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State of the Union 2012: Income Inequality

Introduction

US President Barack Obama’s economic pitch for the 2012 campaign season appears to be reflected in his December 2011 statement that “I believe that America succeeds when everyone gets a fair shot” (Luce, 2011). Are you, like some in the Occupy movements, concerned that the wealthy corporate elite is intentionally withholding money from their employees while they themselves become more wealthy? Whether accurate or not, this is a common perception and merits consideration by likely voters in 2012 and beyond. While Obama’s economic credentials in 2008 were a toss-up with McCain’s own lack of economic understanding, the President’s most likely potential rivals (particularly Romney) are perceived to be far more qualified. A natural strategy for Obama then, would be to hide his weakness by turning from logos (logic) to pathos (emotion) to sell his candidacy for a second term. As a result, the emotional topic of inequality looks as if it will be a major factor in the 2012 election and is worth understanding. There is plenty to be said about income inequality both economically and politically, and this article is by no means a complete analysis of the subject. What will be addressed here is the issue that some have with the current allocation of wealth being distributed amongst the wealthy rather than being shared with employees in the context of salary and wages. In other words, are the rich getting richer and the poor getting poorer?

Income Inequality

The proportion of income that goes to employees/workers is currently at 58% (Harding, 2011, p. 1). This means that for every $1 earned nationally, employees earn fifty-eight cents. This might not be too bad overall, but it is at its lowest since recordkeeping began following the Second World War. Why is this important? Two reasons (both of which are more politically important than economically important): first, profits are increasing but they are being held by the company rather than shared with the workers, and the profits are not being used to hire new workers. Second, the postwar average is around 63%, only a 5% difference between the two, but enough to mean that the average worker is earning $5,000 less than if the share of labor income was merely at the average. Could this mean $5k more in your pocket if you ask for a raise, become a member of a political pressure group or join a union? Not likely, due to all of the three potential reasons for the falling share of profits going to labor (listed below). 

Historically, the labour share tends to rise during recessions as companies hold on to workers and sacrifice profits, then falls back in a recovery. But during the 2008 recession the labor share did the opposite: it fell, and when the recovery began, it kept falling (Harding, 2011, p. 1). 

Assuming this is true, why would workers’ income, or the percentage of corporate income allocated to labor fall during this recession when it usually rises during a downturn? The author (Harding) poses two potential arguments, which he admits are not fully convincing: 

  1. The first argument Harding quotes is a column in the Financial Times by Peter Orszag, Citi vice-Chair and former 2009-2010 Obama budget director. Orszag says that “[t]he two primary drivers [of inequality] are globalisation and technological change” (Harding, 2011, p. 8). This argument is centered on the emergence of newer economies which have increased the labor supply, lowering the price of work globally. If you are an investor, and have the option of hiring an employee in the US at $24/hour, or hiring an employee in China at $1-$2/hour, from an economics standpoint, the choice is fairly clear. Harding implies that Orszag’s argument is unconvincing since the inequality is a new problem, but globalization has been around for decades.
  2. The second argument Harding discusses is one he feels is an innovative explanation by Andrew Smithers of the consultancy firm Smithers & Co in London. Smithers’ idea is that the emphasis on short-term corporate profit is due to the “bonus culture and share options for business executives” (Harding, 2011, p. 8). Smithers believes that rather than investing in new ventures, companies are investing in themselves and increasing corporate profits (and their own wealth) by buying back their company’s stock which was previously held by the investing public. This means that any dividends that might have gone to the public are kept by the company, increasing profits. One problem with this theory is not that it is wrong, but that it is only valid in the very short term (Smithers himself believes that competition will eventually cause more hiring and investment). There comes a point at which the company will own all of its stock again, and companies must eventually expand sales or increase pricing in order to continue increasing the company’s stock price. Like the first scenario, the second problem with this theory is that the short-term oriented executive culture in the West has also been around for quite some time, so this doesn’t explain the difference between this recession and the one in 2000-2001. The third problem is that corporate America is sitting on vast amounts of cash overall, which is unexplained by either the first or second theory. This is where I think the crux of the problem may lie. 

While the above arguments do have merit, they appear to be partial explanations and don’t particularly explain events from the perspective of the corporate investors themselves, which is necessary to consider prior to making a determination. My personal view is this: while the concept of the wealthy corporate titans perpetually holding on to their wealth like a Dickensian miser is certainly popular today, this is a more appropriate criticism of the stereotypical “landed aristocracy” who simply “sit on” their cash, avoid work and enjoy the privileges of wealth. This is much less true of those investors who control business.

There is a particularly good reason why investors prefer not to sit on their cash. Cash as an investment, even in “cash equivalents” such as CDs, Treasuries, money market funds or similar short (or long)-term “risk-free” cash investment vehicles, is just a bit better than putting the money under the mattress. Large corporate investors, such as the much-maligned hedge fund managers, CEOs, investment bankers, etc., prefer to invest their cash in something that will achieve a much larger return than cash investments can provide.

If large investors are holding cash, the reasons can only be that either they have not found, or they have found but are waiting for the right time to invest in an opportunity worth the investment of their cash holdings. With the severity of the downturn and the ability to buy assets much more cheaply during a recession than during a boom, why is this cash still around? Uncertainty kills investment and while things seem to be improving slowly, many are not yet convinced that the global economy is on the mend. If you thought that the economy might crash again soon, is this the time you would pick to start a new business or expand an existing one? Probably not. Until the market shows more signs of improving, cash or cash equivalents are likely to be viewed as the most certain and flexible way to manage assets. Similar to their outlook on starting new businesses, investors are also unlikely to hold on to or hire employees they are not certain they will be able to keep if the market turns ugly again.

Conclusion

The question Democrats and Obama will be asking you is whether you think this cash hoarding amounts to protecting their wealth during a downturn when the people may be thought to need it most. This article primarily discusses the economic concerns faced by corporate executives. Articles in major news sites on this issue are available below. Once you’ve heard the argument for both sides, what do you think? Feel free to add further nuance to the article or post a comment below.

Further Reading

Harding, R. (2011, December 15). $740bn pay gap threat to US recovery. Financial Times, pp. 1, 8.

Luce, E. (2011, December 12). A tough nut to crack. Financial Times, p. 6.

http://thecaucus.blogs.nytimes.com/2011/11/27/spreading-the-wealth-in-democrats-favor/

http://www.scribd.com/doc/74050125/Schumer-Memo

http://www.huffingtonpost.com/2011/11/28/senate-democrats-income-inequality-elections-2012_n_1116478.html 

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About Barry Saturday

The author is a Lexington, Ky-based financial advisor and formerly taught high school social studies for Fayette County Public Schools. Along with a M.A. in Education, his educational background consists of a B.A. in Foreign Languages and International Economics and an M.A. in Diplomacy with a concentration in Global Commerce. In 2012, he finished a two-month stint student teaching in Xi'an, China, and recently (2018) ran for City Council in Lexington, KY (District 4: Tates Creek / Nicholasville Rd area). Today's news outlets profit most from incendiary, surface-level appeals to emotion, which is poisoning much of our political discourse nationwide. Barry created this site in order to learn more about our world and share that knowledge with others. He hopes this site, aimed at an educated audience, will provide objective information for those seeking greater clarity and understanding than is often available in the current news environment. If you like what you see, feel free to comment and share with your network.

5 Responses to “State of the Union 2012: Income Inequality”

  1. Wasn’t a major portion of the crisis a liquidity problem? I agree with you concern that greed played too big a role as well, but what has been the growth in cash holdings vice bonuses paid out?

  2. Income inequality is certainly a hot way to sell politics. Personally, I’m just not sure that giant collections of people who “own” massive business entities are wittingly sitting on wealth. You’re right: it’s no way to grow money. And I get the impression from FT’s current series “Capitalism in Crisis” that not only is the market far from being controlled by a shadowy rich elite, but corporations themselves are often not directly controlled by shareholders. Regulation is great, but still assumes a degree of control that may not work as well today as it did a hundred years ago. I think the system is more complex.

    Interestingly, I read in one of those links about a concept to tax only the first $106,000 of income for social security… I had to read it twice because it hardly strikes me as favoring the middle class. If anything, it means more pressure on struggling families, not more. Left wing, right wing, same bird?

  3. Randi, you’re absolutely right that lack of liquidity was a major issue within the 2008 financial crisis, though it was a symptom of the greater contagion, rather than the cause. Even the National Football League in the U.S. was having trouble paying bills at one point due to short-term credit freezes.

    I am not quite sure what gave the impression that I believed greed played a role. I tend to stay away from attacking others for what emotions they may or may not be experiencing.

    As to the growth in cash holdings versus paid bonuses (to executives, I presume), I have not seen a graph demonstrating that relationship, nor have I studied it in depth. In most cases, my experience tells me that those criteria will be a difficult pair in which to establish a conclusive relationship. In other words, there are times when cash will be extremely low, but bonuses high and vice versa. To the average company’s shareholders, the ideal situation would be “just enough” cash, highly profitable investments and very high bonuses due to high performing officers. Assuming the government and public are satisfied with other factors, that situation is a recipe for corporate happiness.

  4. C., looks like we’re roughly on the same wavelength there. Since you mentioned the taxation of the first $106K for Social Security tax purposes, I thought I’d add to that briefly. The idea is that, since the wealthy will never receive anywhere near that much money from the system, it is unfair to tax them so heavily all the way up the pay scale. Policy makers are looking at this from a couple of angles:

    1. The spirit of the principle under which Social Security was developed was that whatever you pay in today, you will receive an equivalent sum when you retire. The problem is, how do we justify paying millions a year to the top earners?
    2. The tax revenue is important to the system and perhaps we should tax them the same even though they will be effectively uncompensated in the long run. The problem in this scenario is that it will ensure the nation’s wealthy are unsatisfied with the system and will likely attempt to shelter or hide more income, resulting in tax losses exceeding that which would have been received from Social Security.

    Seems the compromise reached was to tax them at a negotiated “fair” level that will allow for significant taxes paid in, but will not obligate the system to generate huge paychecks for them when they retire, particularly as many will also have pensions or significant retirement assets.

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