The Meritocracy Trap

by Daniel Markovits

  “a good general indicator of accumulated advantage”: Reeves, Dream Hoarders, 33.

  the middle-class/poor gaps: See Lindsay Owens, “Inequality in the United States: Understanding Inequality with Data,” presentation at Stanford Center on Poverty and Inequality, https://inequality.stanford.edu/sites/default/files/Inequality_SlideDeck.pdf. See also Centers for Disease Control and Prevention, Health, United States, 2010; Centers for Disease Control and Prevention, “Inadequate and Unhealthy Housing, 2007 and 2009,” Morbidity and Mortality Weekly Report 60 (Suppl.) (2011): 21–27; J. S. Schiller et al., “Summary Health Statistics for U.S. Adults: National Health Interview Survey, 2010,” Vital and Health Statistics 10, no. 252 (2012).

  the last two percentages are virtually identical: Of Americans with any college education, only 14.5 percent smoke, compared to 26.1 percent of Americans with a high school degree only and 25.1 percent of high school dropouts. See J. S. Schiller et al., “Summary Health Statistics for U.S. Adults: National Health Interview Survey, 2010,” Vital and Health Statistics 10, no. 252 (2012).

  also from the middle class: See Chapter 4.

  “telltale, visible sign of wealth”: See Mary Jordan and Kevin Sullivan, “The Painful Truth About Teeth: You Can Work Full Time but Not Have the Money to Fix Your Teeth—Visible Reminders of the Divide Between Rich and Poor,” Washington Post, May 13, 2017, accessed November 19, 2018, www.washingtonpost.com/sf/national/2017/05/13/the-painful-truth-about-teeth/?utm_term=.912ae5db0e89.

  continued to fall: See Case and Deaton, “Rising Morbidity,” 15078, 15080, Table 1.

  annual mortality declines: See Case and Deaton, “Rising Morbidity,” 15078, 15080, Table 1.

  for both men and women: Alan Smith and Federica Cocco, “The Huge Disparities in U.S. Life Expectancy in Five Charts,” Financial Times, January 27, 2017, accessed November 19, 2018, www.ft.com/content/80a76f38-e3be-11e6-8405-9e5580d6e5fb. Hereafter cited as Smith and Cocco, “The Huge Disparities.”

  (from four years to thirteen years): Smith and Cocco, “The Huge Disparities.”

  a high school degree only: For men, life expectancy at twenty-five is: BA or more—54.7 years; some college but no BA—52.2 years; high school degree only—50.6 years; no high school degree—47.9 years. For women, life expectancy at twenty-five is: BA or more—58.5 years; some college but no BA—57.4 years; high school degree only—56.4 years; no high school degree—53.4 years. More Education, Longer Life (Princeton, NJ: Robert Wood Johnson Foundation: Commission to Build a Healthier America, 2008).

  among the top 10 percent: See Saez and Zucman, “Wealth Inequality in the United States,” Appendix, Figures C11, C12.

  between the early 1980s and the mid-2000s: See Saez and Zucman, “Wealth Inequality in the United States,” Appendix, Figures C11, C12.

  now nearly six years: The Measure of America: HD Index and Supplemental Indicators by State, 2013–14 Dataset (Brooklyn, NY: Measure of America, 2014).

  between 2007 and 2011: See Sarah Jones and J. D. Vance, “The False Prophet of Blue America,” New Republic, November 17, 2016, accessed November 19, 2018, https://newrepublic.com/article/138717/jd-vance-false-prophet-blue-america.

  about four years: Hochschild, Strangers in Their Own Land, 8.

  by only the same amount: See Summers, “The Rich Have Advantages.”

  the flesh surrounds us with its own decisions: Philip Larkin, “Ignorance,” in The Whitsun Weddings (London: Faber & Faber, 1964).

  Chapter Eight: Snowball Inequality

  employment and growth in a consumer economy depend: The rich will never consume sufficiently to sustain demand, no matter how rich they are. As Keynes recognized long ago, the diminishing marginal utility of consumption entails that a person’s propensity to consume her income falls as her income rises. See generally John Maynard Keynes, The General Theory of Employment, Interest, and Money (London: Macmillan, 1936).

  expanding private borrowing: Economic modeling formalizes these intuitive connections. Models show that inequality increases the demand for credit and that loose credit can substitute for redistribution in stimulating aggregate demand and thus supporting employment and growth. See Christopher Brown, “Does Income Distribution Matter for Effective Demand? Evidence from the United States,” Review of Political Economy 163 (2004): 291–307, https://doi.org/10.1080/0953825042000225607.

  The rising volatility of middle-class households’ incomes (recall that even as median incomes stagnated, the odds that middle-class families would face significant financial reversals as much as doubled; see Chapter 5) further induced borrowing. See Tom Hertz, Understanding Mobility in America, Center for American Progress (April 26, 2006), 29, https://cdn.americanprogress.org/wpcontent/uploads/issues/2006/04/Hertz_MobilityAnalysis.pdf [inactive] (“Income security is rising for households in the top decile. For the middle class, however, an increase in income volatility has led to an increase in the frequency of large negative income shocks.”).

  As the year-by-year variation of a household’s income about its long-term average grows, the household will be increasingly attracted to debt. On the one hand, borrowed funds provide a rational mechanism for smoothing out the fluctuations in income and thus consumption. On the other, the financial strains associated with fluctuating incomes and financial reversals produce irrational borrowing, as any number of experimental studies associating scarcity and self-destructive borrowing reveal. See Benedict Carey, “Life in the Red,” New York Times, January 14, 2013, accessed November 19, 2018, www.nytimes.com/2013/01/15/science/in-debt-and-digging-deeper-to-find-relief.html; and Sendhil Mullainathan and Eldar Shafir, Scarcity: Why Having Too Little Means So Much (London: Allen Lane, 2013).

  ideologically opposed to outright redistribution: See Rajan, Fault Lines. This phenomenon also had an international and macroeconomic dimension. On the global savings glut, see Martin Wolf, The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis (London: Allen Lane, 2014).

  an almost actuarial logic: These observations attribute debt and financialization to deep structural—and in this sense necessary—features of social and economic arrangements. But contingency of course also played a role. For example, it mattered to the inflation of the housing bubble that it is not practicable to make money off falling house prices by selling short individual houses. It also mattered that the credit rating agencies failed remarkably to identify and publicize mortgage default risk: whereas fewer than 1 percent of all corporate bonds are typically rated AAA, at the height of the mortgage lending and securitization boom, roughly two-thirds of asset-backed securities achieved this rating. See Rajan, Fault Lines, 134.

  alongside other causes: Others included a change in how American companies paid for new ventures (shifting from using retained earnings to seeking outside capital) and a series of geopolitical developments (for example, the 1973 OPEC oil embargo and its effects on inflation and interest rates).

  Midcentury firms funded over 90 percent of their business investments from internal resources rather than new money raised on the capital markets. Fraser, Every Man a Speculator, 488. Today, by contrast, publicly traded firms retain only about 12 percent of their earnings and fund only 60 percent of their new expenditures and only 27 percent of “major” expenditures from past profits, a share that falls to just 15 percent when acquisitions are included. The retained earnings figure reflects retained earnings over net income. Data is for the S&P 500 for the period between 2005 and 2014. See Ralf Elsas, Mark J. Flannery, and Jon A. Garfinkel, “Financing Major Investments: Information About Capital Structure Decisions,” Review of Finance 18, no. 4 (July 2014): 1341–86. Prior eras of intensive financialization produced similar patterns, so that, for example, U.S. firms reinvested only 30 percent of their profits in 1929. See Fraser, Every Man a Speculator, 488.

  debt-financed middle-class consumption: This was the point of the famous “Greenspa
n put,” first issued in the late 1990s in the context of the dot-com bubble and then effectively renewed with respect to the housing bubble in the early 2000s and then again by the new Federal Reserve chair Ben Bernanke in the aftermath of the Great Recession. See Rajan, Fault Lines, 112–15.

  Even very conservative commentators object to this pattern, for example, calling it “bailout arbitrage,” which constituted “an implicit tax imposed by the predations of politically connected financial institutions.” The put, incidentally, kept paying out, as sophisticated financial institutions, having bet rightly that the public would socialize the losses from the housing crash, once again reaped private gains during the nascent housing recovery. Private investors have taken substantial stakes in distressed housing—in April 2013, for example, 68 percent of sales of distressed homes involved investor buyers (the private equity firm Blackstone, for example, owns twenty-six thousand homes in nine states) and only 19 percent involved first-time buyers seeking to occupy their own homes. For conservative commentators’ condemnations of the bailouts, see generally Posner and Weyl, “Against Casino Finance,” 68 (bailout arbitrage), 76 (implicit tax), and John O. McGinnis, “Innovation and Inequality,” National Affairs, no. 14 (Winter 2003): 135–48, 147 (“The too-big-to-fail regime that shields the financial sector has unfairly increased the incomes of some Americans by allowing them to ride to riches on a federal guarantee.”). For investor purchases of distressed homes, see Nathaniel Popper, “Behind the Rise in House Prices, Wall Street Buyers,” New York Times, June 3, 2013, accessed November 19, 2018, https://dealbook.nytimes.com/2013/06/03/behind-the-rise-in-house-prices-wall-street-buyers/.

  “financing strategies fueled by”: See Rajan, Fault Lines, 36. The quoted text comes from U.S. Department of Housing and Urban Development, The National Homeownership Strategy: Partners in the American Dream (May 1995), www.globalurban.org/National_Homeownership_Strategy.pdf.

  “address . . . financial barriers to homeownership”: See Rajan, Fault Lines, 36. The quoted text comes from U.S. Department of Housing and Urban Development, The National Homeownership Strategy: Partners in the American Dream (May 1995), www.globalurban.org/National_Homeownership_Strategy.pdf.

  “lack . . . cash available”: See Rajan, Fault Lines, 3. The quoted text comes from U.S. Department of Housing and Urban Development, The National Homeownership Strategy: Partners in the American Dream (May 1995), https://www.globalurban.org/National_Homeownership_Strategy.pdf.

  housing price appreciation: See Atif Mian and Amir Sufi, “House Prices, Home Equity-Based Borrowing, and the United States Household Leverage Crisis,” NBER Working Paper No. 15283 (August 2009), 1–2. See also Drennan, Income Inequality, 56.

  shift in wages from the middle to the top: See Michael Kumhof and Romain Rancière, “Inequality, Leverage and Crises,” IMF Working Paper no. 10/268 (2011); Robert Hockett and Daniel Dillon, “Income Inequality and Market Fragility: Some Empirics in the Political Economy of Finance,” North Carolina Banking Law Journal 18 (2013); Anant Thaker and Elizabeth Williamson, “Unequal and Unstable: The Relationship between Inequality and Financial Crises,” New America Foundation, Next Social Contract Initiative Policy Brief, January 2012; Fadhel Kaboub, Zdravka Todorova, and Luisa Fernandez, “Inequality-Led Financial Instability,” International Journal of Political Economy 39, no. 1 (2010): 3; Photis Lysandrou, “Global Inequality as One of the Root Causes of the Financial Crisis: A Suggested Explanation,” Economy and Society 40, no. 3 (2011): 323–44; and James Galbraith, Inequality and Instability: A Study of the World Economy Just Before the Great Crisis (Oxford: Oxford University Press, 2012).

  This effect is so powerful that it even operates between the several American states. A statistical analysis shows that each 1 percent fall in the share of total income captured by the bottom 80 percent of earners in a state is associated with a 0.2 percent increase in that state’s per capital household debt three years later. See Drennan, Income Inequality, 47.

  “The negative impact”: See Joseph Stiglitz, The Stiglitz Report: Reforming the International Monetary and Financial Systems in the Wake of the Global Crisis (New York: New Press, 2010), 24.

  roughly doubled since 1970: The financial sector accounted for 2.8 percent of GDP in 1950 and 8.3 percent at its peak, in 2006. See Philippon and Reshef, “Skill Biased Financial Development”; Greenwood and Sharfstein, “The Growth of Finance,” 3.

  attributable to manufacturing: Manufacturing now accounts for roughly 12 percent of GDP. See Yi Li Chien and Paul Morris, “Is U.S. Manufacturing Really Declining?,” On the Economy (blog), St. Louis Fed, April 11, 2017.

  became relatively more important: See Gross Domestic Product by Industry: First Quarter 2018, Bureau of Economic Analysis (2018), www.bea.gov/system/files/2018-07/gdpind118_3.pdf.

  its financing subsidiary, GMAC: See Steven Davidoff Solomon, “Profits in G.M.A.C. Bailout to Benefit Financiers, Not U.S.,” New York Times, August 21, 2012, accessed November 19, 2018. https://dealbook.nytimes.com/2012/08/21/profits-in-g-m-a-c-bailout-to-benefit-financiers-not-u-s/?_r=0. In 2010, GMAC rebranded itself as Ally Financial. See Ally, “History,” accessed January 27, 2019, www.ally.com/about/history/.

  swamped Main Street’s industrial production: Similarly, GE Capital came to control nearly three-quarters of General Electric’s assets. It grew so large that it was designated a systemically important financial institution and was spun off in 2015. See Ted Mann, “How Big Is GE Capital? It Depends,” Wall Street Journal, June 9, 2015, accessed November 19, 2018, www.wsj.com/articles/ge-uses-own-metric-to-value-its-finance-arms-assets-1433842205.

  contributed substantially to this facet of finance: See Greenwood and Sharfstein, “The Growth of Finance,” 17.

  output of the securities industry: See Greenwood and Sharfstein, “The Growth of Finance,” 7.

  between 2000 and 2008: Once again, mortgage securitization was so profitable that some Wall Street banks acquired lending institutions in order to secure for themselves a steady supply of new mortgages to securitize and trade. See Michael A. Santoro and Ronald J. Strauss, Wall Street Values: Business Ethics and the Global Financial Crisis (Cambridge: Cambridge University Press, 2012), 109–10.

  rising household borrowing: See Greenwood and Sharfstein, “The Growth of Finance,” 12.

  over this period: See Greenwood and Sharfstein, “The Growth of Finance,” 7.

  “rested on the housing market”: Rajan, Fault Lines, 6. Rajan continues to say that “new housing construction and existing housing sales provided jobs in construction, real estate brokerage, and finance, while rising house prices provided the home equity to refinance old loans and finance new consumption.”

  rested on economic inequality: International comparisons reinforce this domestic story. Economies that suffer from great economic inequality also display greater financialization. See David A. Zalewski and Charles J. Whalen, “Financialization and Economic Inequality,” Journal of Economic Issues 44, no. 3 (2010): 764–75.

  through the 1950s and 1960s: See David Kaiser, American Physics and the Cold War Bubble (Chicago: University of Chicago Press, in preparation). See more at http://web.mit.edu/dikaiser/www/CWB.html#CWBChapters.

  “science in the service of war”: Emanuel Derman, My Life as a Quant: Reflections on Physics and Finance (Hoboken, NJ: John Wiley & Sons, 2004), 4. Hereafter cited as Derman, My Life as a Quant.

  research dried up: Derman, My Life as a Quant, 4.

  found themselves without academic jobs: The number of physics PhDs produced by American universities, for example, surged in the 1950s and 1960s, peaked in 1970, and then collapsed, falling by over 40 percent by the early 1980s. It would not recover its 1970 level until roughly 2010. See Patrick Mulvey and Star Nicholson, “Trends in Physics PhDs,” American Institute of Physics, Focus On, February 2014, www.aip.org/sites/default/files/statistics/graduate/trendsphds-p-12.2.pdf. Fewer PhD students meant smaller physics d
epartments, and this meant fewer openings for new professors.

  absorbed the new super-skilled workforce: Derman, My Life as a Quant, 92.

  “that paid $150,000”: Derman, My Life as a Quant, 119.

  and then move on: Derman, My Life as a Quant, 123.

  “skilled mathematicians, modelers”: Derman, My Life as a Quant, 5.

  by implementing them: See William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” Journal of Finance 19, no. 3 (September 1964): 425–42, and Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy 81, no. 3 (1973): 637–54.

  measure and manipulate the odds in their wagers: F. N. David, Games, Gods and Gambling (Mineola, NY: Dover, 1998).

  the services they made possible: See generally Dan Awrey, “Toward a Supply-Side Theory of Financial Innovation,” Journal of Comparative Economics 41, no. 2 (2013): 401, and Donald MacKenzie, “Is Economics Performative? Option Theory and the Construction of Derivatives Markets,” paper presented in Tacoma, WA, June 25, 2005, who argues that financial models, and in particular Black-Scholes option pricing, shape financial markets.

  between just 1970 and 1982: For a list, see William L. Silber, “The Process of Financial Innovation,” American Economic Review 73, no. 2 (1983): 89 (listing thirty-eight innovative financial products developed from 1970 to 1982, ranging from “Debit Cards” and ATMs to “Interest Rate Futures”).

  For more on financial innovation in the period, see Merton Miller, “Financial Innovation: The Last Twenty Years and the Next,” Journal of Financial and Quantitative Analysis 21, no. 4 (December 1986): 459 (describing the financial “revolution” of the previous twenty years as having occurred largely due to reactions to regulation and taxes), and Peter Tufano, “Financial Innovation,” in The Handbook of Economics of Finance, ed. George Constantinides, Milton Harris, and René Stulz (Amsterdam: North Holland, 2003), 307 (exploring the history of financial innovation and the explanations given for the extensive amount of innovation seen in both the past and the present). The number of financial patents awarded annually has also increased starkly since midcentury, although changes in patent law confound efforts to read innovation directly off patent numbers. Financial patents remained relatively unused until the State Street decision in 1998. State Street Bank & Trust Co. v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998). (For instance, Bob Merton and Paul Samuelson did not patent their work on infinitely lived options in the 1960s.) After that, financial patents rose markedly until 2014, when the Supreme Court narrowed the availability of patents for such financial products in its Alice decision. Alice Corp. v. CLS Bank International, 134 S.Ct. 2347 (2014). See Adam B. Jaffe and Josh Lerner, Innovation and Its Discontents: How Our Broken Patent System Is Endangering Innovation and Progress, and What to Do About It (Princeton, NJ: Princeton University Press, 2011), 147.