The “grand bargain” that has been the basis of the American economic system since 1913 is entering its end-game phase. What will replace the expiring order is unknown, but there are two substantially different substitutes that could emerge over the medium term. One is a return to the free market that existed before the institution of the progressive income tax and the Federal Reserve in 1913. This isn’t likely, given the weakness and inability of so-called conservative "leaders" to communicate ideas effectively. The other is a form of financial repression resulting in the kind of fascistic state seen in Venezuela. This is the more likely scenario, given President Obama’s mesmeric hold over the mainstream media, government employee unions and the burgeoning recipient class.
What is the “grand bargain” that has persisted in America for a hundred years? It is the unstated, but easily recognizable, agreement among the four economic divisions in the country (socio-economic “classes," if you like) that has directed America’s economy since Woodrow Wilson’s first days in office.
On one side of the bargain are two groups: (i) the financial elite, who control the political elite through billions in direct and indirect campaign contributions, and (ii) the recipients of government redistribution programs and policies. This recipient class includes (a) sixty-five million people (out of 315 million Americans) who collectively compose the bottom 50% of income earners, more than 90% of whom pay no income taxes, (b) more than seven million unionized government employees, (c) sixty-six million individuals on welfare (all forms, e.g., food stamps and Medicaid), (d) sixty-one million retirees receiving Social Security and Medicare and (e) crony-capitalist corporations, including, among many others, government contractors, agribusiness interests and too-big-to-fail financial institutions.
On the other side of the bargain are two distinct groups. The first is the “24 percent." They are the top 25 percent of income earners (thirty million people) minus the top 1 percent (about 1.4 million people), who are the earlier described financial elite. Unlike the top 1 percent, who derive most of their revenue from tax-advantaged forms of “unearned” income (including dividends, capital gains and untaxed municipal bond interest), the “24 percent” obtain the bulk of their income the old fashioned way—they earn it. It is the members of the “24 percent” who pay 50 percent of all income taxes, and they also operate most of America’s small businesses and employ a substantial majority of the non-unionized workers in the country.
The second group, joined at the financial hip with the “24 percent," is the middle 25 percent of income earners (approximately eighty million people), the quartile squeezed between the “24 percent” and the bottom 50 percent. For most of the last hundred years, these “middle class” members largely have seen themselves, or their children, as having upward mobility into the next higher income quartile.
What is the unstated agreement among America’s four socio-economic divisions? No group would “rock the boat” (at least so hard that the ship would capsize) so long as each group’s “trade-off” remained intact. What are these “trade-offs”? The financial elite (i.e., the “top 1 percent”) would pay significant income taxes (37 percent of all income taxes in 2010) so long as they called the tune to which the politicians danced. The “24 percent” would go along with the game, paying an outsized share of the taxes, so long as they could continue to accumulate material possessions and could see continued professional and business opportunities for their children. The middle 25 percent, including most of the successful first-generation immigrants, would cooperate as long as they could see the possibility of a decent retirement and increasing prospects for their offspring. The bottom 50 percent, government employees and retirees (collectively, the largest group—and often a voting majority, as was the case in the 2012 presidential election) would not topple the system as long as their transfer payments and government benefits continued to flow.
If it worked for a hundred years, why is the “grand bargain” now about to expire? Because it simply has become unsustainable. The top 1 percent have miscalculated. They have allowed their puppet politicians to increase the size of the recipient class too much and to increase the scope of government benefits too much. The country’s real productive economy (as distinguished from the nominal GDP, which includes increasing amounts of redistribution spending) no longer produces enough potential tax revenue to pay for the burgeoning welfare state. As a result, deficit spending and the Federal Reserve’s debt monetization (i.e., purchasing U.S. Treasury obligations that the market cannot absorb—currently more than half of all newly issued federal debt) increase at an ever-accelerating rate. That rate is so fast that now there is no “easy fix." With a full head of steam, the locomotive of government spending has derailed and is heading off the proverbial cliff. The U.S. dollar is following it to its ultimate devaluation.
Here are the specifics in a nutshell: Annual federal tax receipts from all sources are about $2.4 trillion. Annually, Social Security costs exceed $800 billion. Annual Medicare and Medicaid expenditures total about $800 billion. Defense spending and other national security spending total nearly $800 billion annually. Those three categories of expenditures consume all federal tax revenue. But with a $16 trillion national debt, annual interest is $220 billion. But that remarkably low figure for interest is the result of the Federal Reserve’s aggressive bond buying program, “Quantitative Easing”—in all of its permutations. If the Fed stopped or even slowed its purchase of Treasury issuances, interest rates on government debt would increase, materially increasing the interest that would have to be paid on the national debt. That means the U.S. will experience an annual structural deficit of more than $200 billion without including any of the other $1.1 trillion for which the Treasury writes checks every year.
With an aging population, meaning fewer paying into the system and more entitled to increasing payments out of the system, “something’s gotta give." What will “give” is the “grand bargain” to which the U.S. has become accustomed.
How will it give? As noted earlier, the new economic order has two likely alternative shapes. If people can be educated to understand that one steep, but relatively short-lived, depression can cleanse the system and begin a new era of prosperity, then a new free-market economy can rise out of the ashes of the soon to be old order. To get there, people would have to agree to delay substantially their receipt of retirement benefits (Social Security and Medicare); unionized government employees would have to accept Wisconsin-style limitations on public-union bargaining; federal regulations on business would have to be rolled back to Reagan-era rules; subsidies to businesses and farmers would have to be eliminated over a short phase-out period; oil and gas drilling on federal lands would have to be allowed to accelerate; the income tax would have to be amended substantially, either converted to a low-rate flat tax with few deductions (including the loss of the deductibility of home-mortgage interest) or scrapped entirely in favor of a national sales tax; the power of the Federal Reserve to create money out of thin air would have to be curtailed. In effect, Keynesian economics would have to be placed in the so-called dustbin of history.
Given the power of the media and the inability of the current generation of Americans to withstand even minimal pain, the more likely new order will be one of increasing financial repression. Federal expenditures will continue to increase. Remember, the spending under Obamacare “kicks in” on January 1, 2014. Even if Hollande-style taxation of the top 25 percent were instituted as in France, the annual deficit after 2014 still would equal nearly $1 trillion. The only way to finance that deficit, given foreigners’ increasing reluctance to purchase new U.S. Treasury emanations, is continued fiat money creation by the Fed and maintenance of a near-zero interest rate policy. Such money creation reduces the value of savings and cuts the income of retirees who depend on interest payments for their nonentitlement income. Inflation will accelerate, affecting those who spend significant amounts of their income on food and energy, lowering general living standards.
Venezuela is the latest country to blaze this trail. The United States, with a current political leadership that has prospered under the banner of class warfare and a political opposition that is best analogized to the gang that couldn’t shoot straight, may be destined to follow in Chavez’s footsteps—along the road to a new serfdom.
Jay Zawatsky is the CEO of havePower, LLC (a natural gas infrastructure developer) and a professor of business, economics and finance at Montgomery College in Rockville, Maryland.