Last week, President Bush told the Wall Street Journal:

First of all, our society has had income inequality for a long time. Secondly, skills gaps yield income gaps. And what needs to be done about the inequality of income is to make sure people have got good education, starting with young kids. 

That’s the conventional wisdom: the increase in income inequality is the result of too many Americans having too little education. Well, maybe not, argue Lawrence Mishel and Richard Rothestein in The American Prospect:

College graduates are, in fact, not in short supply. A background paper for the Tough Choices report (but not one publicized in the report itself) acknowledges that “fewer young college graduates have been able to obtain college labor market jobs, and their real wages and annual earnings have declined accordingly due to rising mal-employment.” In plain language, many college graduates are now forced to take jobs requiring only high school educations.

According to a Wall Street Journal Report on the latest IRS data, income inequality is still increasing. More than 21% of all income went to the top 1% of Americans. The bottom 50% earned about 13%.*

Income inequality is usually discussed in the media and by politicians as a Bad Thing. But it’s not easy to articulate exactly what the problem is. Few serious people would argue that income inequality is intrinsically bad. After all, it’s essential to capitalism—even the fuzzy-wuzzy European kind—and, as such, essential to growth and prosperity, too. So is the real issue just whether there’s too much inequality? I don’t think that’s exactly right, either. As Mickey Kaus pointed out in his pre-blogging days, if you think there’s too much inequality, you ought to be able to say where you’d draw the line. Do we want the top 1% to have just 20% of income? 18%? 15%? How exactly would you come up with such a figure?

I think the critical question to ask is not whether the rich are pulling too far ahead of the middle and poor, but whether everyone is still moving forward. Except for the sheer spectacle of it, I don’t really care how much better than me James Simons is doing, as long as I’m making more now than I was a few years ago. But for most people that hasn’t been the case. The Journal notes that the median tax filer (the one doing better than half of us, but worse than the other half) saw his income fall 2% between 2000 and 2005. That’s a problem.

*Figure corrected since first post

 I wrote this story for the 35th anniversary issue of Money.

There are a lot of ways to answer the question posed in our headline. You could look at how much the economy has grown over the past 35 years. Or at what people are telling pollsters about their satisfaction with life.

Here’s an even more illuminating approach: Let’s go shopping.

Specifically, let’s go to Costco. It’s hard to imagine such a nirvana of consumption existing when Money Magazine began publishing in 1972. (Costco Wholesale was founded in 1983.) Indeed, you can think of a Costco warehouse store as a kind of cinder-block monument to the sweeping economic change that has occurred since the age of Nixon’s wage and price controls.

Start with the dizzying plenty on those high-rack steel shelves. You may have come to save on toilet paper and a few other necessities. But when you push your double-wide cart through those oversize sliding doors, the first thing you see is a half-dozen high-definition televisions perched just right to compel you to gaze upward. Every time you visit, it seems, the screens are bigger, flatter and cheaper.

Plunge deeper in and you’ll find $20 designer-label shirts, $11 crates of South African clementines and, for just $7.50, 28-packs of bottled water. If you can forget the fact that you used to be quite happy to get water from the tap, you are much better off as a consumer.

Read the rest of this entry »

Barry Ritzholz thinks not:

… If Unemployment is actually as low as its been reported by BLS, then there is no slack in the labor market. We have a situation where demand is outstripping supply. In the Oil market, that sends prices higher. In Agricultural commodities, the same thing occurs. Indeed, in every market I can think of, when Demand is greater than Supply, prices rise. That’s Econ 101: prices should be rising robustly in that environment.

Yet we see little evidence that wages and salaries are moving appreciably higher. Outside of bonuses and stock options, most wages have been pretty stagnant. For most of the past 4 years, they had been falling on a relative basis to inflation. Its only the past few quarters or so that hourly wages have risen at the rate of inflation or better.

Hmm.

Max Sawicky offers an explanation.

From Stephen Gandel’s Money feature on on the housing bubble this spring:

The housing boom was good to John Devaney. Really good. He owns a Rolls-Royce, a Gulfstream Jet, a 12,000-square-foot mansion in Key Biscayne and a 143-foot yacht, as well as a few Renoirs and a valuable 1823 reproduction of the Declaration of Independence.

Devaney’s not a developer, and he’s certainly not a flipper. The 36-year-old CEO of United Capital Markets is a bond trader. And one of his specialties is buying and selling bonds that are backed by the mortgage payments of ordinary homeowners.

Option ARMs? Devaney loves ‘em. “The consumer has to be an idiot to take on those loans,” he says. “But it has been one of our best-performing investments.”

From Bloomberg today:

John Devaney, who invests in subprime mortgage bonds, halted redemptions in some of his Horizon hedge funds to cut the odds they’ll be forced to dump more holdings.

“We have received an unusually high number of redemption requests,” Devaney’s United Capital Markets Holdings Inc. said today in a statement. One investor wanted to withdraw about a quarter of the money-losing funds’ money. The Horizon funds, which aren’t being liquidated, last month sold off a “large amount” of securities and also closed out derivative bets on subprime-mortgage bonds at a loss, the company said.

The Key Biscayne, Florida-based firm oversaw $620 million in the fund group on March 31, an April client letter to investors said. Devaney’s stated strategy is to buy subprime-mortgage bonds and other asset-backed securities when they’ve fallen out of favor. A decline in prices amid an increase in home-loan defaults picked up last month as two hedge funds run by Bear Stearns Cos. collapsed. Losses on subprime-loan bonds may total $90 billion, analysts at Frankfurt-based Deutsche Bank AG said last week.

Health insurance is lousy and we’re being forced to pay out of pocket for more and more of our medical care. Right?

The first part of the sentence may be true. But the second isn’t. We’re paying a smaller share of our overall medical bills than we were in the 1970s. Check out this chart from a new Congressional Budget Office report on health reform:

If it doesn’t feel like you are paying less for health care, it’s because in dollar terms, you almpost certainly aren’t. The total cost of health care has skyrocketed. As the CBO notes, there’s a bit of chicken and a bit of egg here. Medical spending goes us because we don’t pay for all of it directly. But we seek out more insurance because costs are going up.

The latest on family income from the Brookings Institution:

–Overall, individual incomes are about as steady as they’ve ever been

–The incomes of household heads have gotten shakier

–The incomes of spouses have grown more reliable

–Household heads generally make more than spouses, so…

–Household incomes have grown more volatile, but…

–It’s not clear why. Some volatility may be due to voluntary choices, such as pursuing education or time with family.  So there’s more work ahead to sort that out. And…

–Rising volatility may be offset to some degree by better access to credit.

In comments, Cameron asks:

I personally would like to be able to invest some portion of my portfolio in hedge funds, but I don’t have millions to invest. Someone should start a “mutual fund” of sorts that pools individual investors’ assets and invests them in hedge funds. Does such a thing exist already, or would it be barred by the securities laws?

There are funds of hedge funds with invesment minimums of under $100,000. But you still have to at least $1 million in assets to qualify, and probably more than that if you don’t want hedges to add up to a huge chunk of your porftolio. But even if you had that kind of dough, I’d skip ‘em. In his new book, Jack Bogle gets it exactly right:

Hedge funds-of-funds? No. Really, no. If a regular hedge fund is too expensive [typically 2% a year plus 20% of profits], just imagine a fund of hedge funds that lays on another layer of expenses.

One thing to know about hedge funds is that its not just bossy regulators keeping you out. Hedge funds do a lot of weird stuff that can’t really work unless they can:

–Lock up investors’ money

–Mark their investments to market infrequently

–Hold assets to a relatively low level

–Keep secrets

–Ignore the tax consequences of their trades. (As a recent Morningstar Advisor article notes, many hedge fund clients are institutions that don’t pay taxes.)

This profile just doesn’t fit the vast majority of individual investors, not even the “sophisticated” ones.

The one thing that intrigues me about hedge funds is not their potential for high returns. (Which is overblown, by the way.) It’s their ability to provide some diversification, and thus lower portfolio risk. If any of these guys are actually worth their “2 & 20,” their returns should be out of sync with the ups and downs of the S&P 500 or the Treasury market.

But if you want diversification, there’s lots you can do before you try begging your way into a hedge fund. You can invest in a fund that buys real estate investment trusts. Or a commodities fund or one of those new exchange-traded notes that tracks commodities. Or look into the emerging category of “long-short” mutual funds that employ some classic hedge strategies, even if they can’t go as far as the true hedgies do. And even this stuff is frankly more than you probably need. As all-around investing smart guy William Bernstein recently said to me: “You want lower risk? Buy T-bills.”

You can’t invest in hedge funds. Your pension fund can. I think that’s one more reason to be happy if you still have a traditional pension–they can invest more broadly than individuals can or should. Former labor secretary Robert Reich says it’s a reason to worry about pensions:

But corporate and government pension plans are increasingly investing in these funds, with money that was previously invested conservatively on behalf of their beneficiaries. Some states are now putting 20 percent or more of public employee pension savings into them. Corporate pension plans, as much as 40 percent of employee savings. But the individuals counting on retirement checks are neither big enough nor tough enough to take care of themselves.

Few if any pension plan managers have any idea of the specific risks they’re taking –because hedge funds and private equity funds don’t have to disclose them. And the people whose pensions are at stake – teachers, policemen, civil servants, and other working Americans – haven’t a clue.

Via Felix Salmon, I just read an entertaining (but I think dubious) blog post from hedge fund blogger Veryan Allen taking on indexing pioneer Jack Bogle. Here’s a taste:

Is it really common sense to imply investment skill cannot exist and investors should not try to identify good fund managers? Not many would want to ride in a car driven by John Bogle. I guess he would just place a brick on the accelerator, remove the steering wheel, gaze at the rear view mirror and wait for the nice destination he anticipates. No need to worry about ongoing risks and obstacles in the path when paradise looms in the so-called long term….

I’m mostly with Bogle on this one. You can argue until you are blue in the face whether investment skill really exists. (Beyond a basic hurdle of competence, that is.) I’m not sure it does, but I’m not sure it doesn’t. But I’m downright certain that I can’t identify market-beating investment skill in advance. Not only is past performance no guarantee of future results (as they say in the fund ads), it probably hurts future results. When a fund manager gets hot he attracts a lot of new money he has to put to work in the market, which usually forces him to build a portfolio that looks more and more like the index. Either that or he quits to start a hedge fund. Buy an index fund and you don’t have to worry about any of that. You just own the whole stock market–and cheaply, too.

But that’s just the case for index funds vs. active mutual fund managers. What about indexers vs. hedge funds, those largely unregulated private investment vehicles that have become so popular among institutions and the super-wealthy?

Hedge funds are different. Buy a typical U.S. stock mutual fund, and you’ll basically get U.S. stocks’ returns, plus or minus luck, and maybe plus or minus a premium/discount for risk, and definitely minus expenses. A real hedge fund, on the other hand, is traveling far afield from the S&P 500. It may be shorting stocks, levering up, buying commodities, doing land deals, investing in private firms, making currency plays… you name it. So a hedge fund has a real shot at making money in falling stock market. (As well as a good shot at falling apart in a rising market, I should add.) If nothing else, they can provide diversification. And that’s not nothin’ at all.

Still, I doubt it’s much easier to identify outperforming hedge fund managers in advance than it is to identify next year’s winning mutual funds. And for most of us, it’s an academic question. You have to have A LOT of money to buy into a hedge fund, and I suspect you have to have bucketloads of gushers full of millions of A LOT of money to get into the best ones–especially if you don’t want to be gouged by middlemen. Some mutual funds are trying to approximate hedge strategies, and I’m intrigued by a few of them, but by their nature they’ll always lack some advantages that the hedgies enjoy. Most will be too big, for example, and they won’t be able to keep their investors from taking their money out for months or even years. (On the other hand, they are far cheaper.)

Some of the smartest pension and endowment managers have been using hedge funds as a basic ingredient of their long-term asset allocation. Are they having any luck identifying real talent? Who knows? But they are broadening their clients’ market exposure in a way that most individual investors cannot. Perhaps that’s one more reason to regret the sharp decline of traditional pensions in favor of 401(k)s. Many of us have been forced to take over the job of managing all of our retirement assets, but we’ll never have access to all the tools the pros can use.