Issue #5, Summer 2007

Broken Contract

It’s time policymakers recognize that in the new global economy, growth and economic security go hand in hand.

For the first time in its history, America is in danger of breaking its quintessential economic promise: that with hard work and education, each generation will have the opportunity to do better than the one that preceded it. Many Americans sense this danger: According to two polls taken in recent years, a majority are “worried and concerned” about reaching their economic goals and believe that their children will be worse off than they are. Their anxiety is understandable. Despite strong macroeconomic performance, many workers today are not fully sharing in the prosperity of the new global economy and must cope with growing levels of economic risk.

Some on the right continue to respond to these troubling economic trends by arguing that unfettered free markets always produce the best of all possible outcomes and denying that insecurity and inequality are much of a problem. Others, predominantly on the left, argue that the global economy is the ineluctable enemy of the average American worker and that the only way to improve his or her lot is to turn inward and place various government requirements and limitations on industry. But both views are misguided, and they ignore the fact that the disruptive forces of the twenty-first century global economy are both a blessing and a curse. These forces bring substantial economic benefits to American families, but they can also cause real economic difficulties. It would be short-sighted to forgo such potential gains, but it would also be unjust and unwise to reject efforts to shore up the social safety net for fear of interfering with market forces.

Rather, what is needed is a new model that acknowledges the two-sided reality of the twenty-first-century economy. Such a model should be guided by an understanding that economic growth is stronger and more sustainable when that growth is broadly shared, and that a robust yet well-tailored government role is necessary both to correct for the market’s limitations and to enhance economic security. As the employer-based system for providing economic security comes under increasing strain from the forces of global competition, this model would not strive to prop up outdated arrangements, but rather it would be built on a new and sustainable social compact among individuals, corporations, and government. Individuals would take primary responsibility for their own economic security and accept certain mandates and default arrangements, but they could rely on employers and government to help manage economic risks that they could not manage alone. Employers would continue to play an important role in facilitating the provision of benefits and paying for a portion of their cost but would not provide such benefits directly. And government would not only set the rules that shape private sector and individual efforts to manage risk but would also serve as the ultimate guarantor of a basic level of economic security. Such a New Social Compact would help American workers manage the risks of the twenty-first century economy, while also sharing in its prosperity.

The Era of Growing Economic Insecurity

Americans’ increasing insecurity about their economic futures is a reflection of two worrisome, and by now familiar, trends. First, American families face greater economic risks and lack adequate safety nets during periods of hardship. Second, the nature of economic growth today is far less broad-based than has been the case throughout American history; most Americans’ wages have been stagnant while the inequality gap has widened enormously.

American workers face greater insecurity because many economic risks have been shifted onto individuals and away from employers and the public sector–a shift that the Economic Policy Institute’s Jared Bernstein has labeled “you’re on your own economics.” Proponents of this approach call for policies that rely almost exclusively on the putative benefits of individual incentives, such as reduced marginal tax rates. They pay little attention to market imperfections and limitations–such as those that result from costly and limited information–or to the reality of individual decision-making, which can differ significantly from the perfectly rational behavior assumed in classical economics. They also ignore the absence of markets for various types of insurance, the fact that markets may not provide merit goods (such as health care) to the degree that society demands, and sometimes even the fact that government must set the rules under which markets operate. And “you’re on your own” advocates fail to realize that their approach can result in significant disparities in economic outcomes, even among those who invest in their education, work hard, and plan prudently for the future. Under a “you’re on your own” approach to economics, those who suffer unforeseen hardship may simply be left behind, while improving economic performance is simply a matter of getting government out of the way.

The embrace of this approach in recent years, coming at the same time that the employer-based benefit model is deteriorating, has resulted in growing individual risk associated with such challenges as health care, retirement security, and job loss. Let’s start with the most urgent source of economic insecurity for many families: health care. As the cost of health insurance premiums has risen–from 8 percent of median family income in 1987 to 17 percent in 2003–fewer firms are offering health insurance, leaving more Americans to fend for themselves. The share of the population with employer-provided health coverage declined from 64 percent in 2000 to 60 percent in 2005. Even firms that have not cut back on their health benefits have shifted the cost of rising premiums to employees in the form of reduced wage growth.

American families also face new uncertainties regarding their pensions, as American businesses move from defined-benefit toward defined-contribution retirement plans. In 1980, more than one-third of private workers were covered by a defined-benefit plan; by 2002, it was only about one-fifth. At the same time, defined-contribution plans have become much more common. In some ways, these plans are advantageous; for example, they provide for a potentially higher rate of return while promoting choice, ownership, and control, which some workers prefer and that may be more compatible with an economy in which people change jobs more frequently. But defined-contribution plans also have significant drawbacks: Increased risk for workers comes with the potential for greater returns. In addition, the plans are voluntary, mostly relying on worker contributions, and workers often fail to enroll.

What’s more, for American workers who lose their jobs, the average (and median) duration of unemployment has increased, while unemployment insurance is doing less to cushion the blow of job loss. The Government Accountability Office (GAO) found that, in part due to tighter state eligibility requirements, the fraction of unemployed workers who received unemployment insurance benefits fell each decade from about 50 percent in the 1950s to about 35 percent in the 1990s. Unemployed low-wage workers are particularly unlikely to receive benefits.

Underlying all of this is the rapid pace of globalization. Although a variety of academic analyses have shown that trade has played only a modest role in domestic job loss and rising inequality, trade can cause painful and highly visible job dislocations for workers in particular industries, even while it is a net economic benefit. This has heightened anxiety about competition from countries like China and India, which is increasingly targeted at high-skill as well as low-skill jobs. Indeed, a recent poll in Foreign Affairs suggests that almost nine out of 10 workers worry about their jobs going offshore. And, while noting that relatively few jobs have been lost to offshoring to date, Princeton economist Alan Blinder finds such anxiety warranted in the long run, estimating that 22 to 29 percent of all U.S. jobs may be at risk of offshoring in a decade or two, a fact that greatly magnifies its political impact.

In addition to greater economic risks, levels of household income volatility are high, even as macroeconomic fluctuations in gross domestic product (GDP) and unemployment have declined relative to previous decades. As a result, families face a significant risk of suffering a precipitous drop in their incomes (as well as the possibility of a rise in income, to be sure). According to the Congressional Budget Office (CBO), between 2002 and 2003 about one in five workers saw their earnings fall by 25 percent and about one in seven saw their earnings fall by more than 50 percent (roughly the same shares that saw their earnings rise by those percentages). And though further research is needed about the trend, there is evidence that levels of income volatility have risen over the past several decades as a percentage of household income.

Finally, the insecurity of American workers is also explained by the nature of economic growth today, which is no longer broadly shared among all Americans, as it was for most of our nation’s history. Whereas growth in productivity and real median family income roughly tracked each other between 1947 and 1973, those trends have since diverged. Instead, the gains of economic growth have gone largely to those at the top, resulting in a stunning rise in inequality. The share of the nation’s income going to the top 10 percent was higher in 2005 than at any point since before 1941. As former Treasury Secretary Lawrence Summers recently told Congress, “In 1979 the top 1 percent of the population earned as much as the bottom 27 percent combined; by 2004, the figure was 46 percent.” The tax cuts of 2001 and 2003 have exacerbated the problem, making the after-tax distribution of income even more unequal–when fully in effect, the tax cuts will increase the after-tax incomes of the top 20 percent by 4.6 percent (and the top 1 percent by 6.8 percent), compared with a 0.5 percent increase for the bottom 20 percent of the income distribution.

The Pitfalls of Insurance

Many of these sources of economic insecurity are beyond the ability of most people to control on their own. People generally manage economic risk through the purchase of insurance, and conservatives have often argued that the market, specifically private insurance of all types, can thus help people weather economic storms. But such optimism ignores several imperfections in the nature of an insurance market.

Perhaps the most significant imperfection is that asymmetric information leads to adverse selection. To take the most obvious example, no sensible firm would sell unemployment insurance in the private market, because the individual knows much more than the insurance company about whether he or she is about to get fired. Similarly, health insurance is often prohibitively expensive when individuals purchase it directly from an insurance company. Because individuals tend to know more about their own health than do insurance companies, the people most likely to find the products financially beneficial will be those with more health risks. Recognizing this, insurance companies will increase the price of the product. The increased price causes a few more individuals to decide the insurance is not worth it, and the pool of people who find the product financially beneficial shrinks even further to include those with even more health risks. The resulting downward spiral means that private markets do not function effectively for many households. For this reason, an effective risk pool needs to be one created around a criterion other than the need to purchase health insurance, such as employment at a company or membership in a union (which is why employer-based insurance has worked relatively well in this regard).

What’s more, some individuals simply do not adequately insure themselves against economic risks, saving too little for retirement, illness, or short-term bouts of unemployment. Notwithstanding what economists view as rational, utility-maximizing behavior, we know from recent work in behavioral economics–the study of how real people actually make choices–that such rationality is far from universal in practice.

Progressives, by contrast, have traditionally recognized the limits of private insurance and addressed them with social insurance programs that include everyone in the risk pool. And through the combination of social insurance and employer-based benefits, government and the private sector together have provided American families with key forms of economic security for decades. However, this model is growing less and less tenable. In the face of growing competitive pressures, American firms are increasingly retreating from their role as a provider of social benefits. What is needed in response is a rebalancing of responsibilities among government, the private sector, and individuals to provide both economic security and economic growth.

Economic Security and Economic Growth

To be sure, many policymakers and analysts, on both sides of the ideological spectrum, have been trained to believe that providing more security to families must come at the expense of economic performance and that these two goals are thus contradictory objectives. Harvard economist and former Chairman of Ronald Reagan’s Council of Economic Advisers Martin Feldstein, for example, has said that social insurance programs “have substantial undesirable effects on incentives and therefore on economic performance. Unemployment insurance programs raise unemployment. Retirement pensions induce earlier retirement and depress saving. And health insurance programs increase medical costs.” Economist Arthur Okun famously compared using government funds for social programs to a “leaky bucket” because so much is lost in the process of delivering the benefit.

While this traditional view offers an important cautionary note, it misses another salient point about the modern economy: While economic growth can clearly increase economic security, economic security can also increase economic growth. Indeed, growing economic insecurity for American families takes a toll on the economy as a whole and thus leads to a vicious cycle. Insecurity impairs overall growth, which thus increases the likelihood that the stagnation in real median wages will persist, which in turn exacerbates the economic insecurity that American families face.

Issue #5, Summer 2007
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Douglass Camichael:

The "contract", old and new, is described more as an engineering problem than a societal one. Such a small number of variables. Left out are the environment, the dwindling leverage of the US, energy costs, land use, and the narrowing range of jobs available in large numbers for large numbers. The goal of this engineering is to maintain growth.

The approach does the old trick of getting us to look at interventions as bad MARKET interventions. In fact markets probably do well when free. But CAPITAL and corporations exist to try to manage competition and represent control - in particular to control markets. The market principles and capital principles are at odds with each other, not in harmony.

The approach here seems aimed at maintaining growth above all, and has no analysis of who benefits from growth. Brokers and finance capital movers primarily. the rest of us can get by with low growth, providing we have adequate distribution.

This kind of article is an attempt to maintain control of the dialog in order to maintain growth. It is insensitive to what is happening to real people, the real reasons why we are getting income and wealth concentration, and is dumb to the problems of energy and environment.

Not the basis for a democratic or progressive - or honest -politics. Its narrowness hints at the severe filter through which the argument has had to pass.

Jul 4, 2007, 4:49 PM

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