Mind the gap

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Mind the gap
By John Plender

Published: April 7 2008 18:37 | Last updated: April 7 2008 18:37



Income inequality in the US is at its highest since that most doom-laden of years: 1929. Throughout the main English-speaking economies, earnings disparities have reached extremes not seen since the age of The Great Gatsby.

Much like this decade, the 1920s were a period of strong corporate profits growth and increasing household debt. Awash with easy money, Wall Street became hooked on what the economist J.K. Galbraith in that subsequent seminal work on the period – The Great Crash – called “the magic of leverage”: the ability to increase returns through borrowing.*

Investment trusts provided the vehicle for this financial merry-go-round, in which one investment trust would “sponsor” another investment trust, which would in turn sponsor a further investment trust. This paper-shuffling multiplication of risk bears a remarkable resemblance to the slicing and dicing of risk in highly leveraged structured credit markets today.

In the 1930s, it ended with bank failures and the Great Depression. Now, after decades of “financialisation” in the US and other Anglophone economies, whereby financial services have increased their share of gross domestic product, banks are being bailed out – using public money – in an effort to ensure the same does not happen again.

From a political perspective the notable feature of the inegalitarian, free-market era that began in the 1980s is how little backlash there has been against the stagnation of ordinary people’s earnings in such a large portion of the developed world economy. Yet there are signs that the mix of policies and economic circumstances that gave a protracted laisser-passer to the rich and to business is coming to an end.

This is potentially dangerous territory. For as Bill Gross, managing director of Pimco, the world’s biggest bond fund, has argued: “When the fruits of society’s labour become maldistributed, when the rich get richer and the middle and lower classes struggle to keep their heads above water as is clearly the case today, then the system ultimately breaks down; boats do not rise equally with the tide; the centre cannot hold.”

The question is what will happen to wealth creation, stock market valuations and economic growth if, as seems increasingly likely, the public’s tolerance of income inequality and what is loosely called the Anglo-American model of free-market capitalism wears thin.

The starting point for any exploration of this question is inevitably the US, where the combination of recession, financial crisis and a presidential election has brought many of the issues to the forefront of the political debate.

One of the main indicators of inequality is the so-called Gini coefficient. The US Census Bureau’s number for this measure in 2005 was, according to Gary Burtless of the Brookings Institution, the highest ever recorded, implying extreme in­equality. An analysis of Congressional Budget Office figures by Jared Bernstein of the Economic Policy Institute points in a similar direction. Between 1979 and 2005 the pre-tax income for the poorest households grew by 1.3 per cent a year, middle incomes before tax grew by less than 1 per cent a year, while those of households in the top 1 per cent grew by 200 per cent pre-tax and, more strikingly, 228 per cent post-tax.

The result of this lopsided distribution of income growth was that by 2005 the average after-tax income for the bottom fifth of households was $15,300, for the middle fifth $50,200 and for the top 1 per cent just over $1m.

Looked at from another perspective, in 1979 the post-tax income of the top 1 per cent was 8 times higher than that of middle income families and 23 times higher than the lowest fifth. By 2005 those ratios grew respectively to 21 and 70. The process reached its extreme point with US President George W. Bush’s tax cuts. Emmanuel Saez of the University of California at Berkeley estimates that in the economic expansion of 2002-06 the plutocratic top 1 per cent captured almost three-quarters of income growth.

Figures for wealth, derived from the Federal Reserve Board’s Survey of Consumer Finances, are less up-to-date but the picture is similar. The share of US wealth owned by the top 1 per cent of households rose steadily from 20 per cent in 1976 to 38 per cent in 1998. The concentration is more extreme than in any other country in the Organisation for Economic Co-operation and Development for which figures are available.



While some economists challenge the integrity of official data on inequality, it is hard to cast doubt on the broad trend over time – and while the causes of the high level of income inequality are a subject of debate, there can be little doubt that globalisation has played a part. In a decreasingly unionised environment, US workers were priced out of the global labour market as manufacturers transferred production to low-cost countries such as China, India and Mexico.

At the same time, and more importantly, an elite of top earners, notably in finance and in boardrooms across the country, have seen an explosive growth in pay, with rewards coming increasingly in the form of options or plain equity. Other explanations include technological change and the impact on top pay of the internationalisation of the market for chief executives.

Politicians have ratcheted up the phenomenon via the federal tax system. From the Depression to the early 1980s the US tax system favoured middle- and lower-income workers over high earners. From the outset of the Ronald Reagan administration the pattern changed.

A disproportionate share of income gains, under both Republicans and Democrats, started going to high earners – a policy dubbed “Robin Hood in reverse” by Paul Krugman, the economist. In the post-cold war world this approach was apparent in the wider attitude to markets, business and the rich. After the deregulatory policies of the Republican administrations of Reagan and George H.W. Bush, the Democrat Bill Clinton was himself a fiscal conservative. While he did increase income tax early on, he subsequently reduced capital gains tax from 28 to 20 per cent and brought the North American Free Trade Agreement into being.

In the UK, where economists at the Institute for Fiscal Studies have identified a rising trend of income inequality to historically high levels since Labour took office in 1997, the issue became uncontroversial**. Tony Blair, when prime minister, declared that it was not his burning ambition to make sure that the footballer David Beckham earned less money. Peter Mandelson, an architect of New Labour, famously remarked that the party was “intensely relaxed about people getting filthy rich – as long as they pay their taxes”. Both men went out of their way to woo business, as did Gordon Brown when the current prime minister was chancellor of the exchequer.

Even in English-speaking countries with a more egalitarian culture, the inequality story holds true. At the start of the 21st century, according to Anthony Atkinson and Andrew Leigh, the income share of the richest 1 per cent of Australians was higher than at any point since the Korean war.***

In Canada, which remains more unionised than its neighbour, the surge in top wages came later and was more concentrated than in the US. Emmanuel Saez and Michael Veall see in this a brain-drain explanation: the threat of migration to the US by skilled Canadian executives or professionals may have driven the surge.****

Liberal economic policies looked attractive to pragmatic left-of-centre politicians because they appeared to deliver high rates of economic growth. As for the rich, they contributed heftily to the tax take. Chris Watling of Longview Economics remarks: “Clearly, with so few workers making such an important contribution to government revenues, it becomes of paramount importance for the government to set policy which does not jeopardise those government revenues. Hence the UK’s current situation of a resident Labour government which has not targeted tax increases at the wealthy after more than 10 years in power but has significantly raised the tax take from the middle classes, most notably through stealth taxes.”

But what was it that made this long period of growing inequality and stagnant incomes for all but the few tolerable for the voters? The answer is that in all the big English-speaking countries, living standards became very detached from incomes. In a period of stable, low-inflationary economic growth known to economists as “the great moderation”, low and middle income people readily took on more debt, while running down their savings.

Rising asset prices, especially in the housing market, created a sense of increasing wealth regardless of income. Remortgaging homes over the long period of declining interest rates provided a convenient source of funds via equity withdrawal to finance increased consumption.

Suddenly all that has changed and, with it, the political calculus. The collapse of the American housing market has left negative equity in its wake. For many, the cost of living is rising faster than wages. Houses can no longer be used as cash dispensers and savings are having to be rebuilt. Financialisation is going into reverse and the financial sector is no longer able to supercharge economic growth. Outside the US the process is less advanced but the trend is clear.

Against that more troubled economic background, the lack of correlation between corporate performance and high earners’ rewards starts to grate with the public. The examples of Stan O’Neal at Merrill Lynch and Chuck Prince at Citigroup, who seemed to be rewarded for failure, grate hard. Elsewhere, even when the reward is paltry by US standards as with the £760,000 pay-off for Adam Applegarth, former chief executive of Northern Rock, the mortgage lender now in UK state hands, it causes as much or more outrage.

There is anger, too, about a system that permits bankers to earn huge bonuses when finance booms, while taxpayers pick up the bill when banks fail. The Anglo-American capital market-based model of capitalism looks tarnished and an awkward question hangs over the free market process. Business once again has a legitimacy problem, as it did when public trust was forfeited after the Enron collapse. The implicit compact between business and politics is breaking down.

The US presidential election has brought out the extent to which the climate has changed. In pursuit of the Democratic nomination Hillary Clinton has vociferously attacked oil, drug and healthcare insurance companies. She has expressed grave reservations about Nafta, an embarrassing legacy from her husband Bill, and she opposes the renewal of Mr Bush’s tax cuts for the rich. Barack Obama, who is outspoken about inequality, goes one step further on a similar platform by calling for the lifting of the limit on income taxed for social security. Much of the old left-right rhetoric is re­appearing in the campaign, carrying with it a strong hint of a reversion to old-style tax-and-spend policies on the Democratic side.

Britain’s government has meanwhile mismanaged its attempt to extract more tax from foreigners who are not domiciled in the UK for tax purposes, thereby unintentionally sending a signal that the country no longer puts out a welcome mat for foreign investors. It sent a similarly inept signal to business with a badly handled reform of capital gains tax.

The change in tax regime for non-doms was originally proposed by the opposition Conservatives – whose leader, David Cameron, has unnerved some of his own supporters by saying he wants to stand up to big business and make business more responsible. The underlying theme was the need to raise taxes in a tight fiscal spot. Business looks set to become the fiscal fall guy.

Growing worries about inequality have been echoed by a handful of private sector business people. Warren Buffett, the investment sage and the world’s richest man, according to Forbes magazine, expressed concern at a fundraising event for Mrs Clinton in December over income inequality and a tax system that is insufficiently redistributive. In the UK Nicholas Ferguson, chairman of SVG Capital, which invests in private equity, caused a furore among his peers by saying it was unfair for private equity partners to be taxed at a lower rate than their cleaning ladies.

Indeed, this backlash against inequality is not confined to the English-speaking world. By the standards of the US or UK, inequality in Japan is negligible. Yet it was nonetheless a central plank of the Democratic Party of Japan’s critique of the incumbent Liberal Democratic party government at the election last July in which the DPJ won a majority in the upper house of the Diet.

A political backlash is growing in Japan against the free flow of global capital. The government last year expanded on national security grounds its list of sectors where foreign investment stakes of over 10 per cent in a company require regulatory sanction.

Fear of foreign predators, whether sovereign wealth funds, hedge funds or multinational companies, also helps explain a recent statement by Takao Kitabata, a top bureaucrat at the Ministry of Economy, Trade and Industry, that companies should be able to choose their shareholders because such people are “fickle, irresponsible and greedy”. Japan’s government has meanwhile done nothing to prevent a dash by companies to adopt “poison pill” defences to ward off foreign takeovers.

In Germany, where the egalitarian ethos is also strong, the Christian Democrat-led government’s relationship with business has undergone a volte-face. Angela Merkel, the chancellor, was a stout defender of business in opposition, even standing up for Klaus Esser, the former boss of the Mannesmann telecommunications group who had been excoriated for taking a multi-million euro pay-off for selling the company to Britain’s Vodafone. She was also highly critical of Germany’s creaky collective wage bargaining system.

Yet lately she has been threatening German business with the imposition of minimum wages in several sectors if they opt out of collective deals and drive wages down. This is a populist response to electoral pressure. Apart from their insecurity about pay, voters have been uneasy over the activities of foreign-owned private equity and hedge funds. Now they are angry at revelations about business leaders evading tax through the use of secret accounts in Liechtenstein. All this has been accompanied by a protectionist-tinged debate on whether to expand the inward investment review regime.

Not all countries fit this pattern. Yet the public reaction can be the same. In France, President Nicolas Sarkozy is heavily criticised for an over-close relationship with rich businessmen. He is trying to pursue what by French standards are very liberal economic policies which, if successful, could increase inequality. But in a country where business is unloved by voters, he faces such problems as the rogue trading scandal at Société Générale and alleged insider dealing at EADS, the Franco-German aerospace group.

Mr Sarkozy’s recent proposal to tax stock options could be a pointer towards less business-friendly policies ahead.

What is clear in this new climate is that protectionism is a more intense threat. If business cannot find a way of curbing boardroom pay excess, its legitimacy will be in question and the politics of squeezing more tax from the corporate sector will look still more compelling. Redistribution will loom larger on the political agenda. The regulatory backlash to the credit crisis may also be more extreme and ill-judged than it would otherwise be, echoing the experience of the 1930s and of the post-Enron Sarbanes-Oxley Act.

Whether the markets have detected this sea change is moot. Until the English-speaking countries put their housing and financial crises behind them, it will be impossible to tell whether the change in climate is transitory or something worse. But the change is real.

*The Great Crash, 1929 (Hamish Hamilton, 1955)
**Racing away? Income inequality and the evolution of high incomes. Mike Brewer, Luke Sibieta and Liam Wren-Lewis, IFS Briefing Note No 76
***The Distribution of Top Incomes in Australia. Australian National University Centre for Economic Policy Research discussion paper No 514
****The Evolution of High Incomes in Canada, 1920-2000, NBER Working Paper No 9607

Copyright The Financial Times Limited 2008