Why Income Inequality Will Always Exist as Part of the Post-Industrial Revolution Global Economy

First: Before we begin, the education system in the United States over the past few decades has done such a poor job teaching basic logic that by virtue of the headline alone, it is statistically likely that you have already made a decision about whether or not this short essay on pay inequality is “good” or “bad”.  You’ve done this without considering any of the factual data or evidence I’m going to offer by virtue of my own experiences in finance, based nothing more on your own political meme.  Regardless of whether or not someone agrees with my facts, this inability for a citizen to carefully consider evidence instead of feeling is part of what is wrong with our Republic.  As a civilization, we have to get away from fear mongering and sound bites.

Reasons Businesses Like Goldman Sachs Will Always Be Able to Pay Employees More Money

Businesses, like people, are different.  Some people are tall, some are short.  Some are black, some Asian.  It’s the nature of the world.  In the same way, some businesses require more employees than others as a result of the business model and industry in which a company operates.

Whether or not a business can lavish employees and owners with huge bonuses, paychecks, dividend checks, and profits on a sustainable basis depends upon one metric and one metric only: operating profit per employee.

For instance, Goldman Sachs has 34,738 full-time employees.  Over the past 36 months, as the world has fallen apart and some of the biggest names in finance have collapsed, Goldman’s pre-tax profit from continuing operations was a staggering $34,500,000,000.  In other words, after paying these huge bonuses, Goldman Sachs has earned an average operating profit of $331,050 per employee, per year, over the past three years.  This amazing performance is evidenced by the fact that the stock is trading near the all-time high set before the market crash several years ago.  Thanks to the management team, shareholders have emerged virtually unscathed as those around them have lost everything.

Wal-Mart Stores, on the other hand, has 2,100,000 employees.  Over the past 36 months, it has earned pre-tax profits of $60,064,000,000.  That works out to an average of only $9,534 in operating profits per employee, per year, over the past three years.

Put another way: On a per employee basis, after paying all compensation and these huge, “excessive” benefits, Goldman Sachs is 34.723 times more profitable than Wal-Mart on a per-employee basis.  This explains why it’s able to offer far better pay and benefits for its employees. In fact, Goldman could give each one of its workers a $3,000 Christmas gift and it would shave just 1% off operating earnings.  If Wal-Mart did the same by adding, say, $75 to everyone’s paycheck each week, it would cause a 31%+ drop in operating profit.  People need to understand the numbers that drive these economics.  Given that the company has a $200 billion market capitalization, that 31% drop in operating profits would result in a loss of $62 billion in stock market value as the lower earnings resulted in a lower valuation put on the company’s shares by pension funds, 401(k) investors, and mutual fund managers.  The “loss” to the owners of Wal-Mart would be $29,524 in market value for this $3,000 per employee bonus.  It would actually be much higher because of the additional payroll taxes and other factors that businesses pay on top of wages.

[mainbodyad]In fact, even if you own no stocks directly, you probably have a large chunk of your retirement invested in Wal-Mart if you have any sort of pension benefits at all, or you own any type of mutual fund or equity-based annuity.  If you are a retired nurse with $500,000 in your 401(k) and you own an S&P 500 index fund, roughly 1.13% of your assets will be in Wal-Mart so your personal loss would be $1,751.50.  If your pension pays you $1,800 per month, the plan likely has the same assets set aside to cover your distributions (it would take about $500,000 in earnings to generate a sustainable $1,800 per month pension payout) so its loss would be the same; although you wouldn’t need to worry about it because your old employer is on the hook for the money, the company has to make up the unfunded pension assets so it’s less money in their bank account for hiring new employees or offering their own bonuses.

Before the rise of our modern economy, it was virtually impossible for firms to earn high operating earnings per employee because of the huge investment in equipment, machinery, and physical labor (the exceptions were businesses such as commodity brokers, which were able to earn a profit without tying up their own capital).

An apple orchard, for instance, would have massive investments in land, dozens (if not hundreds) of hired men and women to walk the field and physically pick the apples, and a warehouse of people to prepare them for shipment.  Today, much of that work has been replaced by machines but the savings went to the customer in the form of lower food prices, rather than to the business owner, because apples are a fungible product (you can’t tell an apple grown on one farm versus another if they are of comparable quality).  The result is that apple farmers aren’t able to offer great medical benefits, new Mercedes, and signing bonuses.  In banking, talent is anything but fungible.  Someone like Warren Buffett, Charlie Munger, or Philip Fisher is exceedingly rare.  If you could get Warren Buffett to work for you, paying him $1 billion a year would be a bargain because he’d likely earn that for your firm on a single transaction.

The moment our society moved beyond capital intensive industries, the fundamental laws of mathematics show that the pay difference between the richest and poorest (in terms of income) was going to widen because the new firms that arose such as advertising agencies, accounting practices, legal partnerships, and dentistry, earn high operating profits per employee.  Old firms, such as steel manufacturing, garment production, and railroads do not.  As a country moves from third world to second world, and later from second world to first world, a larger percentage of the population finds itself employed by these “high” return businesses because the needs of the population change.  The result is an ever-widening increase in the pay differences between the bottom tier, which consists mostly of those without a high school diploma, and the top tier, which statistically contains those with advanced degrees and PhD’s in specialized fields such as medicine.

As a society, our concern should not be pay differential but rather, the absolute standard of living for the bottom 10% of the population. I’ve said it a million times and I’ll continue to say it: If we could double the gap between the rich and the poor but, in doing so, double the real, after-inflation income of the poorest 10% of Americans, I’d do it in a heartbeat.  What matters is how they and their families are able to live.

As a society, we have a long way to go but I’m encouraged by our progress.  Why?  Because in the United States alone, changes in productivity and real standards of living over the past century have exceeded the sum of all recorded human history prior.

Being poor used to mean having no running water, no air conditioning, no central heating, not being able to buy clothes, or own a car.  Today, the poverty line in the United States is high enough that those on it have all of those things – according to one study that examined the European Union to the United States (see EU vs. United States by Fredrik Bergström & Robert Gidehag), in 2007, 46% of poor households in the US owned their own homes, 30% had two or more cars, and 63% received cable or satellite TV.

[mainbodyad]Yes, there is still a lot of work to do but we cannot forget that in the macro-economic scheme of things, our grandparents, parents, and now us, have done an amazing job of building an economic engine that has better opportunities than virtually anywhere else in the world.  I’m sorry, but if you own two (2!) or more cars, you can’t call yourself impoverished.  I didn’t buy my first car – a Jaguar X-Type – until I was in my early twenties and had built up my savings and investments to very respectable levels because I knew that an automobile is one of the single biggest hurdles to achieving financial independence when you factor in all of the incremental costs.  Do you think I wanted to wait that long?  Do you think it was convenient to get around places without transportation?  No, but I wanted to be independent and have enough money to not have to worry about a job.  That takes sacrifice.  You can’t have it both ways.

My hope for you, the reader, is you will now stop and remember, each time you read the news or hear an interview with a company or labor union, that the first metric you should check to determine which side likely has the better argument is operating profit per employee.

Income Inequality Is Also Caused By More Single Parents and Women Achieving Workplace Equality

There is considerable evidence that the rise in income inequality is also partially caused by more single parent households and so-called assortative mating patterns caused by women achieving equality in the workplace.

  • Probably one of the best articles that I have read while watching the downfall of Hostess! Great analysis and Joshua. It reminds me of an old Wall Street Journal commercial that relates profitable businesses with those that have their employees read the Wall Street Journal in the morning instead of standing around “bitching” at the water cooler. In the end it is everyones job to make the company profitable. What is forgotten or ignored is that a companies profit is directly proportional to the benefits it offers their employees. A company can’t be profitable if a considerable amount of its profits are going to pay empoyee benefits. You can only raise the price of your product so high until the consumers stop buying it because there is a less expensive alternative some where else. Operating Profit per Employee is a great measurement to focus on…