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It’s The Middle Class, Stupid!

October 19, 2012

Continuing on the theme of my last post about historic lows in Employee Compensation, the picture gets even worse when you also factor in the big increase in income inequality since the 1970’s. This means most Americans are getting a smaller share of a declining piece of the pie.

According to analysis by Emmanuel Saez, the share of wage and salary income going to the top 1% increased from 5.1% in 1970 to 12.0% in 2006. Alternatively, the share going to the bottom 99% dropped from 94.9% to 88.0%. Over that same time frame, total Employee Compensation dropped from 52% of GDP to 45.2%.

Combining both statistics, we can estimate total compensation as a percent of GDP for the 99%. In 1970 it was 49.3%, but by 2006 it had decreased to 39.8%. That’s a 19% pay cut.

How have they tried to compensate? By borrowing to make up the difference. Between 1970 and 2006, household debt increased from 44% of GDP to 93%.

Since 2009, households have been paying the bill. This is one reason why this recovery has been so weak. Hyman Minsky referred to this as the Paradox of Deleveraging. Janet L. Yellen, President of the Federal Reserve Bank of San Francisco explains how it relates to our current situation.

A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms—and indeed essential to return the economy to a normal state—nevertheless magnify the distress of the economy as a whole.

The seeds of the Great Recession were sown 30+ years ago, when income inequality began it’s long rise. Lagging incomes forced many Americans to choose one of two options:

  1. Do Without. This is the responsible thing to do, but results in poor economic growth.
  2. Borrow. This allows the economy to grow, but only until debt load limits are reached.

Most Americans took option #2. The borrowing spree of the last few decades masked the problem of rising inequality. That all changed in 2007 when household debt hit a record high. Going forward, we have two choices. We can begin reversing the policies that led to high income inequality, or we can wait for Americans to resume their borrowing spree. The choice seems clear.

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