Tuesday, February 03, 2009

The Middle Class Is Crumbling

As unsustainable economies unravel, their middle class crumbles, leaving a deeply divided mass of poor and an ever-wealthier elite, neither of whom can support a bloated Imperial government.

Like many of you, I have been pondering what we can learn from history as the global economy based on ever-increasing debt and asset bubbles collapses. For my own research, I am reading a number of books on the subject--several suggested by readers, of course--and attempting to parse out what history and human nature will bring to bear on the unraveling of post-industrial, cheap-oil dependent economies.

The single most illuminating volume on the coming downcycle was sent to me by longtime correspondent Cheryl A.: The Great Wave: Price Revolutions and the Rhythm of History by David Hackett Fischer.

As an aside: I have a funny feeling I'm losing readership as I veer away from writing about real estate--but since I already addressed every key topic within the housing bust back in 2005, 2006 and 2007, there is little fresh ground to till. What lies ahead is so unprecedented that we need to read very deeply of history and think very skeptically about all the models being presented as templates: from TEOTWAWKI anarchy to The Great Depression.

Based on my current understanding of history--something I am working to improve--I suspect we shall see a "false dawn" around 2011-2012 as the enormous stimulus sums being borrowed by governments everywhere flow into the global economy.

This timing will serve the re-election prospects of the politicos who engineered the stimulus.

But as capital is in short supply, and leverage has vanished, governments will find the cheap money they were able to borrow in Stimulus Blowout #1 (2009) is all gone, and Stimulus Blowout #2 will face the headwinds of rapidly rising interest rates as government and private enterprise compete for a fast-dwindling pool of available capital.

As interest rates rise, the cost of servicing the huge public debt will skyrocket, squeezing out all new spending. Interest on the U.S. Federal debt (some $260 billion in external interest payments, i.e. not counting what is being "paid" for raiding the fictional Social Security Trust Fund) is already larger than all but three government programs: Social Security, Medicare and the Pentagon. As interest rates double, then triple, the interest owed annually will outstrip all other government spending.

At that point, the Red Queen will be unable to run fast enough to keep everything together and the government/system will default on its staggering debts. This is the inevitable endpoint.

Once the governments of the world can no longer borrow trillions of dollars to keep their economies afloat, then a new darkness descends on the global economy, one which might well last until about 2021-2023, when the entire system collapses--either in a managed fashion, if we're wise enough to foresee it, or in a chaotic jumble of war, famine and pandemic.

This would not be the first time, or even the tenth. Human nature dictates that our first and last reaction to unsustainable systems will be denial until the flood has swept away all hope of repairing the broken dikes.

Nonetheless, we must hope that if a mere 4% of the populace--the so-called Remnant--can engage 20% of their fellow citizens to peer past denial, then the Pareto Principle suggests those 20% will actively influence/lead the remaining 80%.

I found it interesting that President Obama has already identified the pressing need to rescue the middle class. Without a middle class, then government ceases to exist, because from the Roman Empire to the present, it is the middle class which pays the bulk of the taxes. The wealthy find waivers and exceptions via corruption and guile, while the poor pay little or nothing but extract much.

Even as Imperial Rome's borders and wealth gave way, 300,000 unemployed urban dwellers of Rome held bread tickets which entitled them to draw free rations from the government, and fully 175 days of the year were set aside for public shows.

This is the "bread and circuses" of terminal decline. Meanwhile, inflation caused by degradation of the currency (bronze coins replaced silver and gold) gutted the merchant and wealthy-farmer classes, and ever-rising burdensome taxes soon drove the remainder into penury. Enabled by bribe and corruption to escape the burdens of taxation, the wealthy elite grew ever richer, and lived on vast estates which were in essence small towns.

We have to be careful not to make too much of the Roman model, or indeed, any other template; we always live in unique times.

Thus I am wondering if the American middle class is crumbling for structural reasons even beyond taxation and government-sponsored degradation of the currency. As destructive as those forces most certainly are, I wonder if the "de-scaling" of the U.S. economy isn't the larger factor.

By "de-scaling" I mean the loss of large organizations capable of generating office towers full of people profitably manipulating information. Simply put: small businesses have no need for HR (human resources) managers, facilitators, project managers, coordinators, assistants to the second vice president of marketing, etc.

The entire edifice of "middle class jobs" depends on large-scale enterprises in need of massive bureaucratic management. The smaller the enterprise, the more actual productive work is done by everyone and the less essentially unproductive "managerial" and "reporting" work is done by anyone.

If we boil down management to its essence, it is this: trying to get recalcitrant workers to do their jobs efficiently while putting the best possible face on things to superiors via reports, meetings, balance sheets, etc.

But all this management requires stupendous sums of money to support. Interestingly, as the Roman Empire lost its grip, its many edicts to the crumbling provinces were largely ignored; without an Imperial presence to track and punish slackers and corrupt officials, then all the reports, demands and communications were essentially one-way: ignored.

Basking in the afterglow of 25 years of prosperity (as bogus as it might have been), we have perhaps forgotten that huge enterprises with all the layers of management beloved by business schools have vanished without a trace: DEC and Wang, to name but two.

In previous recessions, as corporations lost money, they were forced to either strip out layers of management via ESSA--eliminate, simplify, standardize and automate--or go under. It is now widely held that U.S. corporations are "lean and mean" after all this "flattening" of management, but for every reduction in overhead costs a new one has popped up: for instance, Sarbanes-Oxley (SOX), a vast system of costly reporting which was supposed to collar corporate malfeasance.

Instead, the greatest thievery has occured under the nose of SOX. It is in effect a gigantic unproductive tax on large enterprises.

Other regulatory "reporting" systems also exact a staggering toll on private enterprises, and most of it is never questioned: it is truly useful? Now that thousands of jobs depend on it, there is bureaucratic resistance to any trimming of regulatory reporting.

One way to get out from underneath such onerous bureaucratic systems is to leave the country or shut down all but a skeleton crew. Those with no understanding of private enterprise bemoan the loss of "good-paying American jobs" without looking at what it costs to maintain the overhead of the enterprise, never mind its actual production costs.

In general, if you want to pay an employee $50,000, the position will cost at least another $50,000 in overhead. To actually make a profit, the company needs to get $150,000 of value out of the employee whose salary is $50,000.

Thus a reduction in sales will quickly lead to the need to shed not just the salary but all the overhead costs: the medical insurance, the reporting, accounting, etc.

The Federal Government, of course, has no need to turn a profit, and being able to borrow or print unlimited sums of money gives it elbow room no other enterprise can afford. In other words, the regulators and edict-givers can continue to grow even as their tax base shrivels.

We are fast approaching the point, in my view, where global corporations will have only "show" staffs in the U.S. because there is simply no way to make a profit in a global Depression with a high-cost U.S. workforce and regulatory structure to serve.

Goliaths like IBM already have more non-U.S. employees than U.S. based employees, and there is absolutely nothing on the horizon to suggest this trend will reverse: as the government raises the cost of overhead with ever more edicts and regulations and taxes, the pressure to leave the U.S. entirely only increases.

We would do well to recall that businesses of all scales must make a profit; losses will eventually take them down. The higher their overhead, the more likely their demise.

On the other end of the scale, small businesses are like the provinces of the crumbling Empire: they mostly ignore the Imperial edicts because they have no choice financially but to do so.

This is the essence of why I have predicted the blossoming of the informal economy: once the costs of a "legitimate business" with all its reporting, overhead and taxes becomes too high to bear, the entrepreneur has no choice but to slip beneath the radar and work out of his/her home/garage.

The government, of course, will attempt to seek out and punish these miscreants, demanding they pay fines, licensing fees, meet various regulatory codes, etc. But an interesting feedback loop is now in play: the more government squeezes business via higher fees and taxes, the more business owners will simply give up/be driven bankrupt.

To reiterate: the higher the overhead burden, the likelier the bankruptcy. Once the overhead reaches a certain level, cutting staff isn't enough to bring expenses down to match shrinking revenues: as absurd as it sounds, the enterprise could lay off every single worker and still have expenses above revenues due to fixed overhead costs.

As these once-prosperous business close, the government collects less tax, and at least at the local level, eventually this loss of revenue crimps their ability to chase down those who have slid into the informal economy.

You see where this leads. At the global-enterprise scale, corporations will continue to downsize costly, high overhead U.S. offices and staff in favor of lower-cost, lower overhead workforces elsewhere. At the other end of the scale, small businesses will disappear by the tens of thousands, and entrepreneurs who once paid huge sums of rent, taxes, medical insurance, fees, etc. will no longer be paying anything but their own living expenses.

At some point, local government will have to face the reality that their expenses will have to be aligned with diminished revenues. The city of New York has some 330,000 employees (if I recall correctly). Perhaps the economy of the city can only support 250,000. Now the city can attempt, like the Roman Empire, to raise more revenues by taxing the remaining middle class.

But given that small business already faces very high overhead costs, the proper metaphor is a rowboat so heavily loaded that the waves are already lapping over its gunwales. It won't take much more weight to sink it, and right now we see local government desperately shoveling more weight into everyone's sinking rowboat: higher sales taxes, higher fees, and ever more edicts and penalties.

Is there any recognition that higher sales taxes, fees and taxes are not exactly incentives to buy more or start new businesses? Apparently not.

So what happens to "middle class jobs" as private enterprise is de-scaled at both the global-enterprise and small-business levels? They vanish. And as tax revenues plummet in a never-ending down-spiral, then local and state governments will face the same constraints as private enterprise: something has to give, and it can't be the guys and gals picking up the trash every week. It has to be the private drivers of the police captains, and all the other layers of essentially unproductive labor on the public payroll.

Sadly, there is little evidence that we recognize the danger of taxing and regulating the productive middle class out of existence. Instead, all the feedback loops are in place to hasten its crumbling.

Thank you, Geoff F. ($20) for your very generous contribution to this site. I am greatly honored by your support and readership.

Thank you, Christopher P. ($25) for your exceedingly generous donation to this site. I am greatly honored by your support and readership.

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