Is US Middle Class in Secular Decline?

Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution,” Nobel Prize Winner and ‘father of modern macroeconomics’, Prof. Robert Lucas writing in 2004

Lucas was reflecting the consensus view when he made that declaration, but economists have since woken up the destabilizing macro feedback from extreme income inequality after the apparent prosperity of 2003-7 was revealed to be a credit bubble mirage fuelled by the long stagnation of real median earnings growth. Deep structural trends have again been feeding wealth and income inequality, from the disruptive impact of automation technologies to Fed policies focused on asset reflation; S&P companies spending more on shareholder distributions than capex exacerbates income concentration, given predominant equity ownership among the top 10% of households. The US wage share of GDP remains at multi decade lows, and without the rise in government transfer payments post-crisis, real median household incomes would be even more depressed. The growth of the US middle class in the post war years was an historical accident, now being painfully reversed by powerful economic and political trends. The addition of tens of millions of Americans to the middle class in the 1950s and 1960s was a function of America’s dominant position across many industries after the destruction wrought in Europe and Japan and centralized wage bargaining for a workforce that was at its peak 35% unionized which allowed semi-skilled workers to share the gains of world leading productivity growth and live the American Dream. The US also had a highly progressive tax policy on personal wealth (both earned in all forms and inherited) which funded heavy government spending on infrastructure, basic scientific R&D etc. In other words, the sort of interventionist policies (by both parties) to make the average Republican Congressman today hyperventilate and consult his well-thumbed copy of Ayn Rand’s ‘The Fountainhead’ for a bit of ideological reassurance.

While bankers are still under the regulatory cosh for their role in precipitating the financial crisis, it’s remarkable how academic economists who provided the intellectual alibi for some very dangerous policymaking (from ever more extravagant corporate share option packages driving a short term earnings fixation to laissez-faire banking regulation) have escaped unscathed and largely unbowed. Only at the fringes (in areas like behavioural finance) is there an acceptance that the ever more elaborate general equilibrium models are fundamentally flawed. For all the ‘red blooded entrepreneurial capitalism’ espoused by many ideologues in the US, it’s a historical fact that Silicon Valley owes its existence to the Pentagon and CIA while fundamental scientific research in the US, both private and government (the demise of Bell Labs, Xerox PARC etc.), has collapsed since the 1990s and the end of the Cold War.

Over the next decade, we face a surge in algorithm/machine intelligence driven process automation which is now impacting white collar professional jobs and pressuring the incomes of new segments of the population. The ‘cognitive threshold’ required to aspire to a traditional middle class professional lifestyle is rising fast. This will be the defining issue for Western politicians, and indeed central bankers who are still obsessed with plugging GDP output gaps with QE and blind to the underlying structural shifts that render their econometric models obsolete. In a way, it’s a case of back to the future because the key question in economics a century ago was whether capitalism was capable of generating a sustainable distribution of the gains from growth.

Marx’s critique of capitalism was partly that it would ultimately deliver deteriorating growth rates as wealth become increasingly concentrated at the household and corporate levels, and no longer circulated productively in the wider economy but was hoarded. Looking at the level of retained corporate earnings from the UK to Japan and the weak investment impulse globally as well as the rising income and wealth shares of the top 1% of households, there is a strong argument that we are going ‘ex growth’, although demographics is a big underlying factor as much as technology. The core issue is that while technological progress can in theory raise labour productivity and boost wages, it can also without some form of policy intervention make it easier to substitute capital for labour and profits for wages. In that case, even rapid productivity growth may merely enhance capital’s share of income, the return to capital, and the concentration of income and wealth, eventually undermining trend growth rates.

The impact of weak earned income growth in the US was partly reflected in and a driver of the rapid growth in consumer credit pre-crisis, as an attempt to maintain living standards. As far back as 2001, median income was already lagging GDP and productivity growth significantly. The long term polarization of income growth is a global phenomenon, with a few relative exceptions such as Japan and the Scandinavian countries. The ratio of corporate profits to wages and salaries has increased steadily since 2000 in the US to hit all-time highs, on the back of record price mark-ups over unit labour costs. With stagnating real household incomes and hence mass market consumer demand in the US (luxury is a very different matter, as reflected in the stellar performance of the Dow Jones Luxury Index, which has tripled over the past five years), it will be impossible for Asia to replicate the mercantilist policies that fuelled export led growth over the past 15-20 years. As the US current account steadily shrinks on the shale energy boom as well as soft merchandise import demand (and the consensus has been persistently overoptimistic in forecasting an imminent Asian export recovery), rebalancing demand toward domestic households as China hikes minimum wages helps, but that leaves much low margin export capacity increasingly uneconomic, perhaps the real driver behind recent ‘shock’ RMB weakness.

US Data Soft But Broadly Resilient, as Inflation Expectations Rise…

It’s intriguing that with a global equity selloff suggesting imminent deflation, 5-yr-5-yr forward implied US inflation expectations have risen in recent weeks to just under 2.8% (versus 2% during last autumn’s panic), while amid the Spanish solvency panic, euro zone 2-yr swap spreads are still just over 80bps (versus almost 120bps pre LTROs). On a 3-mth moving average basis, implied US 5-10 year inflation expectations in May were 2.5%, and to avoid any technical distortions from negative TIPS yields, the Fed household survey measure is also near its highest point of recent years, so we remain a long way from the deflation scares that have characterised previous bouts of risk-off behaviour.

The major US data series released over the last week were weaker than expected (non-farm payrolls, unemployment, manufacturing, construction, factory orders and auto sales), but in line with my warning back in March of a likely loss of momentum, and the US economy remains quite a distance from a cliff edge. The May ISM Composite Index of industrial sector activity fell to 53.5 from an unrevised 54.8 in April. Most series fell including production, supplier deliveries and inventories. The employment component also fell to 56.9. However, the new orders component rose to its highest level since April 2011 driven by domestic demand, with the separate index of new export orders falling sharply to 53.5 on weakening BRIC demand. Exports are 14% of US GDP, and euro zone exports are only about $200bn a year, or the same as trade with Mexico. The price index fell sharply to 47.5, its lowest level in six months.

The unemployment rate increased to 8.2% in May from 8.1% in April. Essentially, the jobless rate has held nearly steady during the last two months. The positive news is that the labour force increased in May, after posting declines in March and April, lifting the participation rate to 63.8% from 63.6% in April. In addition, employment advanced 422,000 following declines of 31,000 and 169,000 in March and April, respectively. Hourly earnings rose only 0.1% in May to $23.41, which puts the y/y increase at 1.7%, the smallest increase since November 2010.

US personal income increased 0.2% (2.8% y/y) in April, down from 0.4% March; that included a 0.2% rise (3.2% y/y) in wages and salaries. Among other income categories, rental income surged 1.0% (14.2% y/y), a tenth consecutive monthly gain of 1% or more. Dividend income remained strong, rising 1% in April and 6.5% from a year ago, exacerbating overall inequality trends given the concentration of equity ownership in the top income decile. Personal consumption expenditures picked up to a 0.3% increase in April or 4% y/y. Durable goods purchases rose 0.6%, resuming growth after a 1.4% decrease in March led by motor vehicles. The PCE chain price index was flat in April after a 0.2% increase in March; it’s up 1.8% y/y.

In fact, adjusted for inflation, per-capita disposable incomes are currently at about the level first seen in late 2006, although as I’ve highlighted previously, the average hides a widening distribution as income inequality remains the key trend. The best hope near-term for a boost to US retail spending will come from sliding energy prices. Overall, we’re stuck in that on-going ‘washboard’ recovery for both markets and the global economy, in which the psychological scars of 2008 remain raw for investors, terrified of being wrong footed by the next systemic meltdown. The best way to play it is to be tactically flexible, and tilt portfolio risk weightings regularly based on what have proved to be the pretty reliable macro signals.