This document discusses the state of the US economy and middle class. It notes that median household income has fallen in recent decades while income inequality has risen. This has squeezed the middle class, reducing their spending power and constraining economic growth. Low productivity growth has also held down wages. To revive the economy, the document argues for policies that boost innovation, education, and worker training to increase productivity and wages over the long run.

1. STEVEN KACZMAREK
GENE D. BALAS, CFA
631 574 2474
Info@EastEndWealthManagement.com
www.EastEndWealthManagement.org
February 2013
A S low Economy, the Middle C lass and New Ideas
Introduction
I
f one were a physician and the economy its patient,
before prescribing a prescription for its ills, the first
steps would be separating the disease from its symptoms
and identifying cause vs. effect. Certainly, a doctor might
ease the suffering from the symptoms. However, without
treating the underlying cause of the disorder, recovery may
be prolonged before health returns. We want to examine
the economic themes and the cause of slow growth and
clarify what catalysts exist to return the economy to a
higher long run trajectory of growth.
We all know the economy needs to grow faster;
otherwise, we will not be able to hire the unemployed,
reduce our federal budgets deficits or provide a social
safety net to the less fortunate. How we do that is the
trillion dollar question. Record low interest rates and
massive government spending have been tried, to little
avail. While they may have helped at the margins,
perhaps treating some of the symptoms, the root cause
of the disorder is of a more fundamental, deeper nature
that is resistant to these antibiotics. New, more powerful
medicines must be creatively considered, introducing
what has been lacking in political debates: education,
innovation and entrepreneurialism.
We can see these more fundamental issues manifest in
areas such as structural unemployment and low wage
gains. This argues for workers with different and better
training. We can point to decreased innovation in the
form of lower productivity enhancements. This is needed
to provide for both higher corporate profits and worker
wages simultaneously, instead of an either/or decision.
These factors explain why monetary policy and stimulus
spending programs have not delivered hoped-for results.
Let’s explore further.
The Long Term Decline of the Middle Class
On inauguration day, President Obama mentioned
revitalizing the middle class. We are glad that he has
taken notice. The middle class represents the biggest
component of consumer spending power in this country,
which in turn is the biggest component of the economy,
at around 70%. Since wealthy consumers tend to save
more of their incomes, and lower income consumers
don’t have as much spending power, we need a healthy
middle class for a healthy economy. A healthy middle
class is vital to a healthy economy for providing mobility
on America’s socioeconomic ladder and powering the
engine of consumer spending. Middle class consumers
buy more discretionary goods – which tend to provide
jobs – while spending by lower income consumers tend
to be more on basics, such as food, shelter, utilities and
energy, which tend not to provide additional jobs in areas
such as manufacturing.

2. While the economy has surpassed its prerecession peak
and is 16% larger than it was a decade ago in real terms,
real median household income fell by 5% from 2000 to
2009, according to Census data. Additionally, the median
household income of $51,006 is less than the median
household income in 1997, when it was $51,705. No
wonder why people in the typical American household
have felt they aren’t getting ahead. They aren’t.
The Pew Research Center cataloged the issues facing the
middle class in a report titled, “Fewer, Poorer, Gloomier:
The Lost Decade of the Middle Class.”
The middle class has also gotten smaller. Pew defines the
middle class as households with incomes from $39,418 to
The savings rate has fallen as consumers seek to maintain
spending while incomes are constrained, leading to the
deceiving portrait of an expanding consumer sector of
the economy. Without growing incomes, spending per
household cannot grow by much, and total spending is
only supported by household creation and credit, not
growing household incomes.
Consumption patterns can shift as well. Middle class
consumers tend to be, well, consumers. A bigger middle
class with growing middle class household incomes means
a stronger economy than our reality of a growing upper
class with shrinking upper-income household incomes.
Share of the Population
Share of National Income
100%
90%
100%
14%
20%
90%
80%
70%
29%
80%
70%
60%
Upper
61%
50%
52%
Middle
Lower
46%
60%
50%
40%
40%
30%
62%
30%
20%
20%
10%
0%
45%
25%
29%
10%
0%
1970
2011
$118,255 in 2010. With that definition, the middle class
constituted 51% of all adults in 2011, down from 61% in
1970. The middle income tier commanded 45% of the
nation’s income in 2011, down from 62% from 1970.
Some have moved up, others have moved down. The
upper income tier rose to 20% of all adults in 2011 from
14% in 1970, whereas the lower income tier increased to
29% of the adult population, up from 25%. The upper
income tier takes in 46% of national income, up from
29%, while the share of national income going to the
lower tier was 9%, down from 10% four decades prior.
Thus, the nation has become more polarized for income
and wealth distribution.
What does this mean for economic growth going
forward? From 2000 to 2010, the median income of all
three groups fell: lower-income households’ income fell
by 8% (not annualized), middle-income households lost
5%, and upper-income households’ income decreased by
6%.
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10%
9%
1970
2011
Consumers’ Reaction
and Speculation
to Stagnant
Wages: Debt
Over the past decade and a half, consumers have responded
to a lack of wage growth by turning to gambling in the
financial and housing markets to augment their spending
power: following the herd in not one, but two, asset
bubbles and accumulation of excessive debt.
In the past, up to the recent recession, consumers
were able, at least initially, to buoy their spending by
speculation in the equity markets. From 2000 to 2002,
when the tech wreck occurred, we should have learned
our lesson. Historians may well be puzzled why, just a
few years later, we had yet another desperate attempt
to manufacture “transactional” wealth with no input of
capital, labor or innovation.
There was the debt boom, much of it associated with
the housing bubble, but much of it not, predating the
mortgage boom.
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3. From the 1980s up to 2000, the savings rate steadily fell
– even as the population continued to age – and it became
apparent that stagnant incomes were supplemented with
consumer debt to maintain spending. Up to this point in
2000, baby boomers weren’t yet retiring in large numbers,
but still, the savings rate might not have been sufficient
to both pay down that debt and save for retirement. A
logical action would be for households to maintain more
moderate spending, increasing the savings rate and
decreasing debt as retirement approached as the Baby
Boomer generation aged.
Instead, household debt as a percentage of disposable
incomes increased again. From the levels that prevailed
from the mid-1960s to the 1980s, consumer debt was
around 65% of household disposable incomes. It increased
to 100% by 2000, and then by another 40%, from 2000
to 2007, to reach a bit under 140% of disposable incomes
at the peak of the housing bubble. The savings rate fell
even further – even dipping to nearly zero during the
peak of housing mania – and cash-out refinancings and
capital gain proceeds were used to fund consumption.
In the old adage, what is unsustainable always ends, and
usually ends badly, the debt levels were unsustainable,
and foreclosures and bankruptcies mounted. This tipped
the economy into a deep recession and the bad debts
triggered a massive financial crisis.
As we heal from the financial crisis in the U.S. (we’ll
conveniently ignore Europe, as our focus is on the U.S.
consumer), household debt servicing ratios have returned
to more sustainable levels. Much of this was through
defaults, not diligence. So, even though households, in
aggregate, have reduced debt, those with credit histories
scarred by defaults or delinquencies may not regain
access to credit in the near term to begin to spend again
on credit.
Even those with good credit may find it necessary to save
more for retirement, as the country ages. Data show that
the majority of Americans have insufficient funds for
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retirement. Whether due to a lack of access to credit, a
need to save for retirement or paltry income gains, many
households, particularly the middle class, may find it
difficult to accomplish the above goals while increasing
consumer spending by a significant amount. The squeeze
is on.
The Economic Growth Impasse
Why is the middle class squeezed? Low household income
growth inhibits household spending growth, and that in
turn limits corporate revenue improvements. This leads
to businesses holding the rein on pay raises to maintain
corporate profits, leaving workers with few wage gains.
The cycle then starts anew. That is the simple narrative.
What we know from Census data is that the real median
hourly wage has increased by an average annual 0.6%
from 1990 through 2010. (This is adjusted for inflation.)
The past ten years show a similar trend, with hourly pay
increasing by just 0.7% in real terms on an average annual
basis. Certainly, it is hard for individual consumers
to spend more when they are not earning more, and
these statistics are only for people who are working.
Household income, as we discussed, has not increased
reflecting smaller percentage of the population working.
Aggregate consumer spending has grown faster than this
rate for individual households in the past couple decades,
but that is because the population is growing and people
have been saving less and borrowing more. So, a lack of
income gains has been vexing both individual workers
and households for a long time.
Corporate Profits Surge
At the same time, corporate profits have risen to record
highs as a percentage of the economy while wages as a
percent of GDP fell in tandem, so we might be inclined
to blame “greedy” employers. But it is simplistic to think
that employers are necessarily the primary culprit, due to
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4. a supposed profit motive that deprives workers of wage
increases. After all, corporate profitability depends in
large part on maintaining a talented workforce.
The Role of Education
Innovation: The Role of Productivity
A byproduct of education is innovation, which is itself a
force in economic development. Investments in research
and development, coupled with a sufficiently educated
and creative workforce, can turn ideas into economic
results. This can both enhance productivity and lead to
entirely new industries.
Unemployment Rate (%)
Employers do value talent: Education matters when
it comes to unemployment, wages and income growth
and more Americans are pursuing higher education.
First, though, what do we mean by productivity gains,
Americans age 25 and over with a college degree have an
anyway? Is it a worker producing ever more toasters on
unemployment rate of just 3.7%, while 8.1% of those with
an assembly line? No, it is sometimes disruptive new
just a high school diploma are unemployed. For thoese
technologies that can enable companies to increase
without a high school diploma, the unemployment rate
output with the same
is 12.0%, data from
Unemployment Rates by Education Level
inputs of labor. Think
the Bureau of Labor
For Adults Age 25 and Over
14
of how the internet
Statistics show.
remade how we shop,
12.0%
12
Which fields one
bank, travel and
pursues
matter,
obtain information.
10
too. Consider that
Then
think
of
unemployment rates
the jobs that were
8.1%
8
for recent graduates
created – and lost –
in healthcare and
as companies that
6
education are 5.4%
operate on the web
compared to 9.4% for
became prolific while
3.7%
4
people who majored
other jobs, whether
in humanities and the
travel agents or sales
2
liberal arts. To look at
clerks,
receded.
it differently, median
Consider how much
0
earnings among recent
more productive we,
Without HS Diploma
HS Diploma, no College
College Degree
college graduates vary
as a society, became
from $55,000 among
when
businesses
engineering majors to $30,000 in the arts. Our economic
could automate functions or perform other tasks more
growth hinges on our entire population’s collective
quickly.
decisions and the majority of our children are taking
That didn’t happen without some investment. Computer
the less arduous path of liberal arts rather than Science,
servers needed to be bought, self-service retail checkouts
Technology, Engineering and Math.
needed to be installed. Expensive robotic assemblies at
The government could make it easier for people to pursue
manufacturers needed different – and fewer – workers
higher education, perhaps by supporting retraining
to operate them. These all were the makings of higher
efforts as part of the unemployment insurance program.
output with the same, or less, hours of labor. Simply
Such models exist in certain countries in Europe, like
witness the fact that we’ve already exceeded total output,
Germany, where companies receive a subsidy to hire
as measured by GDP, from before the recession, but with
and train new workers. Rather than pay people to stay
millions of fewer workers.
unemployed, the government could pay employers a
The dilemma is how the labor force adapts to these
similar amount to hire and train those people. We might
innovations – and even participates in creating them
borrow some ideas that have succeeded elsewhere to use
– without being left behind. These new technologies
here.
might drive economic growth, but disrupt livelihoods
in the process. There are, after all, very few stagecoach
manufacturers left in the world. Nor are railroads among
the biggest employers either, for that matter.
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5. However, one economic theory is that business cycles
are caused, at least in part, by technology introductions
and their resultant impact on productivity, termed the
real business cycle theory. Researchers at the Chicago
Fed recently documented this relationship. Beginning in
1973, low rates of productivity gains were associated with
a moribund economy in the 1970s. Then, beginning in
the early 1980s, productivity began to grow, modestly at
first, and economic growth responded upwards in turn. In
the mid-1990s, productivity growth took off coinciding
with the tech and internet boom, and we had a booming
economy.
After 2004, however, productivity growth diminished
remarkably – as did the typical worker’s income – and
our economic growth would have slowed markedly
absent debt-fueled consumer spending just prior to the
recession. This slowdown in productivity gains predated
the recession, and while the recession was caused by
other factors, our slow recovery may relate to lessened
productivity gains. Historically, companies have shared
productivity gains with their employees by providing pay
raises. Increasingly, companies are using productivity
gains to enhance profitability, sharing less with
workers, given a large supply of labor and competition
for jobs. Increasingly, companies share gains directly
with shareholders thru stock repurchases and special
dividends.
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Regardless of why it ebbs and flows, productivity gains
help to determine the “speed limit” of the economy.
Basically, potential economic growth can be thought of
as productivity gains plus growth of the labor force and
capital introductions. If the economy grows faster than
this rate, inflation can result as bottlenecks emerge from
more demand for labor and capital than the economy can
provide. Right now, inflation (aside from food and fuel,
which are dictated by forces of nature) is unlikely to be a
problem because of a large excess capacity of both capital
and labor.
Our interest, though, is where economic growth is likely
to converge over time, so let’s explore the economy’s
longer term potential. Growth of the labor force can
be influenced by many things including, birth rates,
immigration and demographics. It can also be impacted
by how many people decide to seek, or not seek, a job.
What interests us, in particular, are productivity gains.
When productivity is high, corporate profits tend to
increase, and companies may share some of those income
gains with their workers. That can increase economic
growth.
Going a step further of what influences productivity gains
is business’ investment in new technology or equipment.
This is what will allow companies to produce more for each
hour of labor. Unfortunately, those investments haven’t
recovered ground lost during the recession. Consider
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6. some of the preceding graphs, indicating lower business
investment in certain capital expenditure categories:
homes. However, a home, once built, provides no new
jobs.
Orders for machinery have rebounded as manufacturing
has enjoyed a renaissance of sorts. However, those
things which make businesses more productive, like
communications equipment, computers and electronic
components, have seen a systematic drop in new orders.
These investments have not recovered completely since
the recession, and the wide ranging services industries
use these to enhance productivity gains.
If the government were to support new business formation
the way it does homeownership, we would likely have
more jobs created. Instead, the government provides
comparably little support for new businesses. Yes, many
new businesses don’t succeed, but some of them turn into
the next Facebook, a multibillion dollar company that is
less than a decade old.
When businesses make fewer investments into equipment
and software, it means a couple of things. One is that
businesses might be more cautious about the future, as
we see now with the fiscal cliff. Another is that companies
have chosen to boost their share prices through stock
repurchases, returning cash to shareholders rather than
making further investments in their own companies. This
can increase earnings per share artificially through fewer
shares, not necessarily more earnings or even revenues.
Since these trends have been in place since the end of the
recession, it also means that businesses might not expect
their output to grow as fast as it had in years past. When
businesses don’t expect output to grow as fast, it becomes
a self-fulfilling prophecy. The reasons for these lowered
expectations are complex, and relate to the many wellpublicized headwinds the economy faces. Lower business
investment is both a cause and effect of slower growth
expectations.
So when policymakers confer to address monetary policy
or consider the effectiveness of previous rounds of fiscal
stimulus and wonder why the economy is still growing
sluggishly, perhaps a large-scale productivity shock is what
we need instead. That, however, is a difficult proposition,
as one cannot simply create the “next internet” just by
lawmakers’ decree or a Fed decision. Instead, the “next
internet” will likely be produced by private industry,
but policymakers must nurture it along without killing
it with excessive regulation. Government could foster
new ideas by helping new businesses form and by easing
regulatory burdens.
Entrepreneurs Provide Innovation
The U.S. provides tremendous support to the goal of
home ownership, such as through the creation of Fannie
Mae and Freddie Mac, as well as providing a mortgage
interest tax deduction. Meanwhile, the Federal Reserve
is buying vast quantities of home mortgage securities
to depress mortgage rates to allow more people to buy
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The government can also rethink regulation. Much of it
is onerous and hinders business creation and thus, job
formation. Of course, there is a reason for some regulation,
to keep our employees, customers and environment safe.
However, unnecessary hurdles for businesses to clear,
aside from public or worker safety, keep many would-be
entrepreneurs from starting their own company.
Small businesses that do succeed often do so because
they have new ideas. Those new ideas are what provides
them a profit, pays their employees, and benefits society.
While many big businesses do have large research and
development labs that lead to patents, individuals with
big ideas need to be nurtured, too. And that is where
policymakers can lend a helping hand. New businesses
and new ideas often lead to new technologies and perhaps
even new industries.
Innovation Leads to New Industries
In that vein, innovation, whether it comes from
entrepreneurs, academia or a large corporation isn’t just
about improving productivity; it can produce entirely new
industries. One example is related to shale oil and natural
gas extraction, or fracking, and that can lead to new jobs in
different fields, revitalizing regions of the country where
fracking is being deployed. Along with other petroleum
extraction, such as oil sands in the Dakotas, the U.S.
can perhaps achieve energy independence and may even
become a net petroleum exporter. Pipeline construction
from these sites, and possibly Canada, can provide for
jobs and budding industries all along the construction
routes. Retooling truck fleets to run on natural gas would
also increase our energy independence.
It is early, and we don’t know the full potential of America’s
new energy industry revolution. We do have to address
potential environmental concerns that some lawmakers
(and their voters) might have. We don’t know how many
jobs this might provide yet. Still, it is an excellent example
of how new industries can develop from new technologies
that spring from innovation. This is how education begets
innovation, which in turn begets new industries and jobs.
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7. Conclusion and Investment Themes
In the meantime, we believe the economy will grow
only moderately, at a rate insufficient to reduce
unemployment substantially as the population grows
in tandem. Remember that in the long run, economic
growth is dependent on growth of the labor force plus
productivity gains. If we assume that productivity gains
may be underwhelming, and the labor force is not quite
adapted to the needs of employers, our potential growth
rate now may be less than it once was. Perhaps 2% is the
new normal.
There are however, plenty of reasons to be optimistic.
America is a country of innovators and entrepreneurs;
we just need a way to foster the transition of a new idea
into new technology or a new industry. We need to invest
more in education so that we have a talented workforce
and innovative entrepreneurs able to translate an idea into
jobs. Policymakers can start by helping new businesses
form and by reducing unnecessary regulations. These are
entirely doable action items. If we can educate our youth
and encourage innovation, we can help our economy grow.
For more information on East End Wealth Management please visit our website: www.eastendwealthmanagement.org
Our most recent performance results through January 2013 are located here.
This information is intended to describe a general investment strategy and is not a recommendation to buy or sell any specific securities. The
strategy discussed does not and should not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of
an account’s portfolio holdings. Any investment carries risk, including the loss of principal. Any investment strategy discussed here or available
through East End Wealth Management is not an obligation of a bank and is not guaranteed by the FDIC and may lose money. Some investments are
not suitable for all investors. Past performance is not indicative of future results. We cannot guarantee that this information is accurate or complete.
As with any investment strategy, you should thoroughly discuss your particular investment situation and with your financial representative and
understand any investment recommendation that might be made before investing any money.
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Management only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements.
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8. B iographies
STEVEN KACZMAREK
Steve is the President of East End Wealth Management. He has over 30 years of experience in trading and risk
management in a wide range of markets. Most recently, Steve held the position of Managing Director at Legend
Merchant Group. His background also includes the positions of Partner at Schonfeld Securities; a proprietary trading
firm, NYMEX floor trader and Lieutenant, United States Army Reserve. Steve graduated New York University with a
degree in Economics.
As an active member of the investing, planning and trading community, Steve is a member of NAIFA and the Financial
Planning Association. Locally, he is the Chairman of the Southampton Youth Board, focused on youth issues on the
East End of Long Island.
gene d. balas, cfa
Balas has over twenty years’ experience in investment management. He currently writes economic commentary for
TheStreet.com’s RealMoney site. Previously, he was Director of Investments at Genworth Financial Asset
Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of
thematic drivers to develop investment strategy, He also headed the firm’s manager due diligence efforts. Prior to
GFAM, Gene was Director, Investment Management & Guidance at Merrill Lynch & Co. In that role, he advised
pension funds, endowments and foundations as to appropriate asset allocation strategy. In previous roles, he advised
both institutional and individual investors on asset allocation and manager selection decisions, beginning his career in
1989. He has an MBA from Columbia Business School and a BBA in Finance from the University of Houston, where
he attended on a full National Merit scholarship. He is a Chartered Financial Analyst.
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