Struck in the Middle

Without a growing middle class, there's no growth. This debt deal now ensures it

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Illustration by Harry Campbell for TIME

Economic research shows that people who feel they are becoming better off over time are more generous, altruistic and participatory. No wonder, then, that the Great Recession and limp recovery of the past three years have given us something as pinched and polarizing as Tea Party politics. The debt-reduction deal that was cut after many weeks of partisan wrangling may have temporarily saved the U.S. from default. But it has exacerbated the real problem underlying our woes: the fact that most people not only feel but actually are much worse off than they were three years ago.

While the income share of the nation's top 1% is hovering around 20% — near what it was in the Gilded Age and up from about 8% in the 1970s — the rest of us haven't gotten a raise in nearly four decades. The wealth gap between whites and blacks is now a chasm: according to a Pew study, the median wealth of white households is now 20 times that of black households, making the gap nearly twice the size it was in the two decades before the Great Recession. Such inequality isn't new, but it's a problem that has been greatly aggravated by the financial crisis, which wiped out the housing wealth of the middle classes even as the richest Americans saw their stock portfolios rebound and their highly paid jobs remain relatively secure.

The debt-reduction deal guarantees that the gap will widen, perhaps dramatically. First, it cuts government spending at a time when spending is needed most. The economy is weak, and the private sector is still hoarding its cash. This, along with the fear that we'll have to go through the same charade every few months or years, has economists downgrading their already low growth forecasts, making a reality of the much feared 2% economy — one in which a few highly skilled workers prosper and the vast middle flounders. "The debacle has eroded corporate, household and investor confidence," says Mohamed El-Erian, CEO of Pimco. "It will translate into lower U.S. economic growth, higher unemployment and more volatile and fragile markets."

What's more, the particulars of the deal favor the rich, since the wealthy escape new taxes and the poor get the spending ax in the back in the form of reduced unemployment benefits, public-sector-job elimination and no increases in spending on programs that might bolster employment or help retrain workers. "It is hard to shrink the size of government right now without exacerbating inequality," says Harvard economist Ken Rogoff, co-author of This Time Is Different, a history of debt crises.

While this is depressing enough, what's really disturbing and not nearly well enough understood is that inequality is a cause, not just a symptom, of the current crisis. By legislating an increase in the wealth gap, we are actually compounding our economic woes, because those in the lower 95% of the population, which does 71% of the spending, simply aren't going to have any cash on hand, nor can they borrow. "High levels of inequality depress longer-term growth by depressing more broad-based consumption. You end up with a lot going on at Walmart and Nordstrom without enough going on in the middle," notes Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities. You also end up with curtailed retail-employment growth, which will ensure that unemployment, at record highs for this stage of a "recovery," will inch higher.

What's interesting is that if we had done more to prevent inequality, we might not have ended up where we are. A recent report from the IMF looked at the causes of the two major U.S. economic crises over the past 100 years — the Great Depression of 1929 and the Great Recession of 2007. There are two remarkable similarities in the eras that preceded these crises: both saw a sharp increase in income inequality and household-debt-to-income ratios. In each case, as the poor and the middle classes were squeezed, they tried to cope by borrowing to maintain their standard of living. The rich, in turn, got richer by lending and looked for more places to invest, bidding up securities that eventually exploded in everyone's face.

In both eras, financial deregulation and loose monetary policy played roles in creating the bubble. But inequality itself — and the political pressure not to reverse it but to hide it — was a crucial factor in the meltdown. The shrinking middle isn't a symptom of the downturn. It's the source of it. How we deal with it may become the most crucial factor in whether we can hope for a lasting recovery.