Policy Paper

The American Social Contract

Lessons from the Great Recession
September 28, 2010 |

The Great Recession has put enormous strain on the American social contract, exposing not only the many holes in our social safety net but also the weaknesses in its basic design and philosophy.

Introduction

In comparison to other OECD societies, America’s social welfare system had done a relatively poor job of cushioning the American population from the economic dislocations associated with the Great Recession. Since the Great Recession began in December 2007, the ranks of America’s poor have swollen by at least 3.7 million; child poverty has climbed to 20.7 percent from 17.8 percent a few years earlier.  One in eight Americans, including one in four children, is now on food stamps because he or she is not eligible for unemployment compensation or other social welfare programs.  Nearly 50 million Americans lack health insurance, and over 17 percent of households report that they have postponed or are delaying seeking healthcare over the past year for financial reasons.

The Great Recession has had such a devastating effect on American society because it struck at the very heart of the American social contract.  More than in other Western societies, employment has been seen as the best guarantee of both economic security and economic opportunity for American workers.  Yet, the recession resulted in the loss of 8.4 million jobs with official unemployment rising to more than 10 percent and the number of unemployed and underemployed climbing to over 25 million. 

What is worse, the employment outlook for the post-bubble economy is extremely worrying:  official unemployment is expected to remain near double digits for some time to come with the number of jobless much higher for workers in vulnerable communities and for those just out of school; job creation is projected to be weak by historical standards, raising the level of structural unemployment and depressing wages; and long-term unemployment is increasing, threatening permanently the livelihoods of millions of Americans.  In addition to the harm done to the unemployed, the high rate of unemployment has a deleterious ripple effect throughout the economy, as falling tax revenues force government budget cuts and lay-offs worsen the long-term outlook for Social Security and Medicare, which have become more important to retirees and prospective retirees who were counting on housing prices or stock market gains for their retirement years. 

Secondly, the Great Recession was the result of the bursting of a housing and credit bubble that had come to be a core feature of America’s social contract over the past decade and a half.  The United States more than other OECD economies has embraced the idea of the ownership society, with the home being the most commonly owned asset among most working Americans.  Credit also became an essential tool for working families to maintain their standard of living and to help smooth out periods of misfortune.  For awhile, rising home prices and access to credit helped mask the effects of stagnating wages.  But now the debt left in the wake of the housing crash is dragging down millions of American families.  As of the beginning of the year, nearly one in four mortgages was underwater, meaning the mortgage holder owes more on the mortgage than the underlying home is worth; that number is expected to increase to 48 percent by 2011.  Overall, American households have suffered a $12.3 trillion loss in household wealth, a significant portion in their homes and retirement accounts, and as a result, one in four Americans over 62 are putting off retirement because they cannot make ends meet.  

Our experience during the Great Recession suggests that there are some fundamental flaws in our social safety net.  It also suggests that we need to rethink some of the main pillars of our social contract relating to how best to achieve full employment and retirement security.

Flaws in America’s System of Economic and Social Security

There are five major problems with America’s system of economic and social security that helps explain why the United States has done so poorly in cushioning the impact of the Great Recession on its middle and working class and why America’s safety net looks even more ragged in its wake.

First, as suggested earlier, the American system of social and economic security revolves too closely around employment at a time when the contingent and part-time workforce is rapidly expanding and structural unemployment is on the rise.  As is well known, health insurance in the United States is still largely employer based—if you lose your job, you most likely lose your health insurance as well—and that will only change modestly under the new health care reform.  But so are other features of America’s social welfare system.  As a result of the welfare reforms passed under the Clinton Administration, America’s principal welfare program—Temporary Assistance for Needy Families—is now linked to work requirements.  Not surprisingly, the number of people accessing the program has scarcely expanded during the recession because employment itself has declined even as the number of poor has increased. 

Likewise, America’s main program for helping the working poor—the earned income tax credit—is dependent on being able to work.  Individuals who can show they have earned income up to a certain level are eligible for a refundable tax credit to supplement their income; those who have not been employed and have no earned income are not. 

Yet as the economic security of Americans has become ever more linked to employment, America’s job machine has broken down.  Since January 2000, the economy has created, on net, no new private sector jobs, and the number of discouraged workers and involuntary part-time workers has steadily increased.  As of August 2010, the official unemployment rate was 9.6 percent, but that number rises to 16.7 percent when people who have given up looking for work and those working part-time out of necessity are included.  That means one in six working Americans are effectively unemployed or underemployed, and because they are unemployed, many of them have lost their access to health care and other social insurance benefits.

Second, U.S. labor markets are characterized by relatively weak unemployment protection; thus job losses occur more quickly than they do in Europe and the unemployment insurance programs available to workers are a lot less robust than they are in the core European Union countries.  Since the beginning of the recession, the official U.S. unemployment rate increased by 4.6 percent, while the unemployment rate in the euro zone during the same period increased by just 2.7 percent.  But unlike in Europe, many unemployed Americans do not have the protection of unemployment insurance.  In most European countries, unemployment benefits are available to nearly all workers, cover well over half of an employee’s earlier salary, and extend for more than a year. 

By contrast, in most states in the United States, unemployment benefits are restricted to a narrow group of workers, often compensate workers for less than half of their previous wages, and generally last less than one year.  Less than two thirds of unemployed workers in the United States are eligible for and receive unemployment insurance benefits.  That is because many states in the United States have very rigorous eligibility requirements that exclude low-income or part-time workers and that limit any compensation to a very short period of unemployment.  As a result, while 15 million workers in the United States are officially unemployed, only 10 million are receiving unemployment insurance benefits, either because they did not qualify initially or because they have already exhausted their benefits.  And the number receiving unemployment insurance benefits would even be lower had Congress not taken special measures several times to extend benefits beyond their normal expiration date.  In sum, America’s system of economic security works reasonably well during periods of full employment but quickly collapses during periods of rising unemployment.

A third reason that the Great Recession has created such stress on the social contract relates to what might be called America’s system of social welfare federalism, which puts much of the financial burden for many social safety net programs—such as unemployment insurance and health care—onto the states and not on the federal government.  Over the past two decades, the Congress has increasingly resorted to the use of federal mandates requiring the states to provide certain benefits but has failed to provide states adequate funding to meet those mandates.   

When economic times are good and state budgets are flush with cash, this system works to some degree.  But during economic downturns, states immediately face a dilemma:  the demands on their budgets rise as the demand for social welfare benefits increases but the ability to meet these demands declines as tax revenues dry up and states are forced to cut expenditures.  What is worse, unlike the federal government which can run deficits, nearly all states are required by law to balance their budgets—which means raising taxes or cutting benefits and services, or both.  Such is the situation today.  State governments are looking at more than a $200 billion shortfall, and are being forced to lay off teachers and other employees, cut benefits, and raise taxes in an effort to balance their budgets.

To be sure, the federal government may step in during an economic downturn to help states, as it has in extending unemployment benefits and in providing some assistance to state and local governments to meet their Medicaid obligations.  But in these cases, the federal support is often too little and too late.  Overall, this makes America’s delivery of social welfare benefits far from being the automatic stabilizers they are in the case of the core European economies.

Fourth, another feature of America’s social welfare state requiring rethinking is the fact that a significant proportion of many of America’s most important social welfare state benefits relating to education, child care, home ownership, and retirement are delivered through the tax code as deductions against income.  This has created two perverse results.  The first is a social welfare state that heavily favors upper- and middle-income groups; indeed the majority of benefits now go to the top 20 percent not to those who need them most, creating in effect a two-tier welfare state.  The top tier enjoys generous deductions for health care, education, home ownership, and personal retirement savings.  The higher one’s tax income and tax bracket, the greater the value of the deductions offered in all these areas.  At the bottom, the less fortunate receive very little from these deductions because they do not have enough income to take advantage of itemizing deductions.

The second effect is that it has created a pro-cyclical social welfare state that awards more benefits during booms and periods of rising economic growth and fewer benefits during recessions and periods of slower economic growth.  Thus, rather than helping smooth out families’ incomes it actually adds to income volatility.  In other words, as unemployment and underemployment rise and the incomes of Americans decline, so do their social benefits for education, child care, and retirement.  As a result, they can quickly find themselves without the resources needed to pay for their children’s education and to save for their own retirement.

Finally, as noted earlier, the United States has embraced much more readily the idea of the ownership society than has Europe, and thus the American social contract has come to rely much more heavily on home ownership and private pension plans than has the European counterpart.  This embrace obviously has advantages when asset prices are rising but it wreaks havoc when asset bubbles burst.   For the past decade, rising home values compensated for stagnant wages, allowing them to maintain and even improve their standard of living by tapping home equity.  In addition, easy access to credit allowed families to weather economic downtowns or medical emergencies but at the expense of rising household indebtedness.  With the bursting of the housing and credit bubble, this essential feature of the Clinton-Bush era imploded, leaving many households with a large debt hangover.  As a result, the Great Recession has dealt a double blow to many Americans; not only have they lost their job but they have lost their home and their life savings as well.  Worse, there is little in the way of programs available to help them pick up the pieces. 

The Great Recession has also hit hard the private retirement savings of working Americans, who have increasingly come to bear the burden and risk of saving for their own retirement.  Over the past two decades, American companies have steadily shrunk their private pension contributions and have put more of the risk onto employees.  They have done so in two ways: either by eliminating company retirement plans altogether or by shifting from a defined benefit to a defined contribution pension program.  In a defined benefit system, a retired worker knows exactly how much he or she will receive each month; in a defined contribution system, the employee makes a contribution into his or her retirement account—most likely a 401k—that is then invested in the bond and equity markets with attendant risks.

The experience of the past decade shows that this shift in the nature of U.S. retirement system has worked to the disadvantage of American workers while creating more vulnerability and uncertainty.  Seniors who retired in the late 90s before the collapse of the stock market in 2000-01 may be able to enjoy a comfortable retirement but those who were planning to retire this decade face a much bleaker retirement future having seen much of their retirement savings lost during the past two market crashes.  That is why for nearly 70 percent of seniors, Social Security is the main source of retirement income but Social Security is far less generous than most seniors need to enjoy a comfortable retirement.

Unlike other economic downturns, which are largely transitory events that have little lasting impact on American society, the Great Recession is likely to be a multi-year society-shaping force that leaves deep and ugly scars.  The most significant effect is likely to be the further collapse of the American middle class, particularly that part of the middle class that has withstood three decades of stagnant wages by living off of rising home prices and easier credit.  As is evident from the number of home foreclosures, the housing bust is having its most concentrated effect on people on the lower and middle rungs of middle class life, hitting particularly hard those who have bought a home in the last five years.  Many of these were first-time home buyers that had achieved a tentative hold on middle class status but now they are being pushed back into poverty with the loss of their home and their job.  Others were upwardly mobile middle-class families who got caught up in the optimism of the housing bubble and moved from a starter home to a more expensive (and overpriced) house during the same time. These families now are confronted with a staggering mortgage debt that they will never be able to work off.

Policy Lessons

Our experience under the Great Recession has underscored the enduring value of the core pillars of a social contract that President Franklin Roosevelt first laid out in his address to Congress in January 1944:  the right to a job, the right to adequate compensation, the right to a secure retirement and affordable health care, and the right to improve one’s position in life through access to quality public education.  Roosevelt recognized that these rights were essential to a healthy society and to an economy that would be free of the destabilizing inequalities and insecurities that led to the Great Depression.

Yet many of these core pillars are still under assault as we adjust to the post-bubble realities of weak economic growth and a huge debt overhang.  The economy is not expected to return to anything approaching full employment until 2016 and even then structural unemployment may be several points higher than it was before the crisis; productivity has skyrocketed during the recession as businesses have cut costs and fired workers but real wages are by contrast stagnating, further exacerbating the gap between productivity and wages that contributed to the crisis in the first place; financially stressed businesses and cash-strapped state and local governments have been forced to cut future retirement programs and to trim other benefits, further eroding many workers’ access to health care and a secure retirement.   

The Great Recession may have reinforced the wisdom that a robust social contract is necessary to avoid destabilizing inequalities but it has also made clear that we need to bring about major changes in how we seek to realize this social contract. 

A New Approach to Full Employment

First, we need a new strategy for maintaining full employment even as we reform our benefits system to be less dependent on formal full-time employment.  Our basic strategy for maintaining high levels of employment over the past two decades was essentially reliant on an expansive monetary policy with minimal intervention in the labor market.  But this strategy won’t work in a world in which consumer demand is constrained by high debt levels, businesses are either facing overcapacity or can meet demand with fewer workers, and much of the demand provided by macroeconomic policy leaks out of the United States to stimulate job creation in other economies.  In such a situation, it is unrealistic to expect macroeconomic policy, especially monetary policy alone, to restore the economy to full employment or for the private sector to generate enough jobs on its own to bring down unemployment.  Concerted public sector policy will also be needed. 

In particular, we need to explore ways to expand public and public-generated employment to make up for shortfalls in private sector job creation.  The best way to create jobs and make the economy more productive over the long term is by increasing public infrastructure investment, some of which can be targeted to communities with particularly high rates of unemployment.  Studies estimate that every $1 billion of infrastructure spending creates on average 18,000 jobs and has a 1.57 multiplier effect on GDP.  The United States has an enormous backlog of unmet public infrastructure needs, and it would make sense to address them over the next five years in order to help return the economy to full employment.

Second, we will need to complement a program of public infrastructure investment with a general expansion of public services.  It may sound heretical to propose expanding public employment at a time when state and local governments are being forced to cut jobs and services but in a high-productivity private sector economy more of the jobs in the future will need to be located in the public sector.  In addition to investing in infrastructure and energy efficiency to provide a better environment for productive enterprise, the public sector can provide well-paid employment while lowering the cost of essential services by expanding its provision of goods like education, daycare, elderly care, and other essential quality of life services.  Such a policy would build upon the trend of the last decade, when public or publicly-supported provision of health and education was responsible for most new job creation.  There are a number of complementary options for expanding public services—for example, an indirect way by providing vouchers for elderly care as proposed by my New America colleagues Michael Lind and Lauren Damme or a more direct way by establishing public programs like the Home Care Corps, as suggested by economist James K. Galbraith, that can expand and shrink to provide jobs and services as needed.

Adequate Compensation

Second, we need to recommit ourselves to the understanding that economic security begins with jobs that pay wages that can support at a minimum a standard of living above the official poverty level.  Unfortunately, a significant portion of the jobs in the U.S. economy fail to meet this standard.  An economy with a disproportionate number of jobs that pay low wages not only adds to the social welfare burdens of government but also creates a lop-sided pattern of economic growth that is subject to the kind of crisis we have just experienced.  Indeed, we will not have a truly sustainable economic recovery or a truly durable social contract until the wages and incomes of American workers begin to rise again.  Therefore one of our principal goals in the wake of the Great Recession must be to increase the take-home pay of workers as part of a new pattern of economic growth.

The take-home pay of workers can be increased in essentially two ways:  by increasing pre-tax pay and by reducing taxes on moderate- and low-income workers.  Over the past decade or two, public policy has sought to supplement after-tax income of low-income workers and the working poor by government subsidies, like the earned income tax credit (EITC).  While the EITC and other programs are useful, it is important to understand that they work best together with higher pre-tax wages, not as a substitute for them. 

In the absence of strong economic growth, the place to begin to raise the pre-tax wages of low-income workers is with the minimum wage.  Although recently increased to $7.25 an hour, the federal minimum wage is still far below its value in the 1960s in inflation-adjusted terms and therefore does not provide a sufficient floor for low-wage workers.  The problem is that the United States, unlike many other OECD countries, does not have an automatic mechanism for adjusting the minimum wage to keep up with inflation or productivity gains.  That needs to change.

Another way to increase pre-tax wages in the service sector would be to create a tighter private service sector labor market by expanding public employment of low-income workers.  As the experience of Sweden has shown, a high level of employment in the public sector can shrink the available private service sector labor pool, increasing the ability of private service sector workers to bargain with employers for higher wages.

In the U.S. context, this means expanding public employment in education, health care, child and elderly care, energy conservation, and arts and recreation.  In addition to reducing inequality and raising pre-tax incomes at the bottom of the labor market, expanding public employment in these areas would reduce the costs of these services to middle-income and low-income Americans and increase their accessibility.  An increasing percentage of the American household’s income is spent on services including health care, day care, and education.  Reducing their cost by means of greater public provision could increase the ability of American workers and families to save without the need for sacrifice. 

Expanding public employment would also have the benefit of encouraging greater productivity growth in the private service sector, which would support higher wages in that sector.  If private health care, leisure and hospitality had to compete for low-wage workers, they would be forced to make better use of productivity enhancing technology as well as to pay high wages. 

A strategy of raising wages in the low-wage private service sector would be complemented by reductions in the tax burden of low-income workers.  The best way to reduce the tax burden on low-wage workers would be to reduce the payroll tax and allow individuals and families to take deductions against the payroll tax instead of the income tax.  In 2006, 44 percent of American taxpayers paid more in payroll taxes than they did in income taxes; that number rises to 66 percent if both the employer and employee parts of the payroll tax are included.  Reducing the payroll tax therefore would have the greatest benefit for low and moderate income Americans.  To make up for the lost revenues from FICA, we could raise the cap on the payroll tax and broaden the FICA base by making capital gains and unearned income subject to FICA contribution, and we could also introduce a modest value-added tax with reimbursements for necessities or up to a certain income level.

Moving from Tax-Benefited Social Programs to Universal Citizen-based Benefits

Reducing the payroll tax would simultaneously increase the take home pay of workers, particularly low-income workers, and reduce the cost of hiring workers, thereby facilitating job creation.  It would also make the overall tax system more progressive in two ways.  It would reduce our dependence on one of the most regressive taxes to fund Social Security and Medicare.  And it would make our system of tax expenditures (tax deductions and tax credits) fairer.  As it is now, upper income individuals and families benefit disproportionately from deductions against the income tax.  Consolidating existing deductions for housing, child care, saving, and education with a single tax offset against the payroll tax would allow low-income individuals to benefit from America’s hidden welfare state while reducing its overall costs.

But we also need to begin to move away from a tax-code based social welfare state that is both inefficient and unfair and toward universal social insurance programs like Social Security and Medicare.   Social Security and Medicare have succeeded because they were universal programs that included all Americans regardless of class; they were citizen-based, and thus not dependent on the employer; they were non-intrusive into the personal lives of citizens, and they were efficient in that they minimized government overhead or the investment of personal time.

Social Security and Medicare have been essential to eliminating poverty among the elderly in the United States.  In 1966 (the first year poverty was measured for the elderly) elderly poverty was at 28.5 percent; in 2007, it was 9.7 percent.   Social Security may even be more important today because retirement savings are skewed heavily by income, with lower income Americans almost entirely dependent on it.  Indeed for those currently 65 and older, Social Security is the largest source of income, accounting for 38.6 percent of their income on average.  By contrast, pensions and annuities income accounted for only 18.6 percent.  The numbers are even more striking for low-income workers.  For the bottom 20 percent of Americans, Social Security accounts for 88.7 percent of their income, pensions and annuities only 4.4 percent of income.

Social Security is also growing in importance because of the decline in defined benefit pensions and the shift toward defined contribution savings accounts like 401(k)s.  Defined contribution plans have turned out to be an unreliable pillar of retirement security in part because of severe market swings and in part because they have tested the ability of many Americans to manage them effectively.  

Yet, in spite of this success, Social Security and Medicare are under new attack today, being the principal targets of those who want to shrink government and close the budget deficit.  But rather than cutting Social Security, a better approach would be to phase out the tax expenditures associated with the tax breaks provided for private retirement savings and to strengthen Social Security and make it an even more meaningful retirement program for low- and moderate-income workers.

Given the damage the crisis has inflicted on the savings of many American households, there is no choice but to see social insurance as an even more critical pillar of retirement security in the United States for the foreseeable future.  We therefore need to give priority to strengthening and expanding Social Security in order to rely less on tax-favored private retirement savings, the benefits of which go disproportionately to the affluent.  One approach would increase the minimum Social Security benefit and the replacement rate for low- and moderate-income Americans.  The revenues to fund these increases can come, in part, from gradually reducing the amount of private retirement income that the wealthy can shelter from taxation. 

Far from hurting the economy, such an expansion of Social Security pay-outs would likely have a permanent stimulating effect on the economy.  Most economists agree that lower income people are more likely to spend an extra dollar on goods and services than are affluent individuals.  It may also discourage asset bubbles from developing in the future and help reduce wealth inequality as well as increase retirement security.

A New Fiscal Federalism

Finally, we need to reform our system of social welfare federalism, relieving states of the financial burden of many social safety net programs.  As noted before, state governments have difficulty meeting their various financial obligations during recessions, and thus programs that were designed in part to be automatic stabilizers of the economy end up being pro-cyclical drags on state budgets.  The fiscal division of labor that has developed between the states and the federal government over the years has produced a very uneven system of economic security, with benefits varying widely among states and with states engaged in various efforts to reduce eligibility to save money while seeking to maximize federal support.  It is time to end these games and put core economic security programs on a firmer fiscal ground. 

It does not make sense for states to assume responsibility for core social safety net programs when they do not have the ability to undertake countercyclical spending by running budget deficits and when they rely generally on much more regressive taxes than does the federal government.  Thus, for both fairness and effectiveness, it would make sense to fully federalize the financing of core economic security programs.  One place to begin would be to complete the process of federalizing Medicaid that it was started but left incomplete by The Affordable Care Act. Another, as suggested by Steven Attewell, would be to make unemployment insurance a federal responsibility.  These reforms would go a long way to make benefits more even and in making these programs effective automatic stabilizers as well as anti-poverty programs.

The next year or two could prove decisive in determining the future shape of the social contract, as the nation debates whether a new economic recovery program to create jobs is needed or must be shelved because of rising deficits, whether tax reform will facilitate job creation and increase worker take-home pay or create even more obstacles to full employment, and whether the push for entitlement reform leads to a weakening of Social Security affecting the retirement security of millions of Americans or whether we strengthen and expand Social Security to make it a more robust pillar of retirement security.  It is therefore important we understand not only what is at stake but how best to strengthen the social contract for the future.