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     Aug 2, '13

Restoring a real middle class
By Reuven Brenner

In an interview last week, President Barack Obama correctly emphasized both that "upside mobility was part and parcel of who we were as Americans" and also that such mobility has been "eroding over the last 20, 30 years, well before the financial crisis". The question is: What can Washington do to remedy the situation?

In order to narrow down the possible answers, here is a brief recap of events that brought about the vanishing middle classes in the US (and other Western countries as well).

After World War II and well until the 1990s, the United States

enjoyed an influx of both highly skilled, ambitious people who were escaping a world largely ruled by dictatorial and unstable regimes and capital. Hundreds of millions of people, those with skills, drive and intelligence equal to those lucky enough to be born in the West or reach its shores were trapped behind iron and other dictatorial curtains.

As long as the US enjoyed monopoly powers on the leveraging of talent and capital, it could impose high taxes, with large segments of the population benefiting from high wages and transfer payments. The global political barriers gave these groups of employees in the US the negotiating powers to extract such extraordinary benefits - and not only in Detroit.

Governments, federal and state, and many other bureaucracies expanded - creating a "middle class" not based on commerce or backed by particular skills. This happened due to such accidental, historical circumstances of having only a dozen Western-type states with top talent - what I often call "the vital fews" - and capital having nowhere else to go.

The fall of communism and the political stabilization of what we now call emerging countries eroded the US's and the West's advantages, weakening such artificially created middle classes' negotiating powers. Talented, entrepreneurial people and capital can and still do move to the United States, but capital and industrious individuals can also now move to other parts of the world, where hundreds of millions of individuals are eager to work harder and catch up for decades of lost time. Technology has been a fact in the speed of such moves - but the key has been the opening of borders.

What then can be done with the suddenly redundant bureaucracies and compensations that put them and large segments of Western population in "middle classes" until the 1990s, even though their skills are now offered for a fraction of the compensation negotiated during the "immobile times"?

For one, economists, politicians and commentators must shed a pre-1990s mentality that fits a world of limited mobility. Paul Krugman, for example, doesn't fear a top marginal tax rate of 70%, given his view that such a rate did not cripple effort at similar levels back in the 1960s and '70s. He concludes that a return to the tax rates of the past is feasible.

But such rates are not at present feasible because capital can move with far more ease to many more destinations, as can the top talent. Unless these same economists recommend imposing heavy impediments to such moves such tax rates are simply not feasible. The present debate about the 35% corporate tax rate illustrates the point. Today US companies avoid paying these rates legally, and prominent ones end up paying in the 4% range (Apple and Google among them), as do European companies (Ikea among these).

The question that should be raised is this. Assume that Washington could impose paying the 35% tax. Assume that more money would be then flowing through the government Would that increased flow stabilize the middle classes in the US and offer chances of greater upward mobility? Or would the upward mobility be speeded up by having the Apples, Googles and Ikeas spend the money on talent and capital? Historically, in open societies, commerce, industry and finance have offered chances for upward mobility - not political parties and governments.

Whereas both the US and the other Western countries must take care of those whose negotiating powers have been drastically weakened and exit as gracefully as possible from commitments made in the past, the speed of recovery of the US and restoring its middle class and upward mobility, depends on pursuing policies that would encourage the shift toward industry and commerce.

Whereas the pre-1990s escapees from Iron Curtain countries were willing to work in the US despite high rates of taxation (the US was still paradise relative to what they left behind), that's no longer the case. Emerging countries are competing for the "vital few" with both lower tax rates and with a population ready to work for less than their US counterparts.

The US does have options. One is to offer a package of taxes and benefits sufficiently exceeding what's offered elsewhere in order to bring more talent and capital to its shores. There may, however, be objections to such a policy, specifically from the countries drained of their best and brightest, which may have unintended political consequences.

Also, with unemployment at present high, US citizens may object to the inflow of highly skilled and entrepreneurial workers, albeit for the wrong reasons. This objection could be dealt with through a campaign showing that ready-made, entrepreneurial talent moving to the US does not make things worse, but in fact makes things better, faster by importing ready made and paid for "capital".

But you need some gutsy political leadership for such a campaign, even though the historical evidence is unequivocal. The influx of 1 million immigrants from Russia to Israel in the late 1980s is representative. About one-third were engineers and technicians. Their talents, combined with the domestic ones, both financed by then just decentralizing capital markets, transformed Israel from a place where there was absolutely no venture capital and no start-ups in 1990 to one that is now labelled a "start-up nation".

Western Europe's post-World War II miracles are an example of such flux and such policies too, as a good part of the 50 million wandering refugees ended up there, combined with occasional drastic changes in fiscal policy (German chancellor Ludwig Erhard's or UK prime minister Margaret Thatcher's).

The long-term option for the US would be to create incentives to foster such a start-up environment. Policies to promote it include reducing the regulatory and fiscal burdens on small enterprises, diminishing and simplifying tax codes and combining it with a credible plan to significantly reduce entitlements secured during the pre-1990 immobile past. (Whether on purpose or by accident, the Federal Reserve's policies are achieving this goal: they redistribute massive amounts from savers to governments, helping them both to sustain their debts and paying for bureaucracies and past commitments - for the moment).

A far better policy would be diminishing by at least a year or two the number of years youngsters spend in schools, colleges and universities. Spending 16+ years in school before finally graduating in disciplines that can be completed in 15 or even 12 years was appropriate, perhaps, for that immobile world, where leisurely schooling was easily rationalized and extravagantly subsidized.

The rest of the world cannot afford such a leisurely approach to education today. A faster education process would immediately be reflected both in the younger generation taking on greater responsibilities sooner and in a diminished tax burden. The steps North Carolina just took in ending the practice of teachers getting automatic raises by competing often Mickey-Mouse master degrees at universities is a tiny step in the right direction of ending what is now a massive education Ponzi scheme.

The Israeli experience once again makes the case for the above. Youngsters there have been educated from early on to tackle big responsibilities, even of the life-and-death variety, by the age of 18. Studies that take 16 years in the US are completed there at least two year quicker. Facing wars, Israeli youth have little choice but gain life experience and grow up fast.

Like it or not, the younger generation in the US now faces the same prospect of having to grow up much faster than in the past, though luckily this would happen not because of wars, but because of sudden, intense global competition. Leveraging entrepreneurial talent with such a generation of disciplined young people is the long-term remedy for rebuilding equity in the United States faster. After all, the youth are the economic future of the country. The rest is commentary.

Neither is simply "creating jobs" the proper response. The US must create jobs with the potential of creating assets. Unemployment benefits, disability benefits and food-stamps are necessary to put a floor for the people going through this rapid transition that few, if any foresaw coming 30 years ago. But this will neither stabilize the middle class nor restore upward mobility. Only a more disciplined, motivated, harder-working and held-accountable younger generation moving into industry, commerce - and yes, finance too - can achieve that.

Reuven Brenner holds the Repap Chair at McGill's Desautels Faculty of Management and serves on the Board and Investment Committee of McGill's Pension Fund. The article draws on his Force of Finance (2002) and "Accelerated Learning" at www.american.com.

(Copyright 2013 Reuven Brenner)




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