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Memo to the Upper Middle Class: Open Your Eyes. You're Next.

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My name’s Pitt, and your ass ain’t talking your way out of this shit. – Pulp Fiction (1994)

 

For as much of my life as I can recall, I’ve been Upper Middle Class. My folks went to college and acquired decent paying jobs. I followed the same plan and, consequently, the career and social orbits in which I’ve spent my days have been filled with doctors, lawyers, brokers, orthodontists, mid-level executives, and every form of modestly successful small businessman you can imagine.

These are sorts of people who live decently, but could never afford to stop working. The people who tend listen as the retail research investment advisers read to them about how the “market affords a great buying opportunity” and often believe they can beat it. The people who work so much, often to maintain lifestyles utilizing the lion's share of their income, that they’ve forgotten about the world outside their class (except for the rich, whose level they seek to reach, but can rarely ascend to). The often isolated people who think because they’ve been fairly successful so far, the carnage savaging the classes below them will never cross the moat into their territory.

I know them well. I eat with them, drink with them, celebrate holidays with them. And when I suggest the “UMC” is not immune, and that the automation and cost-cutting decimating the Lower and Mid-Middle Classes will swallow them as well, most dismissively sniff. Or become annoyed and tell me something about how, “It’s just a cycle. Everything will be just like 2004 again soon. Just you wait.”

Out of sight, out of mind... To talk about what’s happening below is to admit it can impact those above. Better to just ignore it, to embrace the comforting narrative the UMC will decouple from the growing legion of victims one and two rungs down the ladder.

Here’s a newsflash for the UMC. For the accountants, marketers, medical providers, small business owners, salesmen, and mid-level consultants who think they’ve dodged the bullet. You are not decoupling. We are not decoupling. It’s coming for us. And no, merely diversifying your investments and paying down some debt, as that tired retail adviser recommends, is not going to save you.

 


 

How does the shit roll uphill? There's no easy follow-the-dominoes scenario. Commerce being global and hyper-connected, all players operating in a "butterfly wings flapping here = tsunami 5000 miles away" structure, it could unfold in dozens of different ways, involving an endless array of events and actors.

The best way to assess what will happen is to simply look at the margins, and the leverage, of the UMC. And compare them to something they very much resemble: The US Banking System, Circa 2008.

The banks didn't collapse into crisis because 30%, 20%, or even 10% of mortgage loans suddenly became non-performing. They initially began to crater in 2008 because somewhere around 5% more of them than projected went bad. They were levered in such a way, to such an extreme level, that one small category of foolish wagers threatened a ripple effect of defaults. That missing 5% was needed to cover other bets, each one carrying its own unique default penalties. Everybody knew everybody else was similarly levered, and even the rumor an institution had difficulty meeting a commitment created fear among counter parties it was no longer credit worthy. This caused panic, which froze lending, which imperiled more institutions, which caused markets to dive, which caused the economy to tank, which over the longer term caused more people to lose their jobs, which caused more loans to sour, and house prices to fall, and suddenly that 5% differential became a tsunami of losses erasing $5,000,000,000,000 in wealth.

The UMC is over-leveraged in exactly the same fashion, much of it, despite outside appearances to the contrary, living on a financial razor's edge. For starters, the price of entry for many was a pile of onerous student loans, often in the six figures. Wipe out five figures a year in after tax income right there. Now, after that, add in the cost of everyday living. For most upper middle class people, this means managing a home and a family, often in the suburbs or exurbs of a large city. Markets being efficient in wringing dollars out of consumers, the merchants and service providers who sell the essentials of the UMC lifestyle drive the prices to a level just below the threshold of what their consumers can afford.

The house in the good school district is priced 20% over any honest value it could be assigned, and the property taxes 30% higher than necessary. The kids in the neighborhood need equipment for every imaginable sport, instruments for a litany of music lessons, and tutors to reach the top of the class and get a scholarship to a "write your ticket" college. The family needs two cars, four cell phones, and laptops for each of the kids. The home has dual climate zones that jack up the energy prices, and because both parents work fifty to sixty hour weeks, and often part of the weekend, landscapers must paid to do the lawn, and nannies hired to assist with child care. And if anything needs to be repaired, from a clogged pipe to a leak in the roof to a broken garage door, dad doesn't have time for a do-it-yourself fix. Professionals have to be called, at five hundred dollars a pop, minimum. Etc. (the list could go on forever).

For many, this is the price of being in the UMC - of grasping the American Dream. Being a Striver, a Competitor, and keeping up with those ever elusive Joneses.

Of course it's shallow. Of course it's perverted. The culture of the UMC, if that term can be applied, is gag inducing. But those are criticisms for another discussion. As ugly and silly and senseless as it is, for 75% of the UMC, what I described above is the Work-to-Spend-to-Protect-Your-Position treadmill of life.

Now, assume the current debasement of the Lower and Mid-Middle Classes persists, which it will. They spend less. They pay less in taxes. This hits the bottom line of UMC professionals and businessmen, who lose revenue as the classes below can no longer spend on goods and services the UMC provides. And who makes up for the taxes the Lower and Mid-Middle Class no longer pay? You guessed it.

How much will this cost the UMC? Conservatively, 5% of income a year. The same percent of loss that started the chain reaction which broke the banking system.

Now, certainly, the UMC can contract its spending more nimbly than banks, which were dependent on short term financing, and suffered the attacks of short-sellers. But in other regards, it's more vulnerable than banks. The UMC has nothing to liquidate, and little, if any, of its borrowing is operating debt. It owes on non-dischargeable student loans, homes, tuitions, property taxes, credit cards, vehicle financing... All non-revenue producing assets - positions which cannot be quickly unwound. Mountains of debt on yesterday's grad school costs and depreciating "stuff" no one wants. And if they default on any of it? Their credit rating collapses.

And credit is where it gets really interesting. If the loss of creditworthiness ubiquitous in the Lower and Mid-Middle Classes creeps into the UMC, underwriting standards for UMC borrowers will tighten even more severely than they have for Lower and Mid-Middle Class applicants. It's one thing for a bank to lose $3,000 when a factory worker defaults on a credit card; quite another when a doctor tanks a $100,000 line of credit.

If banks pull back on lending to the UMC, or increase borrowing costs to the sector because of enhanced risk, both of which usually happen at once, UMC managers and owners of businesses will respond by laying off or cutting back on the hours of more Lower and Mid-Middle Class workers. "And so it goes," to quote Vonnegut... The cannibalistic cycle persists, with the UMC further damaging its consumers' ability to purchase the goods and services it produces. Suicide by labor cost-cutting.*

It should be apparent to the UMC that it is walking into a trap. That on one side, as the Lower and Mid-Middle Class become more desperate, populist politicians will pander to them by raising taxes, and that those taxes will not fall on the rich, who can avoid them, but on the UMC. And that on the other side, to borrow Henry Ford's logic, you can't cost-cut yourself to profits by creating an economy in which none of the Lower and Mid-Middle Classes who buy your wares have income with which to pay for them.

Sadly, the UMC hears none of this. What it believes, and I hear this from members of it over drinks (when they're even willing to discuss the issue), is a feel-good myth that the serious economic pain to come will exclusively fall on the unskilled, the uneducated, and those with degrees rendered useless (liberal arts majors, law students, architects, etc.). The UMC seems to think mere professional training is a dividing line. That if one has a still-valued white collar skill (surgeon, money manager, CPA), or runs a business with decent market share, as many in the UMC do, these will operate like firewalls, barriers to entry shielding the overwhelming majority of the UMC from wage depression.

This is a dangerous delusion. There is no firewall. There is no UMC decoupling from the lower and Mid-Middle Classes. Just as the banks were wrong when they said sub-prime defaults could be contained and would not poison the greater home lending market, the UMC's belief it can leave the Lower and Mid-Middle classes behind is folly of epic proportions.

Classes aren't territories, or separate nations. We live among each other, trade with each other, and are bound by a political system that transfers wealth between us. The only apt analogy is organs in a body. If you get cancer in one kidney, surgeons can remove it, and you can survive with just the other. But if only 95% of the cancer was contained in that malignant kidney, and 5% escaped before that organ was removed, that's 5% in the bloodstream. And if that 5% metastasizes to another organ, it quickly multiplies, spreads, and after while, you've pockets of it everywhere.

Financial disaster spreads the same way. There's no flashpoint where rampant insolvency explodes from one class into another, no surge where the pain of those below breaches a levy and hits the people on the high ground. The malignant cells of it sneak in, little defaults and bankruptcies here and there, eating away at the host from the inside, and by the time it's noticed, it's too late. You see the foreclosure sign on the neighbor's house in your gated community and think, "But how? He was a Professional. This is an excellent neighborhood!"

Tell that to the bank when it refuses you refinancing because the sheriff's sale of that home next door tanked the value of yours. Cite your UMC bona fides to your business lender when he raises the rate on your operating line. Hear him apologize with, "Sorry. Underwriting sees a lot of weakness in your profile category." Talk about your excellent credit history with the contractor who demands more money down to fix the roof, explaining, "Sorry, but I've been stiffed a lot on jobs lately in these types of neighborhoods."

Contrarian economists and academics may pontificate otherwise, but this is irrefutable: Lower and Mid-Middle class consumption are essential to the system that allows the UMC to live in its manicured communities, pay for its kids to have SAT tutors, and fund tuitions at fancy universities. Under no framework can the UMC thrive over the long term, or even the extended near term, without the income consumers below it provide. Even the paranoid and debt averse of the UMC (your humble author), and those of it who work in multinational corporations which do not depend heavily on the domestic economy, will be crushed with massive tax increases if the Lower and Mid-Middle Classes are driven into mass destitution.

Saving the Lower and Mid-Middle Classes is not an issue of morality, or some soft-headed notion of "fairness." For the UMC, preserving the solvency of those classes is an elementary matter of self preservation. I don't know exactly how this can be done, but I know the first step is for the UMC to stop deluding itself with comforting false narratives about decoupling and start opening its eyes.


 

* I'll cut off the predictable response, "But what about the recent improving employment numbers?" First, the headline employment numbers are irrelevant. The only measure that matters is wage growth, which is stagnant, or negative, depending on which reports you're reading. You don't need a degree in Economics to apprehend that we're cycling millions from well-paying jobs to subsistence labor. Second, much of the drop in unemployment derives from non-participation. The number of long term unemployed remains stubbornly high, and as those people give up, they're no longer counted. (And if you're a cynic, it could be argued the Obama Administration is using policy to massage unemployment numbers lower in advance of the election. One interesting method it may be employing is implementation of policies encouraging Social Security to grant disability benefits to those who would have been denied in the past, characterizing many of the would-be jobless as disabled.) ^

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