On April 1st 2012, my book,”Dagbok från USA”, came out in Sweden. It will also soon be published in English (as an e-book for Kindle and for other readers) with the title: “Diary from the United States – Notes on a society in crisis“. As an appetizer for English speaking readers, I will the coming weeks publish some excerpts from the book.

Why this widening income inequality in American society?

Douglas A. Kass, an American hedge fund manager and blogger, recently coined the term screwflation. He thought that since the American middle class now for several decades, roughly since the early 1970s, has become financially pinched (screwed) between low wages and rising inflation, it was legitimate to talk about screwflation (recalling stagflation, the 1970s word for an economy characterized by both stagnation and inflation, the worst of all possible worlds.) Many people think that screwflation captures something important about today’s U.S. economy. So the concept lives on.

Is it correct to say that the American middle class has had weak real wage growth in recent decades? The answer is yes. The graph below (click for bigger picture, Source: Household Income In The United States, Wikipedia) shows the U.S. real household income before taxes during the period 1967-2003.

The curve at the bottom shows the income development of the 10% poorest families, the upper curve shows how the income of the richest 5% of families has developed, and in between are all the others. The third curve from the bottom (50th percentile) shows the average incomes of American families. It only takes a quick glance at this third curve to recognize that income for American households in general has stood still since the late 1960s. Or almost has stood still. In absolute U.S. dollars, the earnings for the average family increased between 1967 and 2003 from $33,000 to $43,000 (in 2007 prices). It represents an annual increase in real income before tax of 0.85%. It isn’t much when you know that, during the same period, GDP per capita in real terms increased by at least 3% per year. These figures, together with what one can see in the graph, imply a substantial redistribution of income not only among the wage earners as a collective, but also from wage earners to capital owners.

If we instead look at the disposable income (income after taxes), the richest households have, unsurprisingly, increased their share the most. All other income earners have seen their share decline in real terms. More specifically, over the past three decades the households with the 20% highest income have increased their share of income, while all other households have seen their share decline.

How did this happen? It’s a natural question, especially for a European who ponders American income distribution with surprise. There is no simple answer. It can be analyzed in economic, political or cultural terms. The political perspective, why it’s that American politicians do not seem to care much about the huge income inequalities, I will come back to. I will also come back to what makes a group of super income earners, Wall Street bankers and others, think that they are worth their millions, even billions. The latter has something to do with values and culture. In this article I restrict myself to the economic issue.

Michael Spence, Nobel Laureate in economics, together with Sandile Hlatshwayo, also an economist, have recently presented an analysis (Spence & Hlatshwayo, 2011) that allows us to get very close to a credible economic explanation for the widening income inequality in American society (and for that matter in any Western society), and why middle class real wages have stagnated.

The authors divide the U.S. economy into two sectors – the exporting sector or tradable sector and the domestic sector or non-tradable sector. The companies in the tradable sector are competing in the global market. There we find a big part of the manufacturing industry, highly specialized services of various kinds, parts of the financial and insurance sectors, agriculture etc., the kind of the production where the prices are set on an international market. The non-tradable sector prices are determined domestically. There we find health care, schools, other welfare services, the construction industry, retail, etc. These two sectors show two distinct patterns in employment, productivity, and wages.

Between 1990 and 2008, the number employed in the U.S. increased by 27 million, from 122 million to 149 million. (Twenty-seven million is a remarkably high figure when one considers that the Western European countries during the same period hardly created any new jobs at all.) Of these 27 million jobs the non-tradable sector, amazingly, accounted for almost all, 98%. Nearly half of the 27 million jobs came in the public sector and the health care sector (the latter is partly funded by the taxpayer and therefore also to some extent “public”). Together these two sectors created approximately 10 million new jobs between 1990 and 2008.

For productivity, the picture is different. Value added per employee, which is a measure of productivity, rose sharply in the tradable sector, from $70,000 in 1990 to $120,000 in 2008. The domestic sector’s productivity increased more moderately, from $72,000 to $80,000. Since we know that there is a positive correlation between productivity increase and wage and income growth in an industry, this becomes an explanation for why workers in the tradable sector have increased their income more than those working in for example health care and the public sector. But it isn’t the whole picture. If one makes a division of all employed as, on the one hand, senior managers and key specialists (problem solvers like engineers, lawyers, economists, marketers etc.), and on the other hand, all other employees, the managers and key specialists have had relatively a much better income growth during this period.

That managers and professionals have got more of the growth, and all others have received less, can be best explained if we take on one particular industry in the tradable sector and more closely examine what has happened. The electronics industry can be a good example. It’s one of the sectors most exposed to international competition. The number of jobs in the U.S. electronics industry declined by 650 000 during the period Spence and Hlatshwayo studied, from nearly 2 million jobs in 1990 to around 1.3 million in 2008. At the same time productivity rose by 363%! A stunning figure, almost 20% per year. How could that happen? Well, in order to cope with competition in the global market, the U.S. electronics companies outsourced parts of their production to low-wage countries like China or India. The consequence has been fewer employees in the United States. Naturally, those who lost their jobs had the least skilled jobs and thus the lowest wages. This particular group of employees has therefore gone from a job with low pay to no work at all or at best to another job with low pay. Over time, this process has gone further up the value chain of the electronics companies, and higher paying jobs have been subjected to the same pressure. Ultimately, these jobs have also disappeared from the companies. At the same time the sales in dollars have increased dramatically in the sector. What we have is a combination of increasing value added divided among fewer employees, and that explains why productivity has increased by 363%.

At the other end of the hierarchy of the electronics industry, the trend has been the opposite; managers and professionals have seen their relative income rising. These managers and professionals are responsible for efficiency at home, in the company in the U.S., and for negotiations with subcontractors, for example in China and India. They are key persons for their companies and have therefore gradually been able to negotiate an increasingly larger part of the value added and the payroll.

In the most advanced part of the electronics industry, taking Apple as an example, this process has gone very far. Here one can glimpse the future of the U.S. electronics and computer industry. For a retail price of $499 for a new iPad, Apple paid $291 for components and assembly to Foxconn in China. This yields a gross profit of $208 for each iPad sold or 42% of the selling price. The $208 must pay the cost of Apple´s U.S. operations, in practice the company’s top management, R&D, marketing, and more. Nearly all of Apple’s U.S. employees are professionals including a certain number of top managers. And that applies equally to specialized services (e.g., auditing, legal, marketing, financial, etc.) that Apple buys from other U.S. companies.

The threads can be pulled together to form an overall picture. We now better understand why the trend between 1990 and 2008 has meant that income inequality has been increasing. On the upper end of the income scale, managers and specialists ensured that they received a larger share of the pie. That applies not only to managers and professionals working for companies in the exporting sector. Senior managers and key specialists in the domestic, non-tradable sector have also increased their relative wages. In order to get hold of a skilled workforce, good managers and specialists, the domestic sector has had to pay wages at a level generally determined in the tradable sector.

At the other end of the wage scale, the low-skilled jobs became, in relative terms, increasingly less compensated. In the tradable sector due to what we just discussed – outsourcing and other external competition – the simplest jobs have basically disappeared, and the more advanced jobs have declined in number. In the domestic sector, the income of ordinary workers has stagnated or been weak. There are several reasons for that. A relatively weak productivity growth in the non-tradable sector is one factor (remember that value added per employee increased only from $72,000 to $80,000 between 1990 and 2008). The fact that a large proportion, perhaps up to 25% of those who work in the domestic sector in the United States, are public employees, is another factor. In addition, the private part of this sector is fragmented with a lot of small business where competition is high. Relative wage levels in trade, restaurant and other retail, is low in all Western countries – and particularly low in the United States.

From this perspective, one can understand why middle class wages have stood still, or even declined in real terms. There are a lot of middle class people with jobs in the tradable sector, but the number of employees at the intermediate level in the sector, “near the median wage”, have barely increased past 1980, and through arbitrage, wages for this group have been “screwed” between a higher wage level in the U.S. and the lower wage level of subcontracting countries like China, Brazil, and India. Even the middle class working in the domestic sector have seen dismal growth of their income for the reasons I just mentioned.

There is one more issue. How have the extreme incomes, the incomes on the high end of the scale, come about? Spence and Hlatshwayo do not help us with an explanation of this particular phenomenon. According to an article in the New York Times, in 2007 the top percentage of U.S. income recipients took 24% of all income. (The same year the top percentage of those with the greatest wealth, “the richest” in the true sense of the word, commanded about half of all household wealth.) Moreover, the gap between the top-percentage income earners and all the others widens over time. In 1976 the top-percentage got 9% of all income, so in 30 years they have almost tripled their share. The explanation? Simply put, one can say that the people in this category, “the top 1%”, in most cases have earnings from both labor and capital. Above all, they have significant income from capital. We know, and I’ve written about it earlier, that the share of GDP in the U.S. economy that goes to the capital owners has increased significantly over the past three decades. It’s equivalent to saying that the “labor share” has fallen because income from labor and capital are communicating vessels in national accounts terms. In other words, after the 1970s the owners of capital have amassed a growing share of U.S. GDP growth. Among the top-percentage of income earners in any given year, one can be pretty sure that most of them are business owners who have made substantial capital gains by selling their companies. But there are no doubt also people with extremely high incomes from employment, like CEOs of major Wall Street banks with unbridled bonuses, who also have high capital income, for example by owning shares in their own company.

The trend in recent decades towards increased income inequality in the U.S. (and to a lesser degree in all OECD countries) will continue as long as globalization continues. That creates a huge political problem for the U.S, bigger than for the welfare states in Europe. A continuing trend towards bigger income inequalities will probably be a breeding ground for social unrest, and even more for political populism. The emergence of the Tea Party movement in the last two years isn’t a coincidence.

P.S. From this analysis one might think that I have forgotten the effect of new technology on income inequality. This isn’t so. I see constant technological change as an implicit condition for the analysis. The creative destruction that can be attributed to technological developments affects approximately the same groups as those who, as a result of globalization, lose their jobs or see their relative wages go down. New technology is a driving force for the trend towards increasing income inequality, and fewer jobs. In addition, new technology affects both sectors as severely, both the trading and non-trading sector. The fact that the domestic sector does not employ as many switchboard operators, bank cashiers, secretaries, etc. as it did only 10-15 years ago is a reminder that new technology reduces the number of jobs and, just as surely, relative wages across the economy.

Literature:

Spence, M. & Hlatshwayo, S., 2011, “The Evolving Structure of the American Economy and the Employment Challenge”, Working Paper, March 2011, Council on Foreign Relations, New York;

Spence, M., 2011, “Globalization and Unemployment”, Foreign Affairs, July / August 2011;

Kristof, N.D., 2010, “Our Banana Republic”, op-ed, The New York Times, November 6, 2010;

First published (in Swedish): August 28, 2011