Distribution of Income and Wealth is the Issue

As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.

The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.

In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?

In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).

Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.

In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.

There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.

The New York Stock Exchange-Deutsche Boerse Derivatives Merger

The proposed merger between the New York Stock Exchange and Deutsche Boerse would reportedly create a combination that earns at least half of its net income from trading derivatives. See http://www.bloomberg.com/news/2011-02-11/nyse-deutsche-boerse-merger-is-free-with-derivatives.html. The derivatives trading is probably concentrated in financial derivatives, like futures and options for U.S. Treasury securities or stock indexes. (Commodities futures are a relatively small part of the derivatives business.) The stock trading business, facing competition from smaller, faster dark pools and other operators, is evidently in decline.

The derivatives business is about risk management and risk transfer. When the leading exchange in America and the premier exchange in continental Europe join together to form a big risk management market, things are changing and not in a good way.

The fundamental role of the financial markets has historically been to facilitate capital formation. Capital formation consists first and foremost of the sale of stocks and bonds issued by business ventures to savers who want to share in the hoped for profits of those ventures. In other words, capital formation is about taking risks: investors taking risks to help entrepreneurs and established businesses take risks. When major financial markets combine to seek their futures in trading risk management products, one wonders how much capital is being sidetracked from growth oriented investment to speculation.

There is a historically valid role for commodities futures contracts in mitigating the risks of farmers, producers and manufacturers. But when Western financial markets focus more on swapping or selling risks, and less on facilitating capital formation, it's not that hard to understand why Asia is becoming an economic powerhouse while North America and Europe lag. Capital formation is booming in Asia. Fortunes are being made (and sometimes lost). Asia will do well over the next 50 years and perhaps longer because a lot of business risks are being taken, and surely some of those risks will pay off. (After 50 years, Asia's demographic profile will begin to resemble the industrialized world's--more older people and fewer younger people--and no one knows how that will play out.)

Very possibly, the combined NYSE-Deutsche Boerse will be stronger than the two exchanges individually. But its success doesn't necessarily signal prosperity for Western economies as a whole. Economic growth doesn't come from swapping risks. It comes from taking them. The Dutch didn't attain lasting prosperity from trading tulip bulbs. And the combination of the NYSE and Deutsche Boerse is ultimately, not that big a deal. What matters much more is boosting the flow of capital to pimply-faced kids huddled over computers in garages and college dorm rooms, nimble, tech-oriented machine tool companies, specialty steel companies, and other tinkerers and entrepreneurs from sea to shining sea.

Good News From the Forbes 400

In these populist times, the super-wealthy are hardly viewed positively. Many of them should not be. But the overall picture from this year's Forbes 400 (see http://www.forbes.com/wealth/forbes-400#p_3_s_arank_-1_) contains a measure of good news, especially when one looks at the top of the top: the Top 20. The wealthiest person in America is Bill Gates, a software guy, at $54 billion. The next wealthiest is Warren Buffet, an investments guy in Nebraska who's worth $45 billion. Third is Larry Ellison, worth $27 billion from working in the high tech industry. The wealthiest family in America, the Waltons, together worth about $84 billion, hold four places in the Top 20, primarily from their holdings in Walmart, a fairly well-known retailing company. Several other high tech people show up in the Top 20: Larry Page and Sergey Brin (of Google), Michael Dell (PCs), Steve Ballmer (computer software), Paul Allen (computer software), and Jeff Bezos (Internet retailing). Other people in the Top 20 provide news and data (Michael Bloomberg, who also dabbles in politics, and Anne Cox Chambers), or hold manufacturing and energy interests (Charles and David Koch).

It's heartening to note that only two of the Top 20, George Soros and John Paulson, are from Wall Street, and they're not part of the financial world's in-crowd. These two hedge fund guys may have made more money selling short than other ways. Many view them as renegades or outliers. But to their credit, neither of them has gotten a government bailout. They made their money the hard way, by taking a full measure of market risk and coming out smelling like roses. Wall Street's mainstream bankers, who float by these days on government-subsidized bonuses, don't begin to hold a candle to Soros and Paulson.

The good news is that a lot of wealth is still created through productive activities. This is essential for America's future. Wall Street dominates the business news, but the really, really wealthy for the most part didn't get there through financial shuffling and shenanigans. They made or provided useful things that other people wanted and needed. That's good for America's future. It's where government policies and private enterprise should be focused.

Demote GDP and Enhance Economic Well-Being

The most frequently used measure of economic well-being is Gross Domestic Product. Government and private sector leaders, economists, commentators and polemicists fixate over GDP. Its upward movements prompt celebrations and congratulations (usually, self-congratulations). Its downward movements provoke calls for resignation, electoral ouster, and tea parties, and fuel no end of tiresome cable TV commentary. Whether the country is in an economic downturn or upturn is defined by movements in GDP.

Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.

The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.

GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.

Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.

A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.

A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.

Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.

The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.