American Privilege Rots an Empire from Within

A rising empire rewards people who contribute to its growth and invest in its future. The empire's decline begins when certain members of society are over-rewarded by means of privileges, and the empire's money is wasted on outdated endeavors.

Today, America rewards the wrong people and spends disproportionately on projects of the past. Symptoms of the flawed incentive system in the U.S. economy include a massive fiscal budget deficit, high unemployment rate, crumbling infrastructure and a failing basic education system.

International competition isn't threatening the United States, but internal problems are. And unless the United States tackles its wrong-way incentive system and spending spree soon, its gradual decline will continue until it eventually joins the likes of Latin America.

A serious effort to correct the U.S. course started in earnest a few months ago during a congressional fight over raising the national debt ceiling. Democrats and Republicans eventually agreed to mandate US$ 1.2 trillion in budget cuts over 10 years through a "super" committee, which was assigned to work out details.

If the super committee failed to reach an agreement, the cuts would be proportionally slapped on future civilian and defense expenditures, with health care and social security programs exempted. Guess what happened? The committee failed to reach a compromise, and thus the consequences will be felt after mandated cuts begin in 2013.

Next year's election may change the political landscape: One party may again dominate Congress and the White House, leading to a different outcome. Hence, the super committee's failure isn't consequential on its own, but it does provide ammunition for election campaigns, and offers another example of America's dysfunctional political system.

Further, the cuts, even if successful, would not bring the U.S. government budget under control. The total amount on the chopping block is equal to less than one year's deficit. That's not very ambitious for a 10-year program.

Against this backdrop, the United States is experiencing a full-blown economic crisis. The nation's real unemployment rate, which includes idled workers who've given up looking for jobs, is 18 percent. One-tenth of the nation's properties have been foreclosed since 2007, and another tenth have negative equity. The poverty rate is more than 15 percent, and another 20 percent of the population is struggling on incomes near the poverty line. Looming over these grim statistics is the federal government's budget deficit, which is equal to about 10 percent of the nation's GDP.

The breakdown began with the 2008 global financial crisis, which was like a dam break. Problems had been accumulating for years, and a debt bubble had merely temporarily covered up problems. Now, the U.S. government borrows roughly 40 cents for each dollar spent.

Alan Greenspan, a former U.S. Federal Reserve chairman, was mainly responsible for creating the bubble. The fiscal balance was later wrecked by rising health care costs, social security payments and defense spending along with veteran's benefits. Spending on these three items alone increased a combined 107 percent between 2000 and 2010, while nominal GDP rose only 45 percent, to US$ 2.6 trillion – substantially more than total fiscal revenues. If spending on these three items had grown at the same pace as nominal GDP, the fiscal deficit would be less than half of what it is today.

How bad is it? Excessive health care spending tells part of the story, eclipsing the U.S. trade deficit in seriousness. Some 17 percent of the nation's GDP is spent on health care – twice as much as in other developed economies – with about half paid by federal and local governments, and the other half covered by businesses and individuals. Unless these costs are brought under control, America will never resolve its fiscal crunch.

Ironically, excessive health care spending hasn't produced a healthier population. The United States actually fares worse than other developed countries in areas such as life expectancy, diabetes and cardiovascular disease.

Unlike Europe and Japan, the United States has a growing population. So it could count on growth to solve problems. Its agriculture and mining industries are booming. And it has many competitive companies in industries in areas such as aerospace and pharmaceuticals. But it's weighed down by excessive overhead costs such as healthcare, social security and defense.

The Occupy Wall Street movement drew attention to what organizers said was a huge gap between the 99 percent of the nation's citizens whose lives are out of synch with the 1 percent wealthiest Americans.

The top 1 percent control about one-fifth of the nation's income and two-fifths of the wealth. The top 10 percent take in about half of all income and have accumulated 80 percent of the wealth. Meanwhile, about 80 percent of Americans merely get by and have very little wealth available as a cushion for when personal finances turn down.

The gap between the rich and the rest, which has roughly doubled over the past two decades in the United States, is an inevitable result of competition. Of course, competition motivates people, and inequality is often a price worth paying if it motivates people to make the pie bigger. All could be better off with a bigger pie, even if inequality worsened. Limiting competition improves equality but decreases incentives for people to work. A society needs to make a tradeoff between the two.

Inequality worsens in an environment of limited competition, as inefficiency and social friction rise. Examples of this phenomenon include the Philippines, where few families rule through monopolistic practices. The country has become poorer relative to others over the past two decades, while inefficiencies are supported by Filipinos who work abroad and send money home.

Many Latin American countries fall into this category, too, and the United States is heading that way.

Fat Paychecks

Most of America's well-to-do are corporate executives, doctors, lawyers, bankers and the like. Their rewards are tied to positions, not performance. Corporate managers are paid a lot more than average employees, even if they're not worth it.

For example, one report said salaries for big U.S. company CEOs have jumped to 343 times the average pay for their own employees, up from 42 times in 1980. Of course, a CEO whose work generates a lot of value deserves a decent slice. But look at the stock market: Common shareholders have done terribly over the past decade. How can CEOs justify millions in take-home while shareholders – their bosses in theory – do so poorly. I'm sure the compensation consultants can come up with good excuses. But this has been going on for years.

Of course, when CEOs make tens of millions of dollars, their immediate subordinates can make millions. These steep compensation levels for executives are a major reason for rising inequality in the United States. And judging from stock performances, many executives don't deserve fat paychecks.

When big companies started rising in the early 20th century and managers, not shareholders, took control, theorists tried to explain why it was efficient. But as managers essentially decide their own compensation, large companies eventually exist for the benefit of managers, not shareholders nor workers. A board of directors is supposed to look after shareholders' interests, but in reality, most boards are stuffed with friends of the CEO.

One could argue that the economic failure of the United States is not the fault of but the sabotage of capitalism. Indeed, corporate governance is breaking down, and that's one of the most important causes of America's current economic troubles.

Likewise reaping unmerited compensation are highly paid financial professionals. Salaries in the financial industry have risen despite the sector's collapsing firms, shareholder wipeouts and taxpayer bailouts. This industry certainly has worked neither for the economy nor shareholders.

Lawyers are another group of well-paid professionals who maintain the rule of law. But the United States suffers from an oversupply of lawyers, which forces some to look for ways to circumvent or take advantage of the system. The most extreme example is the professional niche of ambulance chasers who are busy seeking ways to sue hospitals, doctors and insurance companies. High-end lawyers working for corporations are busy helping corporate managers maximize benefits without breaking rules. How's that for no added value?

Now, we come to health care. Doctors and hospitals in the United States charge more for their services than in other countries, yet the U.S. population's health condition proves more spending doesn't yield better results. Neither does competition work in the health care market, as the information asymmetry between patients and doctors seriously decreases the effectiveness of market competition in allocating resources.

Because patients are vulnerable and must accept what the doctors say, the health care market has a naturally inflationary tendency. Doctors are biased toward expensive treatment. Prices rise easily in a system in which patients are insured and, hence, not resistant to high prices. Of course, insurance premiums rise to reflect costs, too.

In other developed countries, the runaway tendency of health care costs is checked by government limits on doctor charges to ration services. While many argue the United States delivers better services in some areas, isolated examples can't justify a system that costs twice as much and delivers a less healthy population.

Growing Old

To understand the American government's fiscal trouble, one must study the American Association of Retired Persons, which has more than 40 million members. They constitute a huge bloc of voters in national elections, and their biggest financial concerns are healthcare and social security.

Some 45 percent of federal expenditures go toward health and social security programs. This slice of the spending pie is expected to rise to 51 percent of total expenditures by 2016. Unless something happens that suddenly disrupts this upward spiral, these two parts of the fiscal budget will bankrupt the country.

Meanwhile, the federal government spends a mere 3 percent on education. Local governments fund most education services through property taxes, yet it's shocking to see how little the federal government supports youths as opposed to retired people.

In addition to rewarding the right people, an empire rises by investing in the future. The United States went on a massive investment boom in late 19th and early 20th centuries, creating a superpower. An infrastructure program in the 1950s and information technology investment in the 1970s strengthened its superpower status after World War II.

But America has moved in the opposite direction over the past two decades. Its crumbling infrastructure is a sign that money has been diverted to support retirees. The number of wealthy Americans willing to support charity in the pattern set by the likes of Bill Gates and Warren Buffett are dwindling.

The financial crisis in 2008 and the current fiscal crisis are merely symptoms of deep structural problems in American society. Only a popular awakening and strong leadership can solve these problems and prevent the United States from following calling the International Monetary Fund and asking for a bailout.

Historians have all sorts of theories on why the Roman Empire fell, blaming everything from religion to barbarians. My take is that every empire in history eventually rots from within when privilege, not contribution, becomes the basis for compensation.

The children of the ones who contributed take advantage of their status as the offspring of the empire-builders. They can live comfortably, enjoying easy rewards, even as their neighbors lose jobs and homes. We're seeing the consequences of this phenomenon today in America.

The author is a Board Member of Rosetta Stone Advisors.