Chapter One THE CRISIS OF WAGES AND TRANSFERS Is this improvement in the circumstances of the lower ranks of the people to be regarded as an advantage or an inconveniency? The answer seems at first sight abundantly plain. Servants, labourers and workmen of different kinds, make up the far greater part of every political society. But what improves the circumstances of the greater part can never be regarded as an inconveniency to the whole. --Adam Smith, Inquiry into the Nature and Causes of the Wealth of Nations , 1776, Book I. Chapter VII This is a book about pay. It is about the gap between good and bad jobs, about what can be earned in America in decent as compared with mediocre employment. This gap was once quite small. But the gap has grown, and now it is wider than at any other time since the Great Depression. It so wide that it has come, once again, to threaten the social solidarity and stability of the country. It has come, I believe, to undermine our sense of ourselves as a nation of equals. In this way, rising inequality presents a stark challenge to American national life. The most visible sign of this challenge has emerged not in the marketplace or on the factory floor, as one might possibly expect, but in politics. It surfaces in bitter discussions of budgets, welfare, and entitlement programs. A high degree of inequality causes the comfortable to disavow the needy. It increases the social and the psychological distance separating the haves from the have-nots, making it easier to imagine that defects of character or differences of culture, rather than an unpleasant turn in the larger schemes of economic history, are at the root of the separation. It is leading toward the transformation of the United States from a middle-class democracy into something that more closely resembles an authoritarian quasi democracy, with an overclass, an underclass, and a hidden politics driven by money. To put the matter the other way around, economic equality blurs the distinctions between persons. It makes people feel similar to other people. In this way, equality casts a veil of ignorance over the comparative future of individual fortunes. As we know from the philosopher John Rawls, this ignorance, rather than equality itself, is the key to fairness in social choice. A just society, providing for the less fortunate in an equable way, is one that people would freely choose for themselves, without knowledge of their own position within it. Inequality lifts the veil. Inequality is information; it is knowledge. With high inequality, of income and of wealth, it becomes easy to know whether one is likely in the long run to be a net gainer, or a net loser, from public programs of family assistance, pension security, and health care. The more inequality there is in the present, the more definite is each person's sense of his or her own position, both in the present and for the future. The rich feel more secure; the poor feel less hopeful. High inequality therefore weakens the willingness to share at the same time that it concentrates resources in hands least inclined to be willing. In this way, and for this reason, inequality threatens the ability of society as a whole to provide for the weak, the ill, and the old. The rise in inequality is the cause of our dreadful political condition. It is the cause of the bitter and unending struggle over the Transfer State, of the ugly battles over welfare, affirmative action, health care, social security, and the even uglier preoccupation in some circles with the alleged relationship of race, intelligence, and earnings. The "end of welfare as we knew it," to take a recent example, became possible only as rising inequality ensured that those who ended welfare did not know it, that they were detached from the life experiences of those on the receiving end. Crisis is a misused word, particularly by alarmists who have presented us in recent years with a budget crisis, a Medicare crisis, and a social security crisis. None of those alleged crises really is. They all rest on specious claims about financial abstractions, on scare stories about impending bankruptcy--whether of the government as a whole or of particular government trust funds. They all fade when the economic news is good, only to return when hard times make the public receptive. But they serve the same underlying purpose: to legitimize the reduction of social welfare and social security programs, to withdraw resources from the social to the private realm. And they all enjoy support from the same social quarter: the financial and commercial interests of the wealthy. The real crisis is the underlying attack on the elderly, the poor, and the ill, and the tragic willingness of many working people to join it. What brought this crisis into being? According to popular perception, rising inequality is a kind of black rain, a curse of obscure origin and no known remedy, a matter of mystery covered by words like downsizing, deregulation , and globalization . There is a view that capitalism has simply become more savage, a matter of the temper of the times and a new brutality of markets. Many speak of a paradox in which the social evil of rising inequality accompanies rising average incomes and general prosperity for the country as a whole, a single dark cloud in a silver sky. But is higher inequality, as many believe, something that "just happens"? Or does it serve a deeper purpose, one that is to be expected and accepted? Is the splitting apart of America an accident, or is it the inevitable incident of technological progress and the spread of free markets, a by-product of change and modernity? Is it the cost we must pay for the efficiencies of worldwide production and trade? Is it the price of comparatively low unemployment? Is it a side effect--disagreeable perhaps but a necessary aspect of our development toward a better future? The idea that rising inequality serves a deeper purpose emerges from the economics profession, which has produced a kind of instant wisdom on the subject--a set of views, usually presented as orthodox, but in fact established with great haste and in considerable disorder in recent years. To a predominant faction within the economics profession, the "why" of rising inequality has been answered by a single, all-encompassing phrase: skill-biased technological change . The term technology is very broad, and in many presentations the specific nature of "skill-biased" technological change remains vague. Still, many economists today believe that a main cause of rising inequality lies in the spread of information technologies, and especially in the computer revolution. Massive investment in computers has, they argue, led to a transformation of the workplace. A rush to information technologies has driven up the relative demand for workers trained to use the new technologies. Since only so many well-trained, computer-literate workers are available at the outset of this process, market forces require that they be paid increasing amounts. And so the rate of return to skill increases. Inequality rises because those who are more skilled already hold positions near the top of the wage ladder, so their gains stretch the wage structure. Demand for unskilled labor falls, reducing comparative pay at the bottom of the wage scale. This majority view on the "why" question has led to a split view on two other questions: whether inequality ought to be considered a social problem, and what should be done about it. The strictest believers in the free market argue that rising inequality is not a problem; the market's dictate in this matter should be respected, even celebrated. The reasoning behind this position is a textbook case in the further economics of supply and demand. A shortfall of computer skills, caused by increasing demand for those skills, reflects the rising productivity of those who have mastered computers relative to those who have not. This causes the wage of the computer-skilled to rise. That rising relative wage sends a signal to the labor market, where it is received by everyone from college students to displaced middle managers in late middle age. They decode the message and head back to school. Soon computer courses will be overflowing, the labor markets will be flooded with newly numerate job applicants, and the premium associated with computer skills will disappear. The problem is self-liquidating, unless the transformations of skill-biased technological change continue in the next period, in which case the sequence of corrective responses must be repeated. According to this line of argument, the wage gap produced by the skill differential is actually necessary , so long as the mismatch persists. It is the signal that tells the market to produce a greater number of workers with computer skills. To reduce the gap artificially, so to speak, by raising the wages of the unskilled, would only thwart the market. It would produce unemployment among the unskilled, since their wages would now lie above their worth--a story often told to account for the persistence of high unemployment in Europe. It would discourage retraining and perpetuate the shortage of skills. It might even have the perverse effect of slowing future technological improvements, since employers can scarcely be expected to pursue paths of innovation for which they cannot find an adequately talented workforce. There is a respectable liberal dissent from this position, and it lies in arguing that although the price mechanism may work eventually, it doesn't work quickly enough. Thus, there is a social benefit in accelerating the creation of new skills, or in making access to retraining more equal. A forward-looking policy can anticipate future technological developments and prepare the workforce to meet the challenges to come; it can match expected shifts in demand with policy-driven shifts in supply. Hence there is a case, on the center-left of our reputable politics, for subsidies to education and for training programs. Affirmative action for women and minorities can also be justified; such measures help distribute the privileged positions in the distribution of skills to members of groups that have historically been excluded from privileged positions. It is no accident that education and affirmative action hold their prominent positions on the beleaguered liberal agenda. Access to education is a gateway to opportunity in America, and few doubt (in public) that additional years in the classroom are socially useful. Distributing such access across ethnicities and genders is a way to achieve some diversity in the higher professions and in political and social elites. From a political standpoint, a program of support for education helps to relieve the financial anxieties of struggling middle-class families, who are known to vote. It is comparatively immune from attack by economists, for it leaves the pricing mechanisms of the labor market alone. And it is unlikely to incur criticism from the larger run of society's intellectuals either, for they stand to benefit from expanded subsidies to their own employment. Yet the notion that equalizing skills will equalize incomes rests on a confusion--a confusion between equity in access to lottery tickets and equity in the value of the prizes. It is one thing for a program to hold out, subsidize, and support new chances for individuals to compete on the educational and career ladders. It is something different to promise that the ladder itself will become shorter and wider as a result of an increase in the numbers crowding their way up the rungs. It is something entirely different to suppose that each new entrant and reentrant in the educational sweepstakes will enjoy a chance of success equally high as those who have already entered and won. It is something entirely different, something bold and ingenious, to promise that we can return to the middle-class solidarity of three decades ago, entirely by diffusing knowledge through the population and by allowing free labor markets to work. This is the marvelous adjustment that both sides of the debate--the education activists and the free-market purists--are implicitly promising. They are promising an adjustment of the structure of economic outcomes to the distribution of human skills. They are promising, in effect, that the inequalities occasioned by technological change will take care of themselves. One may reasonably pose the question, When? Twenty years into the computer revolution, and nearly thirty years since the start of rising inequality, many millions have acquired the skills appropriate to the age. Word processing, accounting and calculating on spreadsheets, e-mail and the Internet, computer graphics and publication, computer-aided design: none of this is any longer esoteric. Yet the readjustment of incomes to a wider and more equal distribution of skill levels hasn't even begun to happen. Indeed, so far as one can measure skills by educational attainment, the reverse has occurred and continues to occur. Educational differentials have narrowed, with policy help. Yet wage differentials widened sharply in the 1970s and 1980s; since the mid-1980s the most charitable interpretation of the data is that differentials have remained stable at historically high levels. As Martin Carnoy has eloquently pointed out, this bitter irony is especially poignant for black Americans, who have narrowed the educational gap separating them from whites, only to slip further behind in average earnings. The skills-shortage hypothesis--the idea that computers or other forms of skill-enhancing technology are mainly responsible for what has happened to the wage structure--and the idea that education can cure the problem are, I believe, fantasies. They are comforting fantasies for politicians, policymakers, and business interests, for they lay the blame for the phenomenon of rising inequality on workers themselves (if they fail to keep up with changing times, whose responsibility is that?), they ensure us that something good will come of it anyway (hey, isn't technology wonderful?), and they exonerate the state. For these same reasons, they are also dangerous fantasies, for they insulate us from a serious discussion of why inequality has risen and what might be done about it. This is true even though we do subsidize education (and should do so), affirmative action for disadvantaged groups is a good thing (or so I believe), we have heavily supported the introduction of new technologies to the schools, and computers and other inventions have generally enriched and eased our lives. Measures such as these can be good and socially useful without having application to the crisis of inequality in the wage structure. In this book I argue that rising inequality in the wage structure is neither inevitable nor mysterious nor necessary nor the dark side of a good thing: rather, it was brought on mainly by bad economic performance. Its principal causes lie in the hard blows of recession, unemployment, and slow economic growth, combined with the effects of inflation and political resistance to raising the real value of the minimum wage. These are blows that, when once delivered, are not erased in any short period of economic recovery. They can be reversed, and in American history have been reversed, only by sustained periods of full employment alongside controlled inflation and a determined drive toward social justice. We last saw such a movement in this country in the 1960s, and before that only during World War II. What caused bad economic performance? The answer is plainly visible to anyone with an open mind and a reasonable grasp of the evidence. Economic policy, and very specifically monetary policy, changed. Beginning in 1970, the government abandoned the goal of full employment and instead turned its attention to a fight against inflation. For this purpose, only one instrument was deemed suitable: high interest rates brought into being by the Federal Reserve. There followed a repeated sequence of recessions, each justified at the time as the unfortunate consequence of external shocks and events beyond national control. The high unemployment that recessions produced generated, I shall demonstrate, the rise in inequality that destroyed the middle class. For this, the Federal Reserve, under its reputable chairmen Arthur F. Burns, Paul A. Volcker, and Alan Greenspan, stands primarily responsible. As a matter of secondary importance, rising wage inequality is also linked to economic globalization, a touchy and contentious issue. As a share of the U.S. economy, trade has been expanding since the late 1960s, and imports of manufactures from developing countries, in particular, grew dramatically in the early 1980s. The effects on wages, now thoroughly debated in a large literature, are measurable and significant, though not so vast as economic nationalists sometimes contend. It would be absurd to pretend that imports from low-wage countries have no effect on American wages; it is equally wrong to argue, as we sometimes hear from both left and right, that the Mexican and Chinese tails wag the dog of the American wage structure. Globalization may be irreversible, but its consequences for economic and social inequality are not cast in concrete, and so it is also incorrect to argue that the new global economy necessarily dictates a politics of unrestricted laissez-faire. The cause of higher inequality as trade has expanded lies, rather, in the way American trade expanded, particularly under the huge overvaluation of the dollar and debt crises of the early 1980s. Because of this peculiar, harsh, unnecessary, and policy-created pattern, globalized trade has pulled our manufacturing wage structure in two directions at once: it has gradually layered the United States between the rich countries and the poor, and America has tended to become the leading industrial economy of both the First and the Third Worlds. This was unnecessary and it can be changed. We need not fear trade relations with poor countries so long as we properly fulfill our own responsibilities in the trading system. Thus, whether one examines the international or the domestic aspects of rising inequality, the imprint of economic policy is clear. Things could have been different if economic policy had followed a different course. Things should have been different, because different choices were possible in the past. Moreover, our situation can be changed now. We know it can be changed, because policies are available that have worked to reduce inequality in the past, in both the United States and other countries. Indeed, policies are working now that have slowed the increase in wage inequality. The task we face today is not so much to invent such policies but to recognize them and push them forward further and faster than we have so far dared to do. There is an even bigger story just under the surface of this argument. It is that the ostensibly private, free-market character of the changes in the wage structure is an illusion. Relative wages are much more a matter of politics, and much less a matter of markets, than is generally believed. They are subject to the powerful effects of public policy, albeit policy governed in large measure by private interest and private pressures and frequently hidden from view. Public policies before 1970 largely supported a middle-class society, but not so later on. It follows that deep issues of macroeconomic policy, international economic order, and the role of the state have to be addressed before policies adequate to this crisis may be forthcoming. We have to acknowledge the essentially contingent, reversible, and public causes of the inequality crisis, and we must be willing to take actions that are direct, forceful, and sustained in order to bring it to an end. From 1945 through 1970, the state maintained a wide range of protections for low-wage, less educated, more vulnerable workers, so that a broadly equal pattern of social progress was sustained despite, even in those distant years, rapid technological change. These protections were held in place by a stable macroeconomic policy that avoided sharp or prolonged disruptions to economic growth, and in particular by a monetary policy that was subordinated to these larger objectives. In those years, the government as a whole was committed to the pursuit of full employment, price stability, and high rates of economic growth. Following 1970, technological change continued, but the protections were withdrawn, and at the same time macroeconomic policy became much more unstable. The state shifted its support from the economy--in general, the macroeconomy, to specific leading sectors of the economy-in fact, to the firms and industries most devoted to technological change. Monetary policy led the way, by declaring its independence from the larger objectives of economic policy, and its responsibility for the defeat of inflation above all other economic goals. Wage equality and the middle-class character of American society were victims, in short, of the war on inflation. The wage structure cracked and crumbled under the assault of policies that stabilized the price level at the expense of comparatively low-income working Americans--in 1970, 1974, 1980, 1981, and most recently in 1990. These policies were led and implemented by the Federal Reserve, though with the acquiescence of the rest of the government, which chose the politically easy path of assigning responsibility for fighting inflation to the central bank. It follows that if we wish to restore patterns of wage equality befitting a society that is truly middle class, we need two things: a return to policies of sustained full employment and an entirely different approach, when necessary, to inflation. We will return to this point. This book focuses primarily on wages as the major story of inequality in working America, the fundamental issue in the politics of inequality, and the driving story behind the larger social changes that come when inequality increases. Wages and salaries account for over half of all income flows and for most of the incomes of the 135 million Americans in the labor force, plus their dependents. It is also true, if my calculations are correct, that even if there had been no increase in the inequality of nonwage incomes in America since 1970 and no change in the relation of wages to profits, the rise in U.S. inequality would still have been among the highest in the industrial world. My focus on wage income is also partly driven by theoretical interests, data, and a desire to add something to the literature and debate. Hourly wage rates are of interest here because they are the fundamental outcome of the work contract. Statements about the effect of technology or trade on wage structures are about hourly wage rates in theory; differences in hours worked, nonwage incomes, or family structures have nothing to do with it. Yet empirical research on inequality often has relied on broader measures of income inequality, such as normal weekly earnings or annual earnings, with the risk that fluctuating hours or spells of unemployment may obscure what is happening to wage rates. Individual earnings--weekly, monthly, or annual--combine the effects of the hourly wage rate with fluctuations in hours worked. Even if all hourly wages were equal, and even if there were no sources of income other than personal labor, personal earnings would not be equal because different people would work differing numbers of hours through the week, the month, and the year. Some of this is by choice: certain people prefer more hours of work and the associated income; others prefer less. Some is not by choice, because in the real world unemployment falls on some people against their will. Incomes differ from earnings because of income from capital, including dividends, interest, realized capital gains, and partnership profits. Also, many people receive modest incomes in the form of public assistance and transfers from the government, including social security and welfare. Nonwage incomes account for more than 40 percent of total income today and are clearly a major source of inequality, especially since the distribution of capital ownership is so uneven. Finally, people form themselves into families, and family income is the ultimate determinant of the standard of living. Families with multiple earners rise toward the top of the family income distribution, while families with just one earner fall toward the bottom. As the number of single-headed households rises, so too will inequality. This pattern is compounded in the real world by the grim fact that single-headed households also comprise, to a large extent, those with the most unstable employment experiences and the lowest hourly wages. All of these elements combine to generate the structure of incomes and of inequalities that we all live with. I argue, however, that inequality in wage rates is the foundation of the whole structure. This is partly because wages and salaries remain such a large fraction of total incomes and also because the distribution of certain other forms of income, such as private pensions, depends directly on each recipient's past history of earnings and hence on the inequality of the wage structure. Beyond this, I believe that increases in the inequality of the wage structure have repercussions through the outer layers that lead to higher inequality at the levels of individual earnings, individual incomes, and family incomes. Higher inequality in wage rates tends to polarize the experience of unemployment: jobs paying higher wages are more stable, and those at the bottom become contingent and experience the brunt of ups and downs in labor demand. Higher inequality in family incomes produces higher transfer payments--both public, because more people fall into poverty, and private, because more people incur debts and interest burdens in the effort to maintain parities of living standards despite disparities of income. Finally, wage and income inequality bleed through to family structures. Doubling up and breaking up are both consequences in part of economic stress; hence the rise in inequality due to changes in family structure is partly an aftershock of rising wage and salary inequality and unemployment. The politics of inequality tends to be mainly about transfer payments, for the straightforward reason that transfer payments are mediated by the state, and politics is about the state. The support of these populations who live directly or indirectly off the toil of those who are currently working is the story of our political life. Typically, when we speak of transfers, we refer to the retired elderly and the poor. I will argue, however, that the politics of transfers actually involves three distinct groups, and I would add interest receivers to the poor and the elderly as a population with a direct interest in state policy--namely, the interest rate. The difference between these groups is that while the poor are poor, the elderly tend to be lower middle class and the population of significant interest receivers stretches from the upper middle to the very highest reaches of the income distribution. In the larger scheme of the economy and the government budget, transfer payments to poor people other than the elderly are minor. The now-defunct welfare program Aid to Families with Dependent Children (AFDC), housing assistance, food stamps, and state-supported general relief programs have been vital to those who rely on them. But these programs are comparatively small in budget terms, tiny in relation to the size of the economy, and with perhaps one important exception--the earned income tax credit--they have been falling since the early 1980s. The elderly are a different case. This is a group for whom the news of the past generation has been good on the whole. To a very large degree, the elderly have escaped both poverty and the labor market over a quarter-century's time, as well as the crushing burdens of the cost of medical care. They have done so, of course, through government assistance. Social security goes back to 1935, but for the first generation of its existence, large numbers of the elderly remained poor. It was only beginning in the early 1970s that increases in retirement earnings and medical care under social security, as well as supplemental security income for the disabled and destitute, permitted many older people to quit working earlier and to live better in retirement than they otherwise would or than any previous generation of the elderly has ever done. Some of these large improvements were accidental, or the result of political competition during the election season of 1972. But the accomplishment was nevertheless very real. A whole economy now revolves around an emancipated elderly population; such a thing hardly existed thirty years ago. And among the elderly, the war against poverty has been a resounding success. According to a report from the Census Bureau, the poverty rate of elderly people fell from 35.2 percent in 1959 to 10.5 percent in 1995, a rate lower than that of the working population. What of transfers to the rich? According to one study, the average pretax income of the top 1 percent of American families more than doubled over fifteen years after 1977, reaching $676,000 per year in 1992. This group of the very rich relies on wages and salaries for less than half their income. The other half flows from the distribution of wealth, a controversial and important topic that I will substantially neglect, except for a few words to situate interest in this complex pattern. At the very top of the income distribution, net capital gains are extremely important. In 1988, they accounted for 22.1 percent of the income of the top 1 percent of taxpaying families, and that group received over 68 percent of all gains. Capital gains overall totaled $153 billion; of this, nearly $105 billion went to the top percentile. Partnership net profits, another critical item, totaled $56 billion in 1988 and flowed almost exclusively to the top percentile. Interest income overall is five times larger than capital gains and more stable, and it has grown more as a share of total income than any other category, rising particularly sharply with the rise in interest rates, from 4.6 percent of total personal income in 1977 to 8.2 percent in 1982--an increase larger than the whole defense budget and on a par with social security payments. It is true that interest income is not so concentrated as capital gains and partnership incomes. Interest is earned in significant quantities by significant numbers of moderately wealthy--say, the top 10 percent rather than the very top percentile, both directly and through holdings in pension funds. As compared with capital gains, the rise in interest income represents an important source of transfers to this comparatively large group. Obviously many of them have debts themselves, so not all of interest flows are redistributive. But as one moves up the wealth ladder, net creditors come to predominate over net debtors; on balance, the payment of interest represents a net flow from middle-income debtors and from the government itself(that is, from taxpayers) to creditors among the comparatively well-to-do. The trouble comes when we add the burdens of the three nonworking populations together and present the bill to the working population. Transfers to the truly poor are minor and declining. But when we count transfer payments to the rich, in the form of interest on private and public debts, alongside transfer payments to the elderly, in the form of government programs, the increase in total transfers as a share of personal income over forty years has been dramatic. Interest payments and government programs together accounted for about 11 percent of all personal income in the 1950s. Today the share is about 30 percent, with transfers accounting for over 16 percent and interest for over 13 percent of the total. This phenomenon we may call the rise of the Transfer State. As a result of it, we have in place in the United States today not one but two competing welfare systems. One is a private one disproportionately for the rich, based on their ownership of financial assets. The other is a public one, mainly for the retired population, with dribs and drabs for the younger poor. Both are financed mainly by working Americans, who pay taxes to the state and interest to their creditors, and then try to live on the remainder. Both are administered, in important ways, by the government, for it is the government that sets the tax rate on payrolls to fund social security, and it is the government, through the Federal Reserve system, that sets the key interest rate on loans. My argument is that rising inequality in the wage structure underlies both the evident crisis of public transfers and the not-so-evident but insidious problems of a rising burden of net interest obligations. As the wage structure became less equal, both public and private transfers rose, and the public transfer burden, which inevitably bears the brunt of public attention and efforts at legislative remedy, became the enduring crisis of our political life. Was this accidental? I think not. Why do more equally paid societies tolerate higher public transfer burdens, and why do these systems fall into crisis when inequality rises? There are at least three reasons. The first of these concerns the nature of the transfers themselves, the second concerns the attitudes and political involvement of the rich, and the third concerns the bargain as it appears to the middle class. First, more equal societies have less poverty. The burden of support for the nonelderly poor is therefore less, and the political controversies surrounding the notion of aid to the undeserving tend not to arise. The social problems of the poor tend to be seen much more as the social problems of the temporarily poor--a category into which many people can imagine themselves falling, for example, through loss of employment. Thus, there is greater and wider support for what is, in any event, a smaller and less onerous burden. Transfer programs themselves can then be generous enough to blur the distinction between the poor and the middle class, and the stigma of poverty falls away. Second, more equal societies have fewer rich people. In a society of broadly based equality, the proportion of those opting out of public services, of those for whom public pension plans are financially insignificant, becomes a politically negligible fringe. But as a society polarizes, the rich develop an ethos all their own--an ethos of exaggerated individualism, of independence from the state and rejection of public institutions. The usual political response to this development--certainly the response in the United States--has been to allow the wealthy to reduce their share of payment for the burden. (In the United States, for instance, the cap on payroll earnings taxable for social security is a clear example of this; so too are tax provisions benefiting the wealthy, such as special rates for capital gains.) This then has the effect of shifting the burden of supporting transfer programs from the wealthy toward the middle class, a burden that becomes heavier as transfers increase and the weight of income shifts up the scale from the middle class toward the wealthy. Third, more equal societies will tend to have lower private transfer burdens--less private capital, less debt, less conspicuous consumption and pecuniary emulation. People are willing to pay higher taxes for social insurance if they face a lower burden of private debts. Moreover, in a middle-class society, public services come to be seen as collective assets--something from which the population at large benefits directly. What might be a bad social bargain at 30 percent of income, when benefits are thought to flow mainly to the unworthy, seems like a much better deal even at 40 percent of income, when benefits flow back to the population at large (for example, in the form of Canadian medical care, French trains and mass transit, and the German system of free universities). This explains why these amenities enjoy such widespread support--as has the social security system in the United States. One answer to the inequality crisis, indeed the principal answer offered by the small cohort of true progressives who have survived in political life, is to engage in a stalwart defense of progressive taxation and generous public assistance programs, including social security. This has been the work of angels. And in the preservation of the income tax and the social security system, so far it has been not without a share of successes. Tax reform in 1986 and in 1993 demonstrated that the theme of fairness in the tax structure is a powerful political force; liberals need not flinch from progressive taxation for political reasons. But in the long run, the battle cannot be won by reacting to ever-rising inequality with ever-increasing compensatory transfers, for as society grows increasingly unequal, the political economy of compensatory transfers becomes oppressive. Claustrophobia, a sense of lack of mobility, of flexibility, a loss of liquidity, of possibility and of freedom set in. In the squeeze between entitlements, public interest payments, and private spending, public services are degraded, downgraded, and debased; they become symbols of the shabby, amenities to avoid. The social bargain exempting the rich from their share of the burden--for instance, through caps on income subject to social security payroll taxes and reduced tax rates on capital gains--comes to grate on the middle class as much as the burden itself. An economy of tax slaves and debt peons is, at its worst, an economy of frightened and frustrated people. The American working population is angry because it has both the rich and the elderly on its back, even as it divides into mutually hostile and distrusting camps, and because the economic bargain involved in continuing to carry both looks increasingly bad for those who can least afford it. Lacking public solutions to the problems of life on the treadmill, and lacking also the political parties, platforms, and organizations to put them into effect, it is not surprising that people become open to the appeal of every man for himself, and ultimately the power of this appeal will become irresistible. The signs of this are unmistakable. The antistate political operatives of the wealthy seek allies by offering small tax breaks to those near the top of the wage structure, while chipping away at programs and benefits from the bottom up. There results a form of class warfare--a warfare of code words and indirection--fed by cynical ploys and schemes of diversion. In this way economic polarization and political retrogression mutually reinforce each other. In the United States, the first target of this assault was federal assistance to the very poor, and particularly to young, single mothers. Conservatives and their academic allies fueled their assault on welfare with a powerful rhetoric of welfare reform built on displacement. The frustration generated by a high burden of transfers, of which very little goes to poor people in practice, was channeled into resentment of the supposed privileges and supposed depravities of welfare recipients. The resulting anger led to the abolition of AFDC in 1996, along with deep cuts in the eligibility of even legal landed immigrants for such programs as food stamps and Supplemental Security Income. Still another manifestation of the same phenomenon is the drive to mandate balance--a deficit of zero--in the budget of the U.S. government, a proposal often accompanied by proposals to reduce taxes and make increasing taxes constitutionally difficult. If the objective were budget balance per se, it would make little sense to put an extra barrier in the way of an increase in tax rates. The inconsistency of joining the two proposals reveals the true purpose, which is to increase the pressure for cuts in federal government spending Since advocates of balancing the budget are usually strong supporters of the defense budget and since federal interest payments cannot be reduced by fiat, the effect is to focus this pressure on cuts in transfer spending. In the initial rounds, the agenda focused on scapegoats on one side (the poor, immigrants) and on generalized assaults on public spending (the balanced budget amendment). But this moment is past. The debate now centers openly on the core program of the New Deal social architecture, which was social security, and on the core accomplishment of the Great Society, which was Medicare. Led from secure bastions on Wall Street by investment bankers, a campaign against the social security system, in particular, has moved into the gap left by the successful crusade against welfare. The arguments advanced for "reform" of the social security system are, of course, quite different in kind from those heard against welfare. One does not berate the elderly for their lack of work ethic (even though the reduction of working hours by able-bodied elderly men has been far more dramatic over the past twenty years than that of young black women). Instead we hear a financial argument, to the effect that the trust funds from which social security retirement benefits are paid will be depleted over the next thirty or forty years. This projection, accompanied by dire warnings of bankruptcy and crisis, is said to justify either a large reduction in future benefits or else the transfer of trust fund revenues into mandatory private savings accounts. In either case, the effect is to privatize what was previously social, to reduce both present and future transfers, and to cut the support for the elderly poor to the benefit of the elderly rich. These arguments do not, in fact, reflect a consensus of experts or of reputable work on social security. But the fact is that they are widely accepted, because they appeal to an increasing sense of self-interest on the part of influential communities. This has occurred, I believe, only because for a sufficient group within the broad middle, the increasing stratification of wages and salaries, combined with the increasing burden of public and private transfers, means that there is an increasingly powerful economic incentive to opt out, to take one's own pro rata share of the commonweal, and to go it alone. The heart of the problem lies not with the structure of transfer programs but with the structure of wages and incomes that both breeds the Transfer State and makes it unsustainable. It lies in the splitting apart of the middle class that once dominated the social and psychological landscape in this country, of the great Middle America that was created by World War II and built up through the two and a half decades that followed. This great polarization leads toward the dissociation of the rich, the debt and tax peonage of the middle, and the seeming intractability of the poor, all of which combine to produce the vulnerability of our social programs. For this reason, no amount of debunking, whether of Charles Murray or Peter Peterson, is likely to defuse the march to demolition of the New Deal. Only a reestablishment of the middle-class solidarity that supported the New Deal for a generation can do that and lay the groundwork for widely shared social progress into the future. To summarize bluntly, in rising inequality we long ago cut back on public universities, mass transit, housing, parks, and the arts. We have now decided that we cannot afford the poor. But since cutting the poor saves very little money, it follows that we cannot afford to maintain both the elderly and the wealthy at their current levels of income and consumption. Perhaps we could afford the elderly, perhaps we could afford the rich, each taken alone as matters stand. But we cannot afford them both, and we have to choose which set of transfers to reduce. Part of the solution is to reduce the burden of private transfers by reducing the rate of interest. This is a necessary step for many reasons, direct and indirect, which we will explore in detail. And indeed it is a step whose necessity even the Federal Reserve has recognized on occasion: interest rates and debt burdens fell in the late 1980s and early 1990s. Reductions in the interest rate provide short-term relief, for they make paying other bills--especially taxes--easier, and they ease the federal budget crunch affecting other vital services. But reducing the private transfer burden on a permanent basis is more difficult, since it would involve regulating the extension of private credit, which is a much more difficult proposition. Without this, the problem would not be solved, for an unregulated reduction of debt burdens is only an invitation to a greater accumulation of debt. It is therefore likely that without fundamental reform of the underlying wage structure the public half of the transfer state will continue to give way. This is the meaning of past, losing battles for health care reform, of the disastrous 1996 battle over welfare, and of the developing battles over Medicare and social security. One cannot forge the kind of basic agreement on the terms of a social contract that the survival of social security, Medicare, and other basic protections requires on the basis of the current American distribution of income and wealth. The rise of wage and salary inequality is in this way a development that raises deep questions about the legitimacy of the most prominent social processes of modern economic life, indeed of the system itself. It forces us to ask how much we are really prepared to leave to the market. Having placed ostensibly private wage and salary decisions on a pedestal, having set them out of bounds of normal public policy, are we ready to see the results lead to an abandonment of the poor? Of the elderly? To the destruction of the middle class? Sooner or later, fundamental issues will have to be faced. Sooner or later, we will have to face the choice between gutting the redistributive system or fixing the distributive problem. To fix the distributive problem, we must first understand what caused the rise in wage inequality. Chapters 2 through 4 present a critique of the explanation of rising inequality that has dominated academic discussion in America--an explanation that relates pay to the skills required by new forms of technology. I argue that inequality is not a result of rising skill differentials, expressed in the evaluations of a free and efficient market for labor. Rather, we are observing a process driven by the interaction of economic policy, economic performance, and the existing structures of monopoly power. The fundamental contribution of technological change lies in the redistribution of this form of power toward suppliers of knowledge-intensive capital goods. The contribution of weak and unstable economic performance has been to deprive everyone else, and in particular workers in consumer goods manufacturing and services, of the economic and political power that they would have needed to counterbalance the new monopolies and so to maintain their own position. Chapters 5 through 9, in Part II, ask what the macroeconomic and policy forces are that underlie this redistribution of power and the rising inequality it has produced. These chapters include a systematic look at how the industrial wage structure has changed through time and tests of alternative explanations. To see how the process works, we must rethink how we describe the economy as a whole. I will show that a reorganization of industrial categories into three broad groups--knowledge-based capital goods industries, consumer goods producers, and pure services--can help clarify how the wage structure has evolved. This in turn permits us to see with some precision what the historical forces buffeting the industrial wage structure in the past three decades have actually been. When we examine these forces, we shall find the fingerprints of state policy. It turns out that the main forces affecting inequality and industrial change are not mysterious irruptions of gadgetry and changing human relations. They are, in fact, directly traceable to actions of the government. The most prominent among these to the naked eye are the redistribution of tax burdens, governmental hostility to trade unions, and an indifference to preserving the real value of the minimum wage. But we shall find others more powerful and less visible, in the actions of monetary policy and particularly in the reliance on monetary policy to battle inflation, whatever the cost to working people, especially in terms of unemployment. The thought that state policy caused much of our rising inequality leads to the idea that state policy might properly be involved in the cure. The direct approach to wage inequality is to raise the wages and improve the employment prospects of the comparatively unskilled. The simple view is that society can reduce its inequalities by regulating the gains of the rich and the comparatively successful. The simple view is that the poor can best help themselves when labor is scarce--when there is sustained and stable full employment. The simple view is that all of these are proper responsibilities of government, and a fair action program for unions and political parties. And the historical fact is that such steps are what societies interested in greater equality have always taken. This includes the United States as recently as 1996, when a Republican Congress enacted, and a Democratic president signed, a long-overdue increase in the minimum wage. That will lead toward a discussion of the the economic policies required to bring the inequality crisis to an end. In Chapters 10 through 12, I argue that the stock issues of the modern American economic policy debate cannot deliver cures to economic inequality, and indeed have contributed to the rising inequality of the past generation. These chapters take on the conservative approach to inflation (the natural rate of unemployment), the savings-investment fetishism that preoccupies the center, and also the supply-side policies of research, infrastructure, and education favored by modern liberals. Once we understand how and why inequality has increased and why the mainstream debate has failed to do anything effective about it, we can consider some different answers. The final part reviews these alternatives. My case, in the end, is that reducing inequality requires sustained full employment, stable and low interest rates, and reasonable price stability. The main areas demanding reform are monetary and budget policies and international economic policies. We also need new policies to take the necessary burden of inflation fighting off the back of the Federal Reserve. Direct actions to raise substandard wages, through higher minimum wages and more effective labor organization, are appropriate and not precluded by any valid economic argument. A return to a national presence in wage setting, with a more equal structure as the explicit goal of public policy, would be even better. There is a range of additional steps, including further increases in the minimum wage, renewed investment in urban and public amenities, jobs programs, and universal health care. These measures work. If based on a national program of sustained full employment, they could form a coherent, sensible, economic policy agenda. They may be radical actions, by the tame standards of what now passes for politics in America, and by the defensive agendas on taxation and welfare that have been even the true progressive's lot for several decades. But they are not unprecedented. We have experienced sustained full employment with reasonably stable prices in living memory; our main need is not to reinvent but to rediscover the ways and means of this achievement. In any event, the important point is not whether an action is radical but whether it is needed. The approach has to be direct, or it will not work. If the crisis of rising inequality results from policies and not from the market, it follows that policy is needed for the fix. We cannot rely on the market to sort things out, given only the thin raw material of more widely distributed college degrees. Nor can we accept the economists' nostrum, which is to leave the distributive mechanisms as they are, and then to rely on transfers and progressive taxes to mend the problem of an excessively unequal result. We cannot do this because the rise in wage and salary inequality is itself the fundamental cause of the ongoing rollback of transfer policies and of their untenable political position. As wage inequality goes up, the transfer cure becomes less and less realistic. Unless we come to grips with inequality, social security will surely go the way of welfare sooner or later. In the end, the crisis of the Transfer State has to be met on the terrain of the wage structure, or it will not be met at all. Copyright © 1998 Twentieth Century Fund. All rights reserved.