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Narrow the U.S. Income Gap to Stave Off Another Financial Crisis

(Adds fourth paragraph with income data from Census survey.)

It isn't that nothing has happened in Washington since the credit markets froze and the economy tanked two years ago. Far from it. The combination of massive fiscal stimulus, bank bailouts, auto restructurings, and dramatic monetary easing stabilized an economy that was on the brink of a depression. Landmark universal health-care legislation was passed more than a century after it was first proposed in the U.S. Credit-card reforms abolished a number of egregious industry tactics.

Thirty-four months after the start of the Great Recession—and 16 months after the official end of the worst downturn since the 1930s—Wall Street and the banking industry have been the focus of public policy reform initiatives designed to reduce the risks of a reprise. The most notable achievement is the financial services reform bill, recently buttressed by the Basel III accord on higher international bank capital standards. These two initiatives together represent a vast improvement over the previous regulatory regime.

Yet what about strengthening the Main Street economy for the longer term? It's underappreciated, but America's dramatic three decade-plus rise in income inequality was a fundamental economic force behind the 2007 though 2009 implosion in the economy and financial markets. For instance, after remaining relatively stable for much of the postwar period, the share of total income that went to the wealthiest 10 percent of households rose from 34.6 percent in 1980 to 48.2 percent in 2008.

The recession has taken its toll, too. Real median household income dropped by 2.9 percent—from $51,726 to $50,221—from 2008 to 2009, according to the latest American Community Survey by the Census Bureau. Incomes are down about 4 percent since the start of the recession and over the same time period the nation's poverty rate has gone from 12.5 percent to 14.3 percent.

Raghu Rajan, economist at the University of the Chicago Booth School of Business, calls income inequality one of three major factors that still threaten to keep the economy unhealthy and crisis-prone in his 2010 book, Fault Lines: How Hidden Cracks Still Threaten the World Economy.

Ignoring the Long Term

Of course, the lack of policy movement is understandable. Government officials are far more concerned with reviving job growth than heading off the next credit crunch. Partisan gridlock in Washington—a state of affairs exacerbated by the upcoming mid-term elections—means little can get done on even that front, let alone the long term. Still, White House chief of staff Rahm Emmanuel hit the mark when he admonished legislators not to "let a serious crisis go to waste."

Put somewhat differently, "we need to start focusing on the long-term solutions now," says Rajan. "I would like to get out of this recession in a way that is sustainable, that does not merely pump up growth in the short term, only to see it collapse later."

The rise in income inequality is well-documented. Median income began stagnating in the early 1970s, and income inequality started to surge in the early 1980s. The benefits of America's economic growth since then have mostly gone to a wealthy minority, while the majority of workers have seen their earnings stagnate at best and decline at worst. The long-term trend is toward a small group of financiers, chief executives, professional athletes, entertainers, and other earnings titans pocketing much of the wealth generated by society.

Sluggish Growth in Real Incomes

To take the reading of another measure of the trend, average inflation-adjusted, or real, income per family grew from 1993 to 2008 at a 1.3 percent annual rate—an increase of about 21 percent over 15 years, according to data compiled by Emmanuel Saez, economist at the University of California, Berkeley. Remove the top 1 percent from the calculation, and average real income growth falls to 0.75 percent, an increase of only 12 percent over 15 years. Of course, incomes at the very top of the ladder have fallen along with the downturn, but the losses are temporary.

The trend had one unfortunate side effect: Households took on more and more debt even as their incomes stagnated to keep up living standards. Policymakers found it easier to embrace the "democratization of credit" rather than address the factors behind income stagnation. The motivation wasn't bad. After all, three decades ago it was much harder for median-income families, low-income workers, single women, and minorities to borrow than it is today. Credit that once was limited to the well-heeled became steadily offered throughout society.

"It has been a policy, a public policy in this country, to make more credit available to lower- and moderate-income people, to people starting out, to minorities," says Edward L. Yingling, head of the American Bankers Assn.

The cumulative net result of the loosening of credit, however, was catastrophic. The credit epicenter to offset the consequences of income inequality was housing, but the loan window was open for anyone with a pulse. Credit cards, auto loans, and student loans saw dramatic expansion as well. By the time the consumer credit bubble went bust in 2007, the household-to-GDP debt ratio had reached its highest level since the onset of the Great Depression. Put somewhat differently, household debt hit a record 133 percent of disposable personal income by the end of 2007, a sharp increase from the average debt burden of 90 percent only a decade earlier.

An Unrepeatable Factor

The crisis emerged in the 2000s partly because financial institutions lowered lending standards far below historic norms, especially when it came to home loans. But another factor was at work: The number of two-earner households leveled off. In the preceding decades, many families boosted their incomes as women entered the workforce. In 1968, 38 percent of married women aged 25 to 54 with children worked out of the home. That figure reached more than 70 percent in the early 2000s, and it has stayed in that range since then. Mom and Dad also work about 20 percent more hours than they did 42 years ago.

The upshot: Household income growth, which in years past used to be supported by rising wages, could only be boosted in the modern era by the addition of women to the workforce. With nobody else available to kick in—it's a bit difficult to send minor children off to work—the extra money needed to support mortgage payments, credit-card bills, and student loans is unlikely to materialize.

It isn't a pretty picture. Households are struggling to live within their means by paying down debts and boosting savings. Inequality remains, and what that means in essence is that economic opportunities remain shrunken for many Americans. "We have focused on consumption to paper over the fact that we aren't generating the income that we need," says Rajan. "We need to focus on generating more income."

Focus on Education

What's needed is that all of society's major economic institutions—from business to schools to government—do more to educate and prepare young people for the new world of work. Sad to say, many good jobs are going begging for a lack of workers with the education and skills to fill them. Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, estimates that more than 2.5 percentage points of the current unemployment rate are attributable to a skills or education mismatch between workers and jobs.

What to do about inequality? There's no shortage of ideas, but the bottom line is that more resources should be devoted to education, from early childhood through college and beyond. Over the past quarter century almost all net new job creation has been for college educated workers. There is growing ferment on the local level with the charter school movement, mayors seizing control of school bureaucracies, and the Obama Administration's Race to the Top initiative. Washington has passed a number of measures aimed at improving college attendance by students from low-income families, such as increasing the Pell grants. Still, since 2000, college costs have risen sharply, while the earnings of young college grads are down. Many of America's high-tech titans and leading entrepreneurs have embraced education reform as their major philanthropic cause. Education is high on every parent's list of concerns about their children.

"Americans care about income inequality when it restricts opportunity, access to good jobs with good pay," says Leslie McCall, professor of sociology at Northwestern University. "One way that concern manifests itself is through education."

Problem is, despite all the attention showered on education, far too little is being done relative to the scale of the problem. Beleaguered state governments are slashing public university budgets. Many local governments are reducing their support for K-12 education. The politics of the federal government's debt and deficit are hampering new initiatives. Remarkably, the Republican Party's 45-page A Pledge to America doesn't even mention education. Without greater investments in education and human capital—the true wealth of the nation in the 21st century—incomes will stagnate, the urge to borrow too much will eventually resume, and another crisis will lie in our future.

A solution that is based on improving schools and training programs won't be easy. It will take time and cost money. But there's a bumper sticker pasted to the tailgate of the modern American dream, and it reads, "It's Education, Stupid."

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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