This column by Gary Dvorchak originally appeared on our subscription site RealMoney Silver on May 13.
"If they can get you asking the wrong questions, they don't have to worry about answers." -- Thomas Pynchon, Gravity's Rainbow
Often, the only way to develop insight is to ask the right question. For instance, the pondering of a peculiar question eventually led Einstein to develop his special theory of relativity. He contemplated riding in a train, pointing a flashlight at a mirror on the floor. From his viewpoint, the light would take some fraction of a second to travel the two meters to the floor and back at speed
being the letter physicists use for the speed of light, as in "E=mc2"). He saw a problem, however. Someone standing on the side of the tracks sees the light descend to the floor then reflect back at this speed
, yet this observer notices that the light traverses a farther distance. Because the train is moving, the light goes down then up in a "V" shape, which is longer than the straight up and down that Einstein sees on the train.
(If envisioning this is difficult, try thinking about a bouncing ball from each of the vantage points.)
Einstein's journey to discovery started by asking the right question. How can the light travel two different distances based on the observer yet be measured as moving at the same speed
by both people? Only a mind as brilliant as Einstein's could then make this mental leap: Time goes by at a different rate for each observer. (This is the essential insight of his
.) Now that the theory is accepted science, the answer seems obvious,
if you ask the question in the right way
Turning to our own issues, how can we understand the recent economic crisis? In looking for causes and fixes, some answers can be obvious if we ask the right questions in the right way. Allow me to lay some groundwork then pose a question that requires action if we want to avoid future crises.
As we all know, our economy has created a massive amount of new wealth over the past few generations.
The issue is often politicized, but the distribution of income in the U.S.
during the past two generations. Post-WWII through the 1960s, income gains were strong for all income levels.
Since the late 1970s, the dynamic changed, with the top income levels capturing more and more of the pie produced each year. Those in the lower income levels are really not earning much more than they did 30 years ago.
Since the dawn of time, the "elite" or "wealthy" or "owners" (pick your favorite label) who control production have always taken care of themselves first then shared the remaining production with the workers who actually produced it. Better standards of living for the general public are a function of our ability to produce far in excess of what the top earners need to be happy. Most of us would agree that the great success in western economies is
how well our wealthiest live; it is the large size of our middle class. Interestingly, this trend is still operational. Despite the massive gains in income to the highest earners, they are increasing their consumption at very modest rates.
In other words, our elite still consume as much as they want or need, and leave the rest of our production for the general public.
So here we reach our own peculiar question. The dollars seem to be flowing to the folks at the top, but they are not spending them, rather they are saving them. The folks at the top are getting their fill, and that remaining huge mass of production is still going to the common man. (Simple observation would indicate that most people live better now than 20 years ago, even if their incomes aren't appreciably higher.) Yet three years ago, businesses suddenly cut back production. They have the factories to produce but stopped using them. They have the people to produce yet laid them off.
This is where economists get perplexed. Capacity utilization declined to the 60 percentile range and is still only back to the low 70 percentages, well below peak. Nearly 20% of the population is unemployed, potentially decimating their savings and losing their homes. If we have the resources to produce, why don't the owners start producing? Why do people go broke while factories sit idle? Business owners will tell you that they would gladly hire workers and restart production if customers would show up to buy.
To restore economic growth, we need an answer to this question:
As a society, how do we get people to show up at the store and take home the things they themselves produce?
At the turn of the twentieth century, Henry Ford had an answer.
He paid a shockingly high wage of $5 a day to the common assembly line worker
. As Ford stated, "We believe in making 20,000 men prosperous and contented rather than follow the plan of making a few slave drivers in our establishment millionaires."
For a good part of the post-war period, production increased wages increased, enabling workers to buy what they produced. Our production
consumption systems were in balance.
Sometime in the 1970s, however, the model changed. Perhaps this was generational, or simply an inevitable reassertion of human nature. As we saw in the charts, wages stopped rising. In order to get people to buy what they made, we substituted credit for income. The history of consumer credit tells the tale.
Meanwhile, as compensation was squeezed, corporate profit margins naturally expanded.
The trend makes eminent sense. If you own the productive assets and pay the wages, what makes you feel better? Paying high compensation, which lowers your margins? Or paying less and earning more? Then, on your own payday, what feels better? Earning less, or earning more and saving it? If you save these higher earnings and "invest" them, doesn't owning this "asset" feel better than having nothing extra? Once the credit model replaced the wage model,
element of human nature pressures it to continue.
Of course, the credit model for enabling consumption has a fatal flaw. How can the borrowers ever pay back the loans? Loans made for productive investment, such as new factories, are self-financing; they get paid back by the output of the investment. Loans made for consumption are not assets, just a step toward indentured servitude. Our economic model for the past 30 years -- in which the elite make evermore loans to the masses without corresponding increases in wages -- could only end one way: massive defaults. This finally happened (and is still happening)
in 2008, creating our current economic crisis.
Owners of wealth reacted naturally to the news that their "assets" weren't. They stopped lending, and we now have (had?) our great de-levering recession. Business owners say that they will gladly hire workers and restart production, again, if customers would show up to buy. Policy makers desperately want to restore the credit model. They want to get consumer credit growing again, resume mortgage lending, get the securitization markets "healthy" again. Unfortunately, a credit model of compensation will only lead again to defaults and recession and is a bad path to retread.
Keynesians and big government types look toward a transfer payment model of compensation to get the world moving again. Transfer payments can certainly get people to show up and buy in the short term, and transfer payments are surging. Disconnecting consumption from production, however, is unhealthy in the long term. The incentive to produce must still be present.
When I ask the question -- how do we get people to show up at the store and take home everything they themselves produce? -- I am led to one simple yet difficult answer first offered by Henry Ford a century ago. We need to pay all employees more.
America's economic problem is not a high cost of labor; it is that our cost of labor is too low.
In more sophisticated terms, we need more policies that encourage higher compensation to workers while discouraging consumption lending.
Moving in this direction will be extremely difficult because the owners that control the economy have incentives to avoid this at all costs. What business owner wants to pay higher wages? What company wants a lower profit margin? Who doesn't feel better having a lot of fixed-income assets? Many of the readers of this site are owners of businesses (in full or in part) and naturally and rightly pursue their self-interest, which is higher earnings for themselves. Enlightened self interest, however, a la Ford, leads owners to consider taking less earnings. This can create more sustainable growth of the economic pie for everyone in the longer term. The Jim Cramers of the world who pay their assistants $500,000 a year are enlightened heroes, not fools.
Enlightened government policies could encourage higher compensation
without using the blunt tool of tax and spend to redistribute income
. For instance, the tax code could be modified to tax executive compensation at an accelerating rate, while reducing taxes for lower-wage employees. In this example, if an executive is paid $1 million, the company would pay an additional $1 million surtax. For $5 million, the surtax is $5 million. Executives can still make a good living, but companies would rethink if a CEO is really worth $100 million, if it costs them $200 million in total compensation. Meanwhile, for employees under a threshold, increasing their pay could accelerate the wages deducted from income, thus lowering the corporate tax and making them effectively cheaper to hire. A worker paid $20,000 reduces taxable income by $40,000, but a worker paid $25,000 reduces taxable income by $50,000. Obviously the details need to be worked out, so don't email me to argue about them. The key is this: Use the tax code to create a consistent, predictable incentive scheme in which companies are rewarded to pay lower-level employees more and higher-level executives somewhat less. Most importantly, this leaves the money in private hands and out of the hands of the inefficient and perversely incented public sector.
The alternatives to a wage-based compensation model are not attractive. We can become Africa, with a small band of super wealthy and hollowed out middle class. We can build another mountain of debt that will be defaulted upon. We can build an even more ginormous government that shackles our productive private sector. Or we can incent the public to produce,
to show up and consume what they produce in a sustainable way. I'll take what's behind door No. 4.
Gary Dvorchak is a managing member of Channel Island Partners LLC, a Los Angeles-based hedge fund that manages large cap growth and growth-and-income funds. Dvorchak holds a master's degree in business administration from Northwestern University and a bachelor's degree in computer science from the University of Iowa.