Shutdown 101: The economics of inequality and equity investors

Market Realist

Shutdown economics 101: Kudlow versus Reich (Part 10 of 10)

(Continued from Part 9)

What here shall miss, our toil shall strive to mend

The below graph reflects the GINI index of various countries. A GINI index of zero reflects perfect equality of income distribution, and a GINI index of one reflects maximum income inequality. As a reference point, South Africa had the highest GINI inequality, at 0.70 in 2009. Norway, below, shows a GINI index of 0.25. This article considers income differences within the context of the politics of wealth distribution, as described in the prior article in this series, and considers the applicability of GINI-like measures to frame the current debate surrounding public policy measures focused on a more “equitable” equality of outcome—and the implications for equity investors should inequality continue to rise.

Who is the US?

At the heart of the current budget debate is the underlying notion that the less fortunate 60% of Americans should be entitled to a reasonable foundation of social services that provide the opportunity to live decent lives. These items would include healthcare, higher education opportunities, and an income consistent with the investment an individual makes in developing their particular skill or trade. Those who invest more and work more should earn more, thereby receiving an appropriate return on their invested capital. This is a basic principal of capitalism. If you work and invest more, you get more. If you work less and consume more, you end up with less. In contrast, under communism, the basic principal is “from each according to his ability, to each according to his needs.” This is a very subjective economic framework that has historically not led to very good long-term economic results. In the current debate, the US will be required to define itself in terms of its core values as a society, as reflected in its commitment to establishing and managing a framework for the outer boundaries of the inequality of outcome.

The limits to free-market capitalism

Transcending current US economic dynamics is the issue of outcome: what happens when the return on investment falls disproportionately for certain sectors of society? What role does the government have, if any, to ensure that the purchasing power of high school graduates doesn’t fall too far relative to college graduates? What role, if any, does the government have to ensure that bankers don’t earn more than doctors, lawyers, or school teachers? What are the limits of laissez-faire economics when the top 1%, top 10%, or even the top 40% of Americans start to become much wealthier than the bottom 40%, 10%, or even 1% of Americans? At what point does free-market capitalism sow the seeds for its own demise if excessive inequality leads to growing levels of social, economic, and political revolt? What measures can the top 40% provide that will allow the lower 60% of Americans access to a more level playing field of opportunity—if, in fact, the playing field of economic opportunity is currently too uneven?

The GINI Index

Managing the inequality of outcome isn’t a new science. President Obama didn’t invent higher taxes. While the current administration’s battle with the Republican Party might suggest that the ideas espoused by the Obama Administration are radical simply because they’re a departure from the post-1981 supply-side doctrine and historically ultra-low tax levels for the wealthiest Americans, tax levels under the current Administration are still the lowest in US history—barring a few short years after the 1927 stock market crash. Top tax brackets in the US had been in the 80s and 70s until 1980, though they’re now in the 30s. In other words, Obama is no FDR. However, if the lower 60% of Americans are unable to gain improved access to basic healthcare and higher education opportunities, they could very well vote one into office in the future. The political agenda of Lyndon B Johnson’s “Great Society” could once again come to the fore of political debate, if it’s in fact not here already.

Given these considerations, it could be worthwhile to consider the use of the GINI index as a metric to at least monitor the growth in income inequality in the US, and to serve as a reference point in how the US is defining itself as a social and political institution, relative to other developed economies. Perhaps the GINI metric deserves more attention with reference to developed European countries, after it has been adjusted for specific cultural and geographical differences that exist in the US. A culturally and geographically diverse country like the US can’t be expected to exhibit Denmark-like data anytime soon.

The winter of our discontent

The recent budget impasse suggests that free-market economics isn’t particularly concerned about the growth of the US GINI index from roughly 0.32 to 0.37 since the mid-1980s. However, the Democratic Party seems to believe that the existence of social justice in the US should be consistent with a GINI index in the ballpark of other modern Democratic European nations. Why must the wealthy insist on such high levels of inequality? What makes the US so different from Germany?

Evidently, a lot. US test scores are considerably lower than most European countries, suggesting that there could be a significant productivity differential between the lower 60% of Americans versus the lower 60% of  many European countries. In other words, countries that exhibit greater disparities in education and productivity in their workforce are likely to exhibit greater levels of income inequality, and higher GINI scores. Throwing money at the GINI differential isn’t a guarantee of better economics. The US can’t buy its way into a sustainable Denmark GINI index very quickly, though there’s always room for more investment in human capital—presuming the investment can generate a positive return. With ultra-low interest rates in the US today, perhaps such a course of action is more attractively priced, though current debt levels cast a long shadow as to political and economic feasibility.

Yet the political issue remains. What are we as a society obligated to do, above and beyond free-market economics, to shrink this growing disparity? Will reinvestment in the lower 60% of Americans result in greater economic growth rates in the long run, or will the net result simply be larger government deficits, lower growth rates, and less wealth creation on net—though with a GINI score in line with France’s GINI score of 0.29 instead of our current 0.37. Therein lies the rub.

Kudlow: We were not born to sue, but to command!

As Kudlow points out in the National Review as early as 2007:

  • “I’m surprised that today’s Wall Street Journal story on income inequality failed to mention that while the wealthiest 1 percent of Americans earned 21.2 percent of all incomes in 2005, they now pay nearly 40 percent of all taxes. In 1980, before the Reagan supply-side tax-cut revolution was launched, the top 1 percent earned 8.5 percent of all income and paid 19.1 percent of all taxes. So while the rich are getting richer, the rich are also paying the lion’s share of the taxes. As others have pointed out, the top 5 percent of income earners pay 60 percent of the taxes. The top 25 percent pay 86 percent of taxes. And the top 50 percent pay 97 percent of all taxes. It kind of puts a different spin on the WSJ story, doesn’t it?”

Larry Kudlow does raise a fair point in terms of equity distribution as far as taxation is concerned. The top 5% has seen their real incomes nearly double since 1981, and they’ve also ended up doubling their tax bill as a portion of the overall tax pie. As a result, you can understand the Republican Party platform, which believes the US system still focuses on rewarding success and avoiding the subsidization of failure. As a result, the Republican Party would rather command capital and economic growth than use resources defending their free-market ideology from what they may consider frivolous and unfounded lawsuits or legislation.

Reich: We were not born to command, but to sue!

Robert Reich has a different view of the economic debate at hand. As Clinton’s Secretary of Labor, it appears that Reich places considerable importance on the nuances of the evolving US economy. As Reich points out in the Huffington Post this past August:

  • “But here’s the real worry. The basic assumption that jobs will eventually return when the economy recovers is probably wrong. Some jobs will come back, of course. But the reality that no one wants to talk about is a structural change in the economy that’s been going on for years but which the Great Recession has dramatically accelerated.
  • “Under the pressure of this awful recession, many companies have found ways to cut their payrolls for good. They’ve discovered that new software and computer technologies have made workers in Asia and Latin America just about as productive as Americans, and that the Internet allows far more work to be efficiently outsourced abroad.
  • “This means many Americans won’t be rehired unless they’re willing to settle for much lower wages and benefits. Today’s official unemployment numbers hide the extent to which Americans are already on this path. Among those with jobs, a large and growing number have had to accept lower pay as a condition for keeping them. Or they’ve lost higher-paying jobs and are now in a new ones that pays less.”

Under the pressure of this awful recession, many companies have found ways to cut their payrolls for good. They’ve discovered that new software and computer technologies have made workers in Asia and Latin America just about as productive as Americans, and that the Internet allows far more work to be efficiently outsourced abroad.

This means many Americans won’t be rehired unless they’re willing to settle for much lower wages and benefits. Today’s official unemployment numbers hide the extent to which Americans are already on this path. Among those with jobs, a large and growing number have had to accept lower pay as a condition for keeping them. Or they’ve lost higher-paying jobs and are now in new ones that pays less.

As a result, what choice do displaced US workers have? For the first time in economic history, even the “non-tradeable” sector of our economy has become traded or outsourced via the Internet. White-collar workers in the US are increasingly competing with white collar workers in the global economy, including call center outsourcing. As the US has let the low-end manufacturing portion of the economy be taken up by low–cost base developing economies such as China, it would appear that there’s also a trend toward outsourcing the lower end of “white collar” office work as well. As noted earlier, these trends have made the economy more challenging for the lower 60% of US workers.

The long-run argument

Economists can demonstrate that exporting low-end work frees up resources for higher-productivity work. While this may be the case in the long run, in the short run, displaced workers face considerable challenges in maintaining purchasing power. Given the growth in the costs of education and healthcare relative to the real declines in income for the lower 60% of Americans, it might appear that underinvestment in human capital is a growing problem in the US, resulting in a growing level of income equality. Given the trends in the economic data described in this entire series, you may conclude that you are either in the upper 40% of the US and you will probably be okay for a while, or you’re part of the lower 60% of the US and are on the road to perdition.

In the short run, you’d hope the current debate would find a reasonable compromise between these two competing political agendas. Though economist John Maynard Keynes pointed out, “In the long run, we are all dead,” you’d hope that, in our lifetime, political solutions can be found that optimize the economic growth of the US and offer a fair playing field for the American citizens who are willing to work more to get more—and manage in a fair and equitable manner those who started out with far less.

Shutdown investing: Outlook

Should Congress and the President fail to make progress on budget discussions, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by sequester-driven declines in consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment.

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