Samuelson: The Quagmire of Inequality

You have never heard of the Treaty of Detroit, which you may connect with the French and Indian War (1756-1763). Guess again. The Treaty of Detroit is a long-lost label describing a series of landmark labor agreements between the United Auto Workers and the Big Three U.S. automakers. Starting with a 1948 contract at General Motors, the agreements guaranteed annual wage increases, job security and generous fringe benefits. As Detroit's present turmoil attests, the treaty is in tatters.

Now come economists Frank Levy and Peter Temin of the Massachusetts Institute of Technology, who resurrect the label and say it explains something much greater: the rise of economic inequality. This promises to be a hot issue in the 2008 election. Until now, most economists have blamed the growing pay gap on skill differences caused by the explosion of computer technologies. Levy and Temin contend (correctly) that this is too simple; they also blame a shift in social norms and business practices.

First, some historical background. In late 1945, President Truman summoned 36 business, union and government leaders to a conference. The aim: to forge an understanding between labor and capital more akin to World War II's cooperation than to the Great Depression's strife. It failed; the postwar era began badly. In 1946, there were 4,985 strikes, involving 4.6 million workers (11 percent of all workers). Autoworkers, railroad workers, steelworkers all struck.

The Treaty of Detroit fashioned a crude truce that spread elsewhere. Between major contracts, the automakers got labor peace. In return, workers got job security (reminder: in the 1930s, unemployment averaged 18 percent) and higher incomes. The treaty influenced other unionized industries, where pattern bargaining—companies signing similar contracts—became common. Many non-union companies embraced comparable norms: workers should receive wage gains beyond inflation, job security and good fringe benefits.

The result, say Levy and Temin, was that "market outcomes" in pay were "strongly moderated by institutional factors"—business practices shaped by social values and government policies. After World War II, many executives strove to refurbish the image of Big Business, badly battered in the Depression. Managers and professionals received more than production workers, but legal and bureaucratic filters narrowed the gaps. By the 1980s, this generation of business leaders had mostly retired. Companies increasingly paid what the market would bear or they could afford.

Pay gains diverged. In early postwar decades, compensation increases crudely paralleled productivity gains—improvements in efficiency. From 1950 to 1973, productivity rose 97 percent. Over the same period, median compensation of high-school male graduates aged 35-44 rose (after inflation) 95 percent; for college graduates 35-44, the increase was 106 percent. Those in the top one half of 1 percent received only a 37 percent gain. From 1980 to 2005, productivity increased 71 percent. Median compensation for high-school graduates dropped 4 percent, and compensation for college graduates rose only 24 percent. For those in the top one half of 1 percent, it jumped 89 percent.

Comparisons like these evoke images of greedy CEOs and hedge-fund managers. But the story is more complicated. On the whole, the economy that produces these growing inequalities outperforms the one that created more statistical equality. The norms and practices highlighted by Levy and Temin collapsed mainly because they no longer worked. The idea that everyone's wages should reflect inflation plus a few percentage points worsened both inflation and stability. There were four recessions between 1969 and 1981; by then, inflation was 10 percent and mortgage rates 15 percent. Productivity growth had plunged.

Greater competition—from imports, deregulation, new technologies—also doomed pattern wage setting. Companies with lax pay practices shrink or die. Consider GM, Ford and Chrysler as exhibit A.

Economic inequality is an intellectual quagmire, because its origins and consequences are so murky. Contrary to popular belief, for example, it has not prevented most Americans from getting ahead. Consider families with children. A study by the Congressional Budget Office finds that from 1991 to 2005 income gains averaged 35 percent for the poorest fifth of these households, 19 percent for the middle three fifths and 53 percent for the richest fifth. But all these gains were down slightly from 2000. Here's another twist to the discussion: today's immigration aggravates inequality, because so many new immigrants are poor and unskilled.

In 2008, economic inequality could become a political flash point, because the income gains at the top seem so outsized and gains elsewhere are so choppy. The very uncertainty means that, even amid great prosperity, Americans feel anxious. Whether the debate becomes an empty exercise in class warfare or a genuine search for ways to reconcile economic justice and economic growth is an open question.