Outside the Box

The Crisis of the Middle Class and American Power

January 11, 2013

Thinking about the long term is all too rare a talent these days and one I really appreciate. When you take a longer view, it is easier to see how all the moving parts, the bits and pieces, fit together. And you can see other streams of action impacting your original line of thought.

In today’s Outside the Box, my (and our) old friend George Friedman thinks about the future of employment and how it impacts the expression of American social order and geopolitical power. Sitting here in Stockholm tonight, that was the very point we were making in our dinner conversation with the management team of the Skagen funds. It is not just a US problem, although George looks at the US. This is a global issue as the gulf between the middle class and the upper income classes is widening, and it is widening for structural reasons. There are no easy answers. Dennis Gartman quotes PJ O’Rourke, who basically launched a shot from the right. It speaks for itself:

 Mr. President, the worst thing that you’ve done is that you sent a message to America in your reelection campaign that we live in a zero-sum universe.

There is a fixed amount of good things. Life is a pizza. If some people have too many slices, other people have to eat the pizza box. You had no answer to Mitt Romney’s argument for more pizza parlors baking more pizzas. The solution to our problems, you said, is redistribution of the pizzas we’ve got—with low-cost, government-subsidized pepperoni somehow materializing as the result of higher taxes on pizza-parlor owners.

In this zero-sum universe there is only so much happiness. The idea is that if we wipe the smile off the faces of people with prosperous businesses and successful careers, that will make the rest of us grin.

There is only so much money. The people who have money are hogging it. The way for the rest of us to get money is to turn the hogs into bacon. The evil of zero-sum thinking and redistributive politics has nothing to do with which things are taken or to whom those things are given or what the sum of zero things is supposed to be. The evil lies in denying people the right, the means, and, indeed, the duty to make more things.

 But George notes the other side (bold emphasis mine):

 Last week I wrote about the crisis of unemployment in Europe. I received a great deal of feedback, with Europeans agreeing that this is the core problem and Americans arguing that the United States has the same problem, asserting that U.S. unemployment is twice as high as the government's official unemployment rate. My counterargument is that unemployment in the United States is not a problem in the same sense that it is in Europe because it does not pose a geopolitical threat. The United States does not face political disintegration from unemployment, whatever the number is. Europe might.

At the same time, I would agree that the United States faces a potentially significant but longer-term geopolitical problem deriving from economic trends. The threat to the United States is the persistent decline in the middle class' standard of living, a problem that is reshaping the social order that has been in place since World War II and that, if it continues, poses a threat to American power.

These issues and the threat they pose have to be resolved. The structural mechanisms are creating the inbalance. We need to nurture creativity and we need to reward it, but it creates a wide dispersion of income.

I think you will find George’s analysis quite thought-provoking, and you may find yourself wanting a Stratfor subscription. They are offering my readers a discount on their excellent products, and, you can get on board by clicking here: https://www.stratfor.com/subscribe/mauldin-jmf.

I am in Stockholm tonight (and did Copenhagen and Oslo) on my way to the south of Spain for a few days, for what is hoped will be a vacation, then a day in London for a Soc-Gen Conference and one of my famous “dinners with interesting people.” Dylan Grice (Soc Gen), Anatole Kaletsky (GaveKal, Simon Hunt (serious expert on copper and China), Dan Stetler (chief econ and Boston Consulting and wicked brilliant), Jonathan Tepper (of Variant Perception and my co-author). Just found out Richard Howard of Hayman Partners (Kyle’s Bass’s operation) and a few others will be there, too. I shall learn a lot. Then I’m off to Greece for five days with Christian Menegatti of Roubini Economics before ending up in Geneva and then returning to Dallas.

Have a great week. I am having a blast and will write your Thoughts from the Frontline letter tomorrow. Three computer crashes in five days! What are the chances? Ugh. But Life is fun and you take it all in stride. Just means I needed to think more about this next letter – maybe I will get it right.

Your ready for some Costa del Sol analyst,

John Mauldin, Editor
Outside the Box

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The Crisis of the Middle Class and American Power

By George Friedman

Founder and Chief Executive Officer

Last week I wrote about the crisis of unemployment in Europe. I received a great deal of feedback, with Europeans agreeing that this is the core problem and Americans arguing that the United States has the same problem, asserting that U.S. unemployment is twice as high as the government's official unemployment rate. My counterargument is that unemployment in the United States is not a problem in the same sense that it is in Europe because it does not pose a geopolitical threat. The United States does not face political disintegration from unemployment, whatever the number is. Europe might.

At the same time, I would agree that the United States faces a potentially significant but longer-term geopolitical problem deriving from economic trends. The threat to the United States is the persistent decline in the middle class' standard of living, a problem that is reshaping the social order that has been in place since World War II and that, if it continues, poses a threat to American power.

The Crisis of the American Middle Class

The median household income of Americans in 2011 was $49,103. Adjusted for inflation, the median income is just below what it was in 1989 and is $4,000 less than it was in 2000. Take-home income is a bit less than $40,000 when Social Security and state and federal taxes are included. That means a monthly income, per household, of about $3,300. It is urgent to bear in mind that half of all American households earn less than this. It is also vital to consider not the difference between 1990 and 2011, but the difference between the 1950s and 1960s and the 21st century. This is where the difference in the meaning of middle class becomes most apparent.

In the 1950s and 1960s, the median income allowed you to live with a single earner -- normally the husband, with the wife typically working as homemaker -- and roughly three children. It permitted the purchase of modest tract housing, one late model car and an older one. It allowed a driving vacation somewhere and, with care, some savings as well. I know this because my family was lower-middle class, and this is how we lived, and I know many others in my generation who had the same background. It was not an easy life and many luxuries were denied us, but it wasn't a bad life at all.

Someone earning the median income today might just pull this off, but it wouldn't be easy. Assuming that he did not have college loans to pay off but did have two car loans to pay totaling $700 a month, and that he could buy food, clothing and cover his utilities for $1,200 a month, he would have $1,400 a month for mortgage, real estate taxes and insurance, plus some funds for fixing the air conditioner and dishwasher. At a 5 percent mortgage rate, that would allow him to buy a house in the $200,000 range. He would get a refund back on his taxes from deductions but that would go to pay credit card bills he had from Christmas presents and emergencies. It could be done, but not easily and with great difficulty in major metropolitan areas. And if his employer didn't cover health insurance, that $4,000-5,000 for three or four people would severely limit his expenses. And of course, he would have to have $20,000-40,000 for a down payment and closing costs on his home. There would be little else left over for a week at the seashore with the kids.

And this is for the median. Those below him -- half of all households -- would be shut out of what is considered middle-class life, with the house, the car and the other associated amenities. Those amenities shift upward on the scale for people with at least $70,000 in income. The basics might be available at the median level, given favorable individual circumstance, but below that life becomes surprisingly meager, even in the range of the middle class and certainly what used to be called the lower-middle class.

The Expectation of Upward Mobility

I should pause and mention that this was one of the fundamental causes of the 2007-2008 subprime lending crisis. People below the median took out loans with deferred interest with the expectation that their incomes would continue the rise that was traditional since World War II. The caricature of the borrower as irresponsible misses the point. The expectation of rising real incomes was built into the American culture, and many assumed based on that that the rise would resume in five years. When it didn't they were trapped, but given history, they were not making an irresponsible assumption.

American history was always filled with the assumption that upward mobility was possible. The Midwest and West opened land that could be exploited, and the massive industrialization in the late 19th and early 20th centuries opened opportunities. There was a systemic expectation of upward mobility built into American culture and reality.

The Great Depression was a shock to the system, and it wasn't solved by the New Deal, nor even by World War II alone. The next drive for upward mobility came from post-war programs for veterans, of whom there were more than 10 million. These programs were instrumental in creating post-industrial America, by creating a class of suburban professionals. There were three programs that were critical:

1.    The GI Bill, which allowed veterans to go to college after the war, becoming professionals frequently several notches above their parents.

2.     The part of the GI Bill that provided federally guaranteed mortgages to veterans, allowing low and no down payment mortgages and low interest rates to graduates of publicly funded universities.

3.    The federally funded Interstate Highway System, which made access to land close to but outside of cities easier, enabling both the dispersal of populations on inexpensive land (which made single-family houses possible) and, later, the dispersal of business to the suburbs.

There were undoubtedly many other things that contributed to this, but these three not only reshaped America but also created a new dimension to the upward mobility that was built into American life from the beginning. Moreover, these programs were all directed toward veterans, to whom it was acknowledged a debt was due, or were created for military reasons (the Interstate Highway System was funded to enable the rapid movement of troops from coast to coast, which during World War II was found to be impossible). As a result, there was consensus around the moral propriety of the programs.

The subprime fiasco was rooted in the failure to understand that the foundations of middle class life were not under temporary pressure but something more fundamental. Where a single earner could support a middle class family in the generation after World War II, it now took at least two earners. That meant that the rise of the double-income family corresponded with the decline of the middle class. The lower you go on the income scale, the more likely you are to be a single mother. That shift away from social pressure for two parent homes was certainly part of the problem.

Re-engineering the Corporation

But there was, I think, the crisis of the modern corporation. Corporations provided long-term employment to the middle class. It was not unusual to spend your entire life working for one. Working for a corporation, you received yearly pay increases, either as a union or non-union worker. The middle class had both job security and rising income, along with retirement and other benefits. Over the course of time, the culture of the corporation diverged from the realities, as corporate productivity lagged behind costs and the corporations became more and more dysfunctional and ultimately unsupportable. In addition, the corporations ceased focusing on doing one thing well and instead became conglomerates, with a management frequently unable to keep up with the complexity of multiple lines of business.

For these and many other reasons, the corporation became increasingly inefficient, and in the terms of the 1980s, they had to be re-engineered -- which meant taken apart, pared down, refined and refocused. And the re-engineering of the corporation, designed to make them agile, meant that there was a permanent revolution in business. Everything was being reinvented. Huge amounts of money, managed by people whose specialty was re-engineering companies, were deployed. The choice was between total failure and radical change. From the point of view of the individual worker, this frequently meant the same thing: unemployment. From the view of the economy, it meant the creation of value whether through breaking up companies, closing some of them or sending jobs overseas. It was designed to increase the total efficiency, and it worked for the most part.

This is where the disjuncture occurred. From the point of view of the investor, they had saved the corporation from total meltdown by redesigning it. From the point of view of the workers, some retained the jobs that they would have lost, while others lost the jobs they would have lost anyway. But the important thing is not the subjective bitterness of those who lost their jobs, but something more complex.

As the permanent corporate jobs declined, more people were starting over. Some of them were starting over every few years as the agile corporation grew more efficient and needed fewer employees. That meant that if they got new jobs it would not be at the munificent corporate pay rate but at near entry-level rates in the small companies that were now the growth engine. As these companies failed, were bought or shifted direction, they would lose their jobs and start over again. Wages didn't rise for them and for long periods they might be unemployed, never to get a job again in their now obsolete fields, and certainly not working at a company for the next 20 years.

The restructuring of inefficient companies did create substantial value, but that value did not flow to the now laid-off workers. Some might flow to the remaining workers, but much of it went to the engineers who restructured the companies and the investors they represented. Statistics reveal that, since 1947 (when the data was first compiled), corporate profits as a percentage of gross domestic product are now at their highest level, while wages as a percentage of GDP are now at their lowest level. It was not a question of making the economy more efficient -- it did do that -- it was a question of where the value accumulated. The upper segment of the wage curve and the investors continued to make money. The middle class divided into a segment that entered the upper-middle class, while another faction sank into the lower-middle class.

American society on the whole was never egalitarian. It always accepted that there would be substantial differences in wages and wealth. Indeed, progress was in some ways driven by a desire to emulate the wealthy. There was also the expectation that while others received far more, the entire wealth structure would rise in tandem. It was also understood that, because of skill or luck, others would lose.

What we are facing now is a structural shift, in which the middle class' center, not because of laziness or stupidity, is shifting downward in terms of standard of living. It is a structural shift that is rooted in social change (the breakdown of the conventional family) and economic change (the decline of traditional corporations and the creation of corporate agility that places individual workers at a massive disadvantage).

The inherent crisis rests in an increasingly efficient economy and a population that can't consume what is produced because it can't afford the products. This has happened numerous times in history, but the United States, excepting the Great Depression, was the counterexample.

Obviously, this is a massive political debate, save that political debates identify problems without clarifying them. In political debates, someone must be blamed. In reality, these processes are beyond even the government's ability to control. On one hand, the traditional corporation was beneficial to the workers until it collapsed under the burden of its costs. On the other hand, the efficiencies created threaten to undermine consumption by weakening the effective demand among half of society.

The Long-Term Threat

The greatest danger is one that will not be faced for decades but that is lurking out there. The United States was built on the assumption that a rising tide lifts all ships. That has not been the case for the past generation, and there is no indication that this socio-economic reality will change any time soon. That means that a core assumption is at risk. The problem is that social stability has been built around this assumption -- not on the assumption that everyone is owed a living, but the assumption that on the whole, all benefit from growing productivity and efficiency.

If we move to a system where half of the country is either stagnant or losing ground while the other half is surging, the social fabric of the United States is at risk, and with it the massive global power the United States has accumulated. Other superpowers such as Britain or Rome did not have the idea of a perpetually improving condition of the middle class as a core value. The United States does. If it loses that, it loses one of the pillars of its geopolitical power.

The left would argue that the solution is for laws to transfer wealth from the rich to the middle class. That would increase consumption but, depending on the scope, would threaten the amount of capital available to investment by the transfer itself and by eliminating incentives to invest. You can't invest what you don't have, and you won't accept the risk of investment if the payoff is transferred away from you.

The agility of the American corporation is critical. The right will argue that allowing the free market to function will fix the problem. The free market doesn't guarantee social outcomes, merely economic ones. In other words, it may give more efficiency on the whole and grow the economy as a whole, but by itself it doesn't guarantee how wealth is distributed. The left cannot be indifferent to the historical consequences of extreme redistribution of wealth. The right cannot be indifferent to the political consequences of a middle-class life undermined, nor can it be indifferent to half the population's inability to buy the products and services that businesses sell.

The most significant actions made by governments tend to be unintentional. The GI Bill was designed to limit unemployment among returning serviceman; it inadvertently created a professional class of college graduates. The VA loan was designed to stimulate the construction industry; it created the basis for suburban home ownership. The Interstate Highway System was meant to move troops rapidly in the event of war; it created a new pattern of land use that was suburbia.

It is unclear how the private sector can deal with the problem of pressure on the middle class. Government programs frequently fail to fulfill even minimal intentions while squandering scarce resources. The United States has been a fortunate country, with solutions frequently emerging in unexpected ways.

It would seem to me that unless the United States gets lucky again, its global dominance is in jeopardy. Considering its history, the United States can expect to get lucky again, but it usually gets lucky when it is frightened. And at this point it isn't frightened but angry, believing that if only its own solutions were employed, this problem and all others would go away. I am arguing that the conventional solutions offered by all sides do not yet grasp the magnitude of the problem -- that the foundation of American society is at risk -- and therefore all sides are content to repeat what has been said before.

People who are smarter and luckier than I am will have to craft the solution. I am simply pointing out the potential consequences of the problem and the inadequacy of all the ideas I have seen so far.

 

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Paul Dorio

Jan. 13, 2013, 7:07 a.m.

George wrote: “The expectation of rising real incomes was built into the American culture, and many assumed based on that that the rise would resume in five years. When it didn’t they were trapped, but given history, they were not making an irresponsible assumption.”

I disagree that the “assumption” was not “irresponsible.” I was not raised to project my future finances onto my present when making a purchase. Actuarial tables are fine for insurance brokers but not for the average individual attempting to calculate the affordability of a present purchase. The main problem in the USA, from the point of view of the consumer, is the seeming inability to budget accurately.

As they say: Hope is not a strategy. Purchasing a home, or any other large ticket item, without rational and realistic budgeting using one’s current income is absolutely naive, irresponsible and foolhardy.

dnpt@ukr.net

Jan. 13, 2013, 5:40 a.m.

This is not a crisis of the middle class. This is a systemic crisis of the existing system of production, the crisis of transition to a new system of production. It is only natural that this is beginning to change the value and function of the middle class. This is part of a global change that will change the geopolitical coordinate system change understanding of the economic and political power. Changing the philosophy of the world order ( http://crisismir.com/analiticheskie-materialy/ekonomika/13-mirovoj-ekonomicheskij-krizis-prichiny-i-posledstviya-quo-vadis.html ).In the first stage of the world crisis is over globalization and make way for the construction of the new economy. And the next phase will begin large-scale formation of a new economic system.

Joseph Somerville

Jan. 13, 2013, 12:07 a.m.

John,

Thie was a teriffic analysi, but there is only one answer and until we move or return to it, nothing we say will be more than words raging against the darkness, ‘all sound and fury’...resulting in nothing. Care to know the answer. It is simple, elegant and difficult, but not impossible. If so, email works fine.

Joe

Michael J Menzie

Jan. 12, 2013, 11:41 p.m.

Our “global dominance” is a large part of the problem, all the money wasted on our empire would be much better spent on repairing our infrastructure, not to mention the enemies we wouldn’t make by sticking our nose into their business.

palazzilynda@yahoo.ca

Jan. 12, 2013, 11:34 p.m.

Mr. Friedman, you have provided a rationale for what I have been sensing for a few years now, as I witness the underlying seismic shifts in the socio-economic fundamentals of our world.  As a retired Superintendent of Schools for a large urban and suburban school board, it was not hard to see - if you cared to look - that the fundamental basis of our North American world was changing.  I wish your thoughts were required reading for every politician, educator, student and professional in this country, as well as every member of the media.  To go one step further, it should be on the agenda and in the minutes of every board meeting.

Thank you.

Dallas Kennedy

Jan. 12, 2013, 10:26 p.m.

Yes, you have to use per-capita real income, not per-household. But even in those terms, the US middle class has seen its real income decline slightly. And that doesn’t account for explosion in costs for certain middle class goods, in particular, health care and college. These have been inflating faster than the general price level for over 30 years, especially in the last 15 years.

The seeds of these developments were planted in the 1960s and 70s, when an era political overpromising led to money printing and high inflation. The departure of the US from the gold standard in 1971 enabled this development. Better monetary policy in the 80s and early 90s held these trends in check for a while, so that savers could enjoy decent real returns on their savings. But that all changed in the 90s, when the Fed and others decided that the crisis of America living beyond its means could be hidden by financial bubbles. These bubbles enriched financial sector middlemen and some others; it left the aspiring lower middle class and working class—and increasingly, the middle class itself—crushed by debt.

These bubbles also featured a gross misallocation of capital that could have been put to productive use, but was instead put into residential housing (strangely enough, counted as “investment” by the geniuses who run government agencies).

Underlying the housing, higher education, and health care bubbles are large government subsidies that drive up the costs for everyone. Health care and higher ed have been moving in the wrong direction cost-wise for years and are in desperate need of reform. And not everyone needs to own a house. The subprime mortgage bubble that started in the 90s began as an attempt to help lower income homeowners cash in on home equity, all to keep that illusion going of getting wealthier and wealthier.

The basis of the income inequality trend (which is happening in other developed countries—it just started earlier here) is the division between the college-educated and the non-college-educated. Add to that the automation of semi-skilled and unskilled labor, the breakdown of the nuclear family, globalization, and the lack of training alternatives for the non-college-bound (something we used to have), and you have the complete picture of sub-middle-class decline to add to the picture of middle class decline from weak income growth and cost inflation.

hpoppel@sbcglobal.net

Jan. 12, 2013, 2:54 p.m.

Comparing the buying power of median household incomes across several decades is misleading unless and until one adjusts the data for the concomitent changes in average size of households.
The average family today consists of about 2.6 people vs. 3.3 people in the 1950s and 1960s. While the definitions of “households” and “families” may not be completely congruent, one can infer that a household today has to house, cloth, feed, entertain and maintain the health of roughly 25% fewer people than 50+ years ago.
So in that respect, households are quite better off today than in the “good old days.”

max@maxdavies.us

Jan. 12, 2013, 2:44 p.m.

I have been travelling in the developing world since the 1970’s.When I began, third-world nations had primitive transport and communications infrastructures and employed hardly any capital equipment - the difference between us and them was enormous. Building a road involved teeming hordes of men breaking rocks and carting them off by hand, and not the giant road-building machines you would see at home. Today, by contrast and in just about every developing nation, the kind of capital equipment we have take for granted is deployed everywhere and in every industry.

As Adam Smith identified, it is comparative advantage that generates wealth, and if you travel the world now you have to ask yourself, where is the US’ comparative advantage? Most developing nations have banking, communications, transport and technologies that are at least as good as our own, and in many cases because newer, better. The rule of law and of property rights is nearly universal, and stock exchanges and sophisticated capital markets trade world-wide. You can trade stocks in Hanoi with as much security and speed as you can in New York, in Beijing as in London. To anyone who remembers the Vietnam and China of the 1970’s, this is simply incredible.

So why should the West be rich and the East be poor?  A hundred years GK Chesterton said the reason the West ruled was that we had the Gatling Gun and they didn’t. Well, now they got the 21st century equivalent of Gatling guns, technology, education and capital, often in improved versions of our own.

Eventually the creation of wealth world-wide will raise all living standards above what the American middle-class has been enjoying, but until it does the effect of leveling across the East and the West will be very painful for us.

Daniel Kennedy 94695649

Jan. 12, 2013, 1:28 p.m.

Technology is clearly reducing the need for and value of labor. However, it is also enabling significantly lower costs of production and, as a result, end product cost. It is also enabling massive customization as products can be produced in economical lots of one. Reducing the need for labor (or increasing the opportunity for leisure) and enabling customization should not be a curse. The issue to be addressed is how does an economy function when the value of labor goes to zip?

Bob Shapiro

Jan. 12, 2013, 12:27 p.m.

I would say that George’s strength is geopolitics, not economics.

Some businesses grow, while others go out of business. Those who go out of business do so mainly because a more efficient competitor has replaced them. By the very nature of competition, existing businesses as a whole are more efficient than those of 100, 50, or even 20 years ago.

George’s proposition that in the ‘80s businesses all of a sudden generally became inefficient because costs rose is insupportable, unless you consider the source of those rising costs. Those costs are taxation, regulation, and crowding out of businesses by government debt issuance from the capital markets today reaching over $1 Trillion a year and $16+ Trillion in total.

George seems to miss the very nature of every business. There are three natural constituencies which must be satisfied. The owners/investors MUST receive a satisfactory reward or they will cease to invest or liquidate. Customers MUST be satisfied or they will not buy what is produced. And, employees MUST receive satisfactory wages & benefits or they will work fewer hours or take a job with a competitive business. If any of the three gets more than a satisfactory share, the other two get less, and the business will become less competitive.

Through high taxes, regulation, and capital market activity, government has insinuated itself as a third constituency which MUST be satisfied, and government decides what is satisfactory for them. Automatically, the other three MUST suffer.

George looks to the education & mortgage benefits of the GI Bill and the construction of the Interstate Highway System as economic game changers for the US. However, while we always can see positive effects of any action (yes, even government action may have some positive effects), we never can see what would have happened in their absence. While George would fall for one of the three great lies (I’m from the Government, and I’m here to help you), I prefer not to be that naive.

The decline of the US Economy, and the decline of the American Middle Class, is the result of too much government. My preferred solution is to reject George’s call for more of “the hair of the dog that bit me.” If too much government is the problem, then less government is the solution.

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