Monday, December 15, 2014

The Creation of the Middle Class

The term “middle class” is ill defined.  People on the top end of any wealth scale would prefer to be thought of as “upper middle class” when tax rates are apportioned.  Those on the lower end are even more determined to be included; the alternative is to be considered “lower class.”  For statisticians and economists, a convenient formula is to define the top 10% as the upper class, the next 40% as the middle class, and the final 50% as the lower class.  Thomas Piketty uses this classification to provide an interesting discussion of how wealth has evolved over time in his book Capital in the Twenty-First Century.

Wealth has been chosen as the quantity to track rather than income or some other attribute, because some degree of wealth is required in order to invest in one’s future in an attempt to better oneself.  Wealth is what you accumulate beyond what must be spent to meet daily needs.  It can include savings, real estate, and financial investments.  It is difficult to view a person as middle class if they are not able to reach a stage where they can save for the future.  Note that Piketty defines capital and wealth as equivalent quantities that include anything that has a monetary value.

Piketty provides his figures and tables here.  Consider this table that examines the wealth distribution in various regions and at various times.



Note the last column titled “Very high Inequality.”  This represents the conditions in Europe around 1910, a period of high prosperity just prior to World War I.  The top 10% possessed 90% of the total wealth, with 50% going to the top 1%.  What may be somewhat surprising is that what are referring to as the middle and lower classes each possessed 5% of the wealth.  This led Piketty to conclude that there was effectively no middle class prior to 1910 in Europe.  The situation was similar but a bit less extreme in the US with the upper class holding about 81% of the wealth.

Columns three and four compare the wealth distributions representative of Europe and the US at the current time (evaluated in 2010).  The share possessed by the middle class has now risen to 35% in Europe and 25% in the US.  The amount located in the lower class has remained constant over time at 5%.  What these numbers suggest is that a portion of the wealth that had resided in the upper class has been transferred to the middle class.  Or, more precisely, a middle class was created that could be distinguished from the lower class.  If one assumes that the US had 5% residing in the lower class in 1910, then the middle class would have had about 14% of the wealth—a slightly more egalitarian distribution than that of Europe.  However, this also indicates that the US middle class gained much less than that of Europe over the last century.

The figure below plots the share of wealth held by the top 10% over time for Europe and the US.



The wealth of the top 10% in both regions peaks in 1910 and falls to minimum in Europe around 1980, while the US share falls less far and bottoms out somewhere in the period 1950-1970.  After 1910 came a continuous series of economic and social shocks: World War I, followed by the Great Depression, followed by World War II, and finally the postwar phase of rebuilding and otherwise responding to this sequence of events.  World War I had little physical effect on the US, but it did require a great increase in spending and an associated rise in the level of taxation.  With Europe experiencing large numbers of fatalities and disabled veterans, the European countries had to tax heavily to cover war costs and to begin assembling what are now referred to as “welfare states.”  The interwar years were difficult in Europe with debts to be paid, unstable economic conditions, and tumultuous political developments. The depression years of the 1930s were more consequential for the US as it needed to tax and spend heavily to support the needs of its population and begin its version of a welfare state.  World War II was far more catastrophic for Europe than the earlier war, causing damage and social disruption on a scale that is barely imaginable to later generations.

Tony Judt provides insight into the effect of recent history on European thinking in his book Postwar.

“The 1960s saw the apogee of the European state.  The relation of the citizen to the state in Western Europe in the course of the previous century had been a shifting compromise between military needs and political claims; the modern rights of newly enfranchised citizens offset by older obligations to defend the realm.  But since 1945 that relationship had become increasingly to be characterized by a dense tissue of social benefits and economic strategies in which it was the state that served its subjects, rather than the other way around.”

With postwar Europe in chaos it was necessary for a strong and active state to organize recovery.  With the success of that recovery came a belief in the efficacy of state-determined policies.

“The state, it was widely believed, would always do a better job than the unrestricted market: not just in dispensing justice and securing the realm, or distributing goods and services, but in designing and applying strategies for social cohesion, moral sustenance and cultural vitality.  The notion that such matters might better be left to enlightened self-interest and the workings of a free market in commodities and ideas was regarded in mainstream European political and academic circles as a quaint relic of pre-Keynesian times: at best a failure to learn the lessons of the Depression, at worst an invitation to conflict and a veiled appeal to the basest human instincts”

“The state, then, was a good thing; and there was a lot of it….The overwhelming bulk of the increase in spending went on insurance, pensions, health, education and housing.”

This love affair with the state would lose some of its ardor over the years, but the social benefits have mostly remained in place; and the feeling of communalism—we are all in this together—has remained strong.  The decline in the wealth share of the upper class was nearly linear over the period from 1910 to 1970.  The post-apogee period of the European state saw a leveling off of this share followed by a gradual increase that continues to this day.  The result was a share of the wealth for the middle class that increased from 5% to 35%.

The US followed a different path through these trying times.  Spared war on its own turf, its greatest social and economic challenges arose from the Great Depression of the 1930s.  It was in this period that it passed the Social Security Act that provided for a pension in retirement, unemployment insurance, aid to families with dependent children, and other welfare benefits that remain the core of the US version of a welfare state (access to healthcare would come much later).

Postwar, there was no rebuilding required except for a reallocation of resources from military production to commercial products—and business was good.  There was, however, the need for a grateful and sympathetic nation to deal with the millions of returning servicemen.

Ira Katznelson provides some insight into these times in the US in his book When Affirmative Action Was White.  Katznelson points out that all social legislation of the time required support by the southern Democratic senators for passage.  In their zeal to insure that no assistance went to blacks, the Social Security Act precluded occupations that were readily available to blacks, and insisted that social welfare programs be administered at the state and local levels rather having national standards imposed.

“Across the nation, fully 65 percent of African Americans fell outside the reach of the new program; between 70 and 80 percent in different parts of the South.  Of course, this excision also left out many whites; indeed, some 40 percent in a country that was still substantially agrarian.  Not until 1954, when Republicans controlled the White House, the Senate, and the House of Representatives, and southern Democrats finally lost their ability to mold legislation, were occupational exclusions that had kept the majority of blacks out of the Social Security system eliminated.”

These southern Democrats are still in power in the South today, they have just changed their labels from Democrat to Republican—and they still have influence over all legislation.

The social welfare legislation was designed not to produce prosperity, but to allow those who might fall into poverty to survive poverty.  Surviving poverty is not the same as reaching a state where accumulation of assets can take place.  It is difficult to see this social legislation as being successful in helping many people reach the middle class.

There is another social support effort that must be discussed, one whose aim was to produce prosperity, but only for a limited class of people.  Katznelson refers to the GI Bill passed to support the returning military as a “social revolution” and claims it “created middle class America.”  Of course, the southern legislators again made sure that blacks were hindered from participating in this program; hence Katznelson’s reference to race-based affirmative action in favor of whites.

About 16 million people had been mobilized for the war effort.  The main features of the law were designed to provide time and resources to help those returning make the transition to civilian life.  Katznelson provides this perspective:

“Even today, this legislation, which quickly came to be called the GI Bill of Rights, qualifies as the most wide-ranging set of social benefits ever offered by the federal government in a single comprehensive initiative....it reached eight of ten men born during the 1920s.”

“One by one, family by family, these expenditures transformed the United States by the way they eased the pathway of the soldiers—the generation that was marrying and setting forth into adulthood—returning to civilian life.  With the help of the GI Bill, millions bought homes, attended college, started business ventures, and found jobs commensurate with their skills....this legislation created middle class America.  No other instrument was nearly as important.”

The scale of the investment in human capital is staggering to those accustomed to today’s parsimonious legislators.

“More than 200,000 used the bill’s access to capital to acquire farms and start businesses.  Veterans Administration mortgages paid for nearly 5 million new homes.  Prior to the Second World War, banks often demanded that buyers pay half in cash and imposed short loan periods, effectively restricting purchase to the upper middle class and upper class.  With GI Bill interest rates capped at modest rates, and down payments waived for loans up to thirty years, the potential clientele broadened dramatically.”

The government spent more on educating its returning soldiers than it spent on rebuilding devastated Europe.

“By 1950, the federal government had spent more on schooling for veterans than on expenditures for the Marshall Plan....On the eve of the Second World War, some 160,000 Americans were graduating from college each year.  By the end of the decade, this number had tripled, to some 500,000.  By 1955, about 2,250,000 veterans had participated in higher education.  The country gained more than 400,000 engineers, 200,000 teachers, 90,000 scientists, 60,000 doctors, and 22,000 dentists....Another 5,600,000 veterans enrolled in some 10,000 vocational institutions to study a wide array of trades from carpentry to refrigeration, plumbing to electricity, automobile and airplane repair to business training.”

“For most returning soldiers, the full range of benefits—the entire cost of tuition plus a living stipend—was relatively easy to obtain....”

The numbers quoted above indicate the scale of the investment in a population that was a bit less than half of the nation’s current population.  Another way to examine the immensity of the program is by looking at expenditures.

“By 1948, 15 percent of the federal budget was devoted to the GI Bill....”

Today, 15 percent of the federal budget would amount to about $600 billion per year.  Such a program was truly large and ambitious, but did it create a middle class?  It is difficult to believe that it would have made no difference, but the plot of wealth share by the upper class shows no effect in the postwar period.  While the GI Bill was certainly a social event, it cannot be considered a revolution.  Revolutions create a legacy.  Where are the subsidized higher education and mortgages today?  

Where an effect is seen on the wealth distribution is in the 1930s when the Social Security Act was implemented to counter the effect of the Depression.  That may have had more to do with the stock market crash than any wealth redistribution.

It is clear that a significant amount of wealth has been accumulated over the last century by the 40% of the population that has been defined to be the middle class.  How exactly has that happened?  It is also clear that the bottom half of the population has been excluded from any gain in the share of wealth.  Why is that so?  Whatever the mechanism, it appears that Europe has been more effective at spreading the wealth.  Its middle class saw its share rise from 5% to 35%, a gain of 30%.  In the US, the middle class share went from about 14% to 25%, a gain of 11%.

Piketty clearly believes that taxation is the driving mechanism.

“….it is important to note that the effect of the tax on capital income is not to reduce the total accumulation of wealth but to modify the structure of the wealth distribution over the long run.  In terms of the theoretical model, as well as in the historical data, an increase in the tax on capital income from 0 to 30 percent (reducing the net return on capital from 5 to 3.5 percent) may well leave the total stock of capital unchanged over the long run for the simple reason that the decrease in the upper centile’s share of wealth is compensated by the rise of the middle class.  This is precisely what happened in the twentieth century—although the lesson is sometimes forgotten today.”

Since Europe has been more successful in building up its middle class, it should be of value to consider how they might have accomplished that.

Clearly one can modify a wealth distribution by confiscating that of one group and giving it to another, but that is not a sustainable scheme.  Piketty explains the current approach:

“….modern redistribution does not consist in transferring income from the rich to the poor, at least not in so explicit a way.  It consists rather in financing public services and replacement incomes that are more or less equal for everyone, especially in the areas of health, education, and pensions.”

This concept of providing services “equal for everyone” could be the key.  Europe was emerging from a series of catastrophes, but it also remembered that it had endured centuries of highly unequal societies.

Consider this input from Tony Judt:

“Why were Europeans willing to pay so much for insurance and other long-term welfare provisions, at a time when life was still truly hard and material shortages endemic?  The first reason is that, precisely because times were difficult, the postwar welfare systems were a guarantee of a certain minimum of justice, or fairness.”

The desire to put in place a system where there was equality of opportunity seemed to be paramount.  A large amount of government spending was required to fund what was necessary.  Different countries went about it in different ways.  From Piketty:

“….a detailed study of French taxes in 2010, which looked at all forms of taxation, found that the overall rate of taxation (47 percent of national income on average) broke down as follows.  The bottom 50 percent of the income distribution pay a rate of 40-45 percent; the next 40 percent pay 45-50 percent; but the top 5 percent and even more the top 1 percent pay lower rates, with the top 0.1 percent paying only 35 percent.”

“….other states, such as Denmark, finance all social spending with an enormous income tax, the revenues from which are allocated to pensions, unemployment and health insurance, and many other purposes.”

So we have a regressive tax system and a progressive tax system that both lead to a more prosperous middle class than exists in the US.  Soaking the rich doesn’t seem to be the motive, or even necessary.  Perhaps the most important thing is the level of tax revenue and the types of services the revenue can provide.

Judt presents this insight into the benefits of the welfare state:

“….although the greatest immediate advantage was felt by the poor, the real long-term beneficiaries were the professional and commercial middle class.  In many cases they had not previously been eligible for work-related health, unemployment or retirement benefits and had been obliged, before the war, to purchase such services and benefits from the private sector.  Now they had full access to them, either free or at low cost.  Taken with the state provision of free or subsidized secondary and higher education for their children, this left the salaried professional and white collar classes with both a better quality of life and more disposal income.  Far from dividing the social classes against each other, the European welfare state bound them closer together than ever before, with a common interest in its preservation and defense.”

Paying taxes begins to look like a good investment.  Turn a block of your wages over to the government and you no longer have to worry about how you might survive a serious medical condition; you no longer have to spend a lifetime saving to pay for your children’s education; and you no longer have another lifetime of worry about saving for retirement.  You come out ahead and can accumulate savings for investing or whatever else you might desire.  In addition, there is that mandated five or six weeks of vacation that you can enjoy with what is left of your income. 

What seems to be happening is taxation as social insurance.  As with all insurance schemes not everyone benefits equally.  The poor see an income floor that protects them from disaster.  The wealthy may pay in more than they get back, but there is value in what they do receive.  The middle class family seems to be in the sweet spot where the return on investment is the greatest.

That is not such a bad way to run a nation.

And now it becomes clear how Europe developed a more prosperous middle class than the US.


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