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A History Lesson On The Income Gap

Last week, I painted the picture of a movement I strongly believe is gaining momentum. For lack of a better term, let’s call it the “People First” movement. Simply put, the “People First” movement is about respect – it is about creating the conditions inside our organizations which empower people to continually satisfy their human psychological needs. Doing so ultimately allows people to challenge their potential. 

One of the reasons this movement is gaining traction is because CEOs are finally recognizing the economic benefits to organizations in putting their people first. Do the math – a healthy percentage of people challenging their potential inside an organization increases the potential of the organization in every single way. 

Today, I wanted to rewind the clock and examine some of the reasons we even need a “People First” movement. In order to require a movement, societal imbalances must be present. I believe what has created the “People First” movement are imbalances of power.  

As crazy as it sounds, I’d like to rewind the clock all the way back to 1929, just before the Great Depression. Why? Because this was the last time the gap between the rich and the poor was at levels we are currently experiencing (Verbal Summary here). The chart below shows a graphical summary of that trend.

The Great Depression And The Income Gap

The massive stock market crash starting in late 1929 and lasting through much of the 1930’s served to reverse the trend in the income gap. The second world war also united the population against a common enemy as North America entered a period of massive expansion in manufacturing. As a result, the income gap steadily fell to its low point in the 1970’s. 

Late in the 1970’s the income gap began rising again. The credit crisis temporarily reduced the income gap from 2008-2009, but it has been rising steadily again since then. 

The 1970’s – A Reversing Trend

So what caused the income gap to reverse course in the 1970’s? The answer might not be quite as nuanced as you think. Two interconnected events had a major ripple effect throughout the economy and throughout society. 

First, Milton Friedman’s influence grew like wildfire as he became world-renowned as a brilliant economist. Second, public company stock buybacks came back into vogue with a vengeance. 

Milton Friedman

Friedman was a huge proponent of free market theory, winning the Nobel Prize for Economics in 1976. And here’s where the interconnection comes in…he was also highly influential politically. He was an advisor to Ronald Reagan during his Presidency from 1981 to 1989 and was very cozy with Margaret Thatcher while she served as Prime Minister of the UK from 1979 to 1990.

One of Friedman’s most famous theories was coined “The Friedman Doctrine” or “Shareholder Theory” (depending on the publication). This theory very simply stated that a corporation’s only responsibility is to maximize returns for its shareholders. Friedman argued that shareholders were free to make their own decisions with regards to any social responsibilities they wished to pursue. Given the breadth of Friedman’s influence and the prospective boon to CEOs and investors who subscribed to his theories, corporations were only too happy to comply. 

Thus began an era of steadily increasing corporate profitability. But while CEO pay has grown considerably both in absolute and relative terms and shareholders have reaped the reward of steadily increasing stock prices, weakened unions, sparse wage increases, and increased demands on front line workers have taken their toll. 

Stock Buybacks

During the Great Depression public companies, sensing an opportunity, began to use capital from operations to buy back their own shares relatively cheaply. At the time there was such a public outcry of abuses of power and insider trading that it catalyzed the creation of the Securities and Exchange Act of 1934. This document is still regularly referenced today. Corporations promptly curtailed their stock buybacks, instead using profits to reinvest in business operations, increased wages and dividends to shareholders. 

As you can imagine, there are many differing opinions on what effect the Securities and Exchange Act had on the population. Some argue that it prolonged the Great Depression by restricting capital flows when the economy was so challenged. But it is inescapable that the policy required businesses to refocus their attention away from financial engineering and into business operations. 

In 1982, with Friedman as his economic advisor and a Wall Street investment banker in the position of SEC Chair, Reagan changed the rules to allow stock buybacks once again. This decision resulted in the share of corporate profits used for buybacks to climb from under 1% in 1982 to a peak of 77% in early 2008.

Given that the majority of CEO pay comes in the form of bonuses based on rising stock prices, it’s no wonder that such a huge amount of capital has been directed to stock buybacks. And the beneficiaries are quite clear – senior leadership and shareholders. I fully admit that I have participated in these rising stock prices as a shareholder. But it is hard to escape the fact that financial engineering does little to help the broader population while the rich get richer.

Next week we’ll examine the ripple effects of a widening income gap.

 

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Brent C. Wagner