unfortunately, Republicans have made themselves largely unelectable due to the fact that Republican governments tend to forget everything they said in the election, and instead, once in office, embark on an orgy of war, police state expansion, and even bigger payoffs to their crony capitalist buddies.

Perhaps, before this crisis era is through, the U.S. political system will get back on track again. But, in the end, it might be some other country that manages to find the Magic Formula for wealth and prosperity – the kind of wealth and prosperity that “lifts all boats,” as it used to be said.