First among the causes of middle class pain is the strength of capital relative to labor. In the 1960s and 1970s, management correlated size with compensation. Corporations diversified and acquired to create earnings. From 1980 forward, management disposed of noncore businesses and focused on extracting the highest level of profitability from the core businesses. Management options rewarded this short-term profitability (wage containment) focus as the interest of shareholders and management were closely aligned.
Reinforcing management focus was the emergence of a more robust market for corporate control. It is important to recognize that hostile takeovers are a relatively new phenomena, the first being the acquisition of Electric Storage Battery by International Nickel in 1974. Corporate raiders in the 1980s and private equity firms thereafter stood in the wings ready to acquire those concerns that fell short of expectation. The vulnerable were not limited to underperformers. The company that invests in new businesses and competes for market share to develop markets for the long-run often becomes vulnerable to being acquired as result of profit margin compression. Hostile takeovers create an incentive for management to focus on short-term profit maximization.
Second is the impact of globalization. Companies have accessed cheap labor through outsourcing manufacturing to low cost domiciles while keeping product development and marketing as high margin domestic functions. China has become the low-end manufacturer to the world and India, thanks to the Internet, provides services by wire. Former governor and Republican candidate for president Mitt Romney made a commitment to designate China as a currency manipulator on his first day in office. He is correct. Austin Goolsbee, chairman of the Council of Economic Advisers (2010-11) quantifies it this way; China’s wages are one-fifth that of the U.S. and its productivity is one-half. Algebraically, its cost is 40 percent of our own. This disparity has led to the rapid accumulation of $3 trillion of global reserves. This level of reserve accumulation is hardly consistent with a currency at free market.
One has to wonder if we have not ceded too much too quickly. The low-end manufacturing that used to provide employment in our inner cities and rural communities is gone. We have tolerated this because it is our hope that as the consumer market in China grows our multi-nationals will have the opportunity to grow with it. But the consumer market in China has been slow to develop. Because the safety net in China is poorly developed, the savings rate exceeds 35 percent. Presumably, as the Chinese government provides a bigger blanket the consumer will spend more. It is interesting that at a time when the U.S. is moving to austerity and the curtailment of entitlements that we are encouraging China to enhance them. Do we really believe that China is investing at 60 percent of GDP to provide infrastructure for multi-nationals to capture the market; not likely!
Third, anti-trust policy has recognized globalization and redefined industry consolidation relative to a global market. We have tolerated domestic market concentration in the pursuit of global markets. Fewer competitors benefit capital and weaken the hand of labor.
Fourth, easy monetary policy has created bubbles and encouraged the consumer to incur excessive debt. The middle class was able to maintain its standard of living as real wages deteriorated through both borrowing and withdrawing funds from home appreciation. The crisis of 2008 left a legacy of consumer and mortgage debt that has been slow to decline.
The Federal Reserve has held interest rates at zero for the last four years. It has bought treasury bonds and mortgages on the open market to drive down long-term interest rates and force savers to take more risk. The “too big to fail” banks and highly levered borrowers have been the major beneficiaries of these actions whereas middle class savers have received negative yields when adjusted for inflation.
History will reflect poorly on the private equity wave, the failure to respond to currency manipulation in global trade, and the failed policies of the Federal Reserve. What solutions fall out? The government should eliminate interest deductions for highly leveraged transactions and the capital gains treatment for private equity groups. Policy should encourage long-term investment in productive assets, not in transactions. China is a currency manipulator but it invests its reserves in U.S. treasury bonds. We should take advantage of the low yields that China provides by investing in infrastructure. Not shovel ready projects but thoughtful long-term projects like rebuilding failing bridges and protecting communities at sea-level. Finally, the Fed should cease its distortion of interest rates and restore a free market to the cost of money. The subsidy to under-performing banking assets should stop and the accelerated restructuring of loans should follow. Banking must support economic activity. Carrying insolvent assets is inconsistent with that goal.