THE BLOG
12/01/2014 06:50 am ET Updated Dec 06, 2017

The Driving Force Behind Runaway Inequality

ASSOCIATED PRESS

Runaway inequality is destroying the American Dream. Is it too late to save it?

That depends on what is really driving inequality. In the 1960s the gap between CEOs and the average worker was 20 to 1. By 2012 it was 354 to 1. What happened?

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More than a few pundits and policy wonks imply that it's our own damn fault -- we're just not educated enough to compete in the global marketplace. Instead of learning more math and science, we play video games, sext and grow obese. New York Times columnist David Leonhardt provides a more nuanced variation of this theme when he writes that average wages could be boosted by policies to support "above all stronger schools and colleges to lift the skills of the nation's workforce. Countries that have made more education progress over the last generation have experienced bigger income gains than the United States, and even here the pay gap between college graduates and everyone else has reached a record high."

Progressives, however, usually point to other factors such as our paltry minimum wage, the lack of higher taxes on the rich, and the declining power of labor unions. This analysis drives the recent successful efforts to win state and local minimum wage increases, and stronger union footholds among low-wage workers.

But what about Wall Street?

When Occupy Wall Street exploded onto the scene, high finance was nabbed as the primary culprit for rising inequality. But as that movement waned, so did the focus on Wall Street. Even Thomas Piketty's powerful critique of rising inequality (Capital in the 21st Century) places little emphasis on the role of high finance.

So what is Wall Street's contribution to rising inequality?

To find answers, the International Labor Organization produced an eye-popping study of 71 countries in its Global Wage Report 2012/13. They test the relative significance of possible causes of wage inequality such as globalization, new technology, and cutbacks in government support for workers and unions. They also add another possible explanation which they call financialization -- how much of a nation's economy is devoted to Wall Street-like financial activities. Using statistical techniques they measure the degree that each causal factor contributes to wage stagnation.

For example, do countries with more global trade have more or less inequality? Does having more advanced technology account for declining or increasing worker wages? Do countries with large labor movements have higher wages than those with smaller labor movements?

The chart below summarizes the ILO's startling results for developed economies. Occupy Wall Street apparently had it right: Financial activities are the dominant cause of rising inequality.

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The Financial Strip-mining of America

Professor William Lazonick's excellent work (see Profits Without Prosperity) provides insight into how Wall Street promotes inequality. It starts with understanding that the dramatic jump in the CEO/worker pay gap coincides with an equally dramatic change in the fundamental structure of the modern corporation.

Until the 1980s, the basic philosophy of Corporate America was "retain and reinvest." Corporate survival and prosperity depended on plowing back most of a corporation's profits into increased worker wages and training, research and development, and new plant and equipment. But as Professor Lazonick puts it, "The key to rising living standards under retain and reinvest is training, retaining, and rewarding employees because it is through attachment to firms for significant portions of their careers that people's productivity and pay increases."

Banks, to be sure, provided some loans for expansion and for mergers, but stringent New Deal regulations kept high finance in check. From WWII until 1980, there was no wage premium to be gained by working on Wall Street, and the wage gap between CEOs and the average worker hovered at about 20 to 1.

Then came financial deregulation during which Wall Street escaped from its New Deal shackles. Almost immediately a new crop of financiers emerged who raised large sums of money to buy up companies. Instead of creating new value within the corporation, the fundamental goal of these corporate raiders (now called private equity and hedge fund managers) was to extract value away the corporation and into their pockets. What they did was nothing short of revolutionary What they did also should have been outlawed. They transformed the corporate ethos of "retain and reinvest" into "downsize and distribute." Here's how it works

First they buy up firms using borrowed money and make the acquired corporation pay back the loans. For pulling off the deal, they use some of that borrowed money to pay themselves enormous fees, right off the top. They also provide fat bonuses for the CEOs who are to run the acquired corporation. Most importantly, they change the way top officers are rewarded. From this point on, most of their incomes would derive from stock options. The more the stock price rose, the more the CEOs would pocket.

As a result, the new incentive would be focused solely on making the firm's stock price climb. Nothing else mattered. How do you do that? You use as much of the profits as possible to buy up your own stocks! And when profits are slim, you borrow more money to buy even more of your own stock. The more you buy, the fewer shares are in circulation, and therefore each share is worth more. The stock price climbs. As the chart below shows, buying back your own stock became the new corporate way of life. (Many thanks to Professor Lazonick for providing the raw data.)

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By 2008-09 Corporate America was, in effect, using 75% of its profits to buy back its own stock. At the same time, loan and after loan was piled onto the corporate books to buy up even more stock. So that after buying the stock and paying off the loans, there was very little profit remaining to reinvest in the company. (The loan payments and fees, of course, went to Wall Street firms.) This is how "retain and invest" devolved into "downsize and distribute."

To play this game, worker wages, R&D and new plant and equipment are cut to the bone. Older plants are eliminated. Production is outsourced to low-wage areas. Temporary workers replace permanent employees. Benefits like health care and pensions are reduced or eliminated. Unions are undermined. And bankruptcy is sometimes used to break contracts and further reduce these costs. The fees for all this "financial engineering" go to Wall Street. The stock-option-loaded CEOs become part of Wall Street -- it's on-site, wealth extraction overseers. Nearly all corporations whether raided or not, soon followed this lucrative model. Strip-mining the corporation becomes its fundamental activity. Good-bye American Dream.

The financialization of the modern corporation is the driving force of runaway inequality. Therefore, building a movement to take on Wall Street is necessary even while struggling to raise the minimum wage, fighting for more progressive taxation, restoring union power and calling for free higher education for all. The fact is that runaway wage inequality will be with us indefinitely until we remove Wall Street's tentacles and ethos from the modern corporation.

To get there, we will need something like an Occupy 2.0, that instead of lasting only six months, endures for a generation.

(This post originally appeared on Alternet.org)

Les Leopold is the director of the Labor Institute in New York. His most recent book is How to Make a Million Dollars an Hour: Why Hedge Funds get away with Siphoning away America's Wealth, (Wiley, 2013).