Beyond changes in technology, product markets, and labor-market institutions, changes in financial institutions have helped to create wage stagnation and wage inequality.
Four parallel trends are notable:
- heightened focus on shareholder value,
- increased use of debt financing,
- deregulation of financial markets, and
- expansion of the financial-services sector.[1]
Shift to Shareholder Value
Under the forms of managerial capitalism that emerged out of the New Deal and were sustained in the Social Compact decades following WWII, corporations made money through investments in productive enterprises and the creation and realization of value through the management of labor, even in the context of increasingly global markets. Shareholder claims were important but not the only consideration in corporate decision-making. Corporate labor-relations negotiators and managers had considerable discretion to negotiate wages and benefits and create incentives for a productive workforce — necessary for long-term growth and profitability.
Today, an increasing proportion of the economy is organized around financial capitalism — where productive enterprises are viewed as bundles of assets to be reconfigured with the goal of maximizing financial returns. The focus of investment activities has shifted — from investing in productive, value-added enterprises to extracting money from companies for re-investment in higher-yielding activities.
As part of this new financial business model, power within corporations has shifted from labor relations and human resource executives to finance and other top executives who serve as agents of increasingly demanding financial markets.[2] Executives’ stated goal of maximizing shareholder value shifts the distribution of corporate profits from wage earners to shareholders. One way this goal is achieved is by lowering labor costs, which often translates into downward pressure on wages or wage stagnation at the bottom of the income distribution.
Reliance on Debt
The success of the new financial business model also has depended on greater use of debt financing among both financial and non-financial corporations (See picture, sectoral gross debt, 1974-2008.). According to agency theory, debt limits managers’ discretion and requires them to prioritize shareholder interests (Jensen 1986). Debt financing grew in the 1980s with the emergence of high-yield, so-called “junk” bonds that could be used to finance hostile corporate takeovers. Investors could band together to take over poorly performing companies and effectively discipline managers — creating a “market for corporate control” (Lazonick 1992). Corporate raiders could profit by buying conglomerates and selling their parts off to competitors, which they did on a large scale (Davis, 2009). These activities became possible as of 1982, due to Justice Department rules that facilitated intra-industry mergers and a Supreme Court decision that struck down state anti-takeover laws.
In addition, new institutional investors — mutual funds, trusts, insurance companies, and pension funds — began holding a larger share of corporate debt.[3] Because they are highly diversified (rarely holding more than 1 percent of a company), they are known to cause companies to pursue risky strategies (such as heavier debt) for higher returns. Higher debt interferes with cyclical-risk insurance for employees, e.g., via wage smoothing and job guarantees, and can endanger a firm when markets turn down. Institutional owners also press firms for a larger share of corporate resources, and, as a result, institutional activism statistically is associated with asset divestitures and with layoffs (Jacoby 2009). Laid-off workers suffer large and persistent reductions in earnings lasting up to 20 years or more, not only for those laid-off in recessions but also for those displaced during better economic periods (von Wachter, Song, and Manchester 2007).
Deregulation of Financial Markets
Deregulation of financial markets has helped create the institutional framework to support the new financial business model. Large institutional investors emerged as the result of a pension reform bill (ERISA, 1974, 1978) that allowed pension funds and insurance companies to hold shares of stock and risky bonds in their portfolios. Saving and loan banks (S&Ls) were allowed to hold junk bonds and invest in risky activities under the Garn-St. Germain Act of 1982. Reagan-era tax-law changes provided incentives for debt-financing over the use of retained earnings for investment, leading many to use retained earnings for stock buybacks to inflate the value of stocks and reward shareholders (Lazonick 2009; Sum and McLaughlin, 2010).
A series of banking-law reforms — culminating in the 1999 Gramm-Leach-Bliley Act (GLBA) — repealed the Glass-Steagall Act of 1933, thereby allowing all types of banks and insurance companies to consolidate into financial institutions with concentrated pools of capital. Investment banks were allowed to hold less capital in reserve, thereby facilitating greater use of leverage in trading activities (Lowenstein 2004, Sherman 2009). New financial instruments (such as credit-default swaps) and financial actors (hedge funds and private-equity funds) emerged and were explicitly exempted from regulation under the 2000 Commodity Futures Modernization Act.
As a result of these changes, one-third of the Fortune 500 were acquired or merged between 1980 and 2000. In almost every industry, the remaining firms restructured to focus on “core competencies” offering higher value-added for shareholders. They outsourced lower value-added activities to lower-cost U.S. subcontractors or overseas suppliers. In autos, for example, G.M. spun off its parts supplier into a separate entity, Delphi; and Ford did the same by creating Visteon. This process turned the largest employers into smaller ones — especially manufacturers that previously provided stable jobs with high wages and opportunities for mobility (Davis, 2009) — and created second- and third-tier jobs offering lower wages and benefits in supplier firms. These strategies were possible, in part, because of declining union power and a growing excess supply of blue-collar labor.
Growth of Financial Services
These changes also have led to dramatic growth in the size and income of the financial-services industry. Between 1947 and 2005, finance and insurance grew from 2.32 percent of U.S. GDP and 2.76 percent of employee compensation to 7.69 percent and 7.65 percent, respectively.[4] Their 2005 share of employment was 4.4 percent; and much of the growth of
total compensation reflected growth in compensation per employee, particularly since the early 1980s. The share of corporate profits captured by the sector also grew from 25.7 percent to 43 percent between 1973 and 2005 (Palley 2007:36).[5]
While it is impossible to assign a causal weight to the effects of the growth in the financial sector on wage determination or the distribution of income, clearly a disproportionate part of the productivity gains in the last 30 years has gone to the top 1 percent or less of the distribution, and this top 1 percent includes a disproportionate share of persons employed in the financial sector (Blair, 2010).
Dew-Becker Gordon estimates that 45 percent of the real-income gains went to the top 10 percent of wage and salary earners during 1966-2001, compared to 27 percent in 1966. Half of that increase went to the top 0.01 percent. The most recent data from Piketty and Saez find similar patterns and estimate that the income share of the top 1 percent of households stood at 10.2 percent in 1980 and 14.4 percent in 1990; 21.5 percent in 2000 and 21 percent in 2008.[6] This inequality has come under greater scrutiny since the financial collapse and the Great Recession.
The financial industries’ large profits and salaries corresponded with an increase in the industry’s influence on Congressional policy (Barley, 2010).[7] During the original Social Compact, such high salaries might have been criticized by an activist president and been constrained by the realization that similar demands would be put on union bargaining tables. In the 1980s, high compensation for bond traders and investment bankers and the dominant rhetoric that short-term alignment of executive and shareholder interests should dominate over all other considerations legitimatized the growing gap between the compensation of corporate CEOs and average workers.
NOTES
[1] See Batt and Appelbaum (2010) for a fuller discussion.
[2] Jacoby (2005) documented the significant differences in salaries of top financial- and human-resource executives in the U.S. in contrast to their relatively equal value in Japan.
[3] U.S. institutional investors in 1960 owned 12 percent of U.S. equities; by 1990 they owned 45 percent and the share rose to 61 percent in 2005. Institutions today own 68 percent of the 1,000 largest U.S. public corporations (Jacoby 2009).
[4] See Philippon (2007). In National Income and Product Accounts, there is no independent output measure for the finance and insurance industries. The industry’s share of GDP is largely determined by its compensation, which is predicated on the theory that an employee’s compensation represents his or her marginal product.
[5] Davis (2009). From a shareholder’s perspective, incentives should reward executives for share performance above average share performance in the industry. In practice, executives were often rewarded for all share-price increases even if competitors’ shares increased faster.
[6] Data downloaded from Emmanuel Saez website: http://www.econ.berkeley.edu/~saez/. These data are updated from Piketty and Saez (2003). The numbers in question come from Table A3 and represent income including capital gains.
[7] An example is Senator Charles Schumer, former chair of the Democratic Senatorial Campaign Committee, who speaks out often on income inequality but was unwilling to deal with the “carried interest” provisions that allowed hedge fund and private equity managers’ incomes to be taxed as capital gains, at particularly low rates. Hedge funds and private equity have been significant contributors to the Democratic Party. See Levy and Temin (2009) for additional examples.
Batt, Rosemary and Eileen Appelbaum. 2010. “Globalization, New Financial Actors, and Institutional Change: Reflections on the Legacy of LEST.” Paper presented at the Colloquium: Travail, Emploi et Competence dans la Mondialisation, LEST, Université de la Méditerranée, May 27-28.
Davis, Gerald F. 2009. Managed by the Markets: How Finance Re-shaped America. New York: Oxford University Press.
Jacoby, Sanford. 2005. The Embedded Corporation: Corporate Governance and Human Resource Management in Japan and the United States, Princeton: Princeton University Press.
Jacoby, Sanford. 2009. “Finance and Labor: Perspectives on Risk, Inequality, and Democracy” in Clair Brown, Barry Eichengreen, and Michael Reich, eds., Labor in the Era of Globalization. Cambridge: Cambridge University Press.
Levy, Frank and Peter Temin, (2009) “Institutions and Wages in Post-World War II America,” Chapter 1 in Brown, et. al., eds Labor in the Era of Globalization, Cambridge University Press.
Philippon, Thomas (2007), “Why has the U.S. Financial Sector Grown so Much? The Role of Corporate Finance.” NBER Working paper 13405.
Piketty, Thomas and Emmanuel Saez, "Income Inequality in the United States, 1913-1998” Quarterly Journal of Economics, 118(1), 2003, 1-39.
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