If Capitalism Works Then Why Aren't You Rich?

In 1879 Henry George wrote a critique of unbridled capitalism titled Progress and Poverty. As the title suggests, George acknowledged the “wealth-producing power” of capitalism, but criticized it for the widening disparity between the haves and have-nots:

... it becomes no easier for the masses of our people to make a living. On the contrary, it is becoming harder. The gulf between the employed and employer is becoming wider; social contrasts are becoming sharper; as liveried carriages appear, so do barefooted children. (1)

Keep in mind, this was written before any the regulatory and social safety net legislation that we take for granted today. Congress passed the Sherman Anti-trust act in 1890; the Pure Food and Drug Act in 1906; and ratified the Sixteenth Amendment to the Constitution in 1913, making an income tax constitutional. Social Security was created with the Wagner Act in 1935, establishing what Franklin Roosevelt once called “cradle to grave” security. We embarked on the War on Poverty and affirmative action in the 1960s. In 2003, president George Bush added a prescription drug benefit to Medicare, at a projected cost of some $400 billion over the next decade. (2)

Yet Henry George’s criticism of class privilege resonates today in politics and the media. Remove the reference to “liveried carriages,” and the above quote could have come from any Democrat congressman today. How often have you hear the flawed observation that “the rich are getting richer and the poor are getting poorer?” The story of inequality never loses its audience, but does it imply a lack of economic mobility for those who aspire for more?

Keeping in mind all that we have done for economic equality since the 1870s, let me respond (belatedly) to Henry George’s critique. I want to address the question of why economic opportunity does not seem to erase economic disparity. It should, and I want to show you why.

This is a story about a cleaning lady who became a millionaire. Well, actually it is the story of my cleaning lady, who could have become a millionaire and did not. It is the story of your cleaning lady; your auto mechanic; your accountant; your dad; and you. It is the story of how all of us could be millionaires by simply investing a modest amount of money each month over a long period of time. Because the example I am going to show you is realistic and even conservative in its assumptions, it creates another story in the telling – the story of why most of us are not millionaires, given that we had the chance.

The lesson is that financial success, like success in other aspects of life, springs from an idea – in this case the belief that becoming wealthy within one’s lifetime is possible. Generally speaking, if you are middle aged today, and you had saved about $500 a month over the course of your career, you can retire worth well over a million dollars. If you are 40 today and have 20 years to retirement, you can still retire with an account worth $378,000. That assumes you start saving $500 a month in an account that earns 10% over the next twenty years.

Before I discuss how realistic a 10% return is, let me make a point about the power of compound interest over time. Did you notice what those extra ten years were worth? They were worth over $620,000. Working people do not recognize the opportunity to become wealthy because they do not recognize the value of time.

I am going to show you a tool that you can use to prove to yourself that investment over time creates more wealth than you thought possible. It is important that you do prove it to yourself, because the missing ingredient in most people’s retirement planning (other than self-discipline) is the belief that they can actually be worth half a million dollars; a million dollars; or much more, by the time they retire.

The table below is called a compound interest chart. It shows the value of one dollar invested at various rates of return over various periods of time. You can use it to project your own retirement account by choosing a rate of return and time frame that is realistic for you. Just glance at the figures and you can see that time is more powerful than money. One dollar invested monthly for 20 years is worth three to five times more than a dollar invested monthly at the same rate for 10 years, using realistic rates of return. Doubling the time increases the value of your account by a multiple of between 3 to 5.

In Henry George’s time only a few wealthy men invested in stocks, and those shares were traded privately. Today stocks are available to virtually anyone, and those investments are protected by the regulatory institutions we have created over the last century. Yet only half of U.S. households have some of their savings in stocks. Just as in the nineteenth century, stock ownership is still concentrated among the wealthy.

According to a report by the Economic Policy Institute, the middle 20% of U.S. households have only about $12,000 invested in stocks, principally through 401K and other retirement plans. Stock ownership for the bottom 40% of U.S. households is insignificant – an average of about $1,800 per family. By contrast, the stock holdings of the top ten percent of U.S. households average more than half a million dollars. (3)

This is confusing to me, as it is entirely realistic for working people to save their money at rates of return of about 10% by investing in the stock market. At least, it has been realistic to save at rates of 10%. There is some disagreement about how the stock market may perform in the future, given slow wage growth, an ageing society, and the pressures of globalization. Still, arguing from history, I would say that a 10% return in a stock mutual fund is realistic and achievable.

Like everything else in public policy the debate over privatization has devolved into two polar opposites: private savings versus government-sponsored savings. The latter is just a euphemism for income redistribution from working people to retired people. Social Security is not a savings plan.

If you acknowledge that, and would still prefer to have the government take care of you in your old age, then you have bought into the idea that the government can take care of you better than you can take care of yourself. Before you make that choice, however, you may want to reconsider the argument that reduced economic growth will make private savings futile. This actually makes no sense. Social security is funded from working people’s payroll taxes. When that is insufficient, it will be funded from general tax revenues. If factors such as demographics and globalization keep the economy from supporting individual investment portfolios, then where is the tax revenue going to come from to keep the social security system solvent? The idea that we can simply tax ourselves into prosperity is ludicrous. Can you name a society that has ever done it?

The truth is, you can retire wealthy enough to live comfortably if you have just one of three things listed below:

•        money.
•        a high rate of return,
•        or time.

OK, the first one is kind of obvious, but it is necessary to acknowledge it. If you start with money, you can invest to preserve it and retire comfortable – not a given in our society as capitalism allows for downward as well upward mobility. I read that it only takes two generations for most family wealth to dissipate.

The second item is also intuitive, if not obvious, especially to those of us who had the experience of investing in the stock market in the 1990s. I know a guy who made enough money in tech stocks to retire, and then watched his portfolio shrink to nothing as the air went out of the market. Why he did not sell out when his portfolio had lost only half of its value is a question he will probably ask himself for the rest of his working life.

Lastly, you can retire comfortably wealthy if you have time. The good news is that if you have lots of time, you do not need either of the first two  items. You do not need to start with a lot of money, and you do not need a stock portfolio that compounds at ridiculous multiples. You just need to put money away consistently (preferably monthly, as a deduction from your paycheck) in an investment that does reasonably well.

Well, let me amend that: you do need to have both the income and self discipline to maintain a savings program over time. Most people have the former but not the latter, and I offer as evidence the fact that a home is the single largest asset most people have when they stop working. Contributing to a savings plan is voluntary; paying your mortgage is not. A house is a mandatory savings plan.

Further, the recent run-up in housing prices in most states shows that people will invest heavily in an asset they truly believe will make them wealthy. The  housing boom is currently making a lot of people wealthy. The economic consulting firm economy.com  estimates that $705 billion of cash was taken out of the housing market just last year. The bad news is that nearly 20% of that came from home-equity credit lines. People are using their homes as supercharged credit cards. The good news is that about 70% of that cash came from people selling and moving on (or moving up), although I would suggest that a lot of them are over-leveraged.(4)

Let’s go back to my cleaning lady. She is a real person. She charges $50 an hour to clean a two-bedroom apartment, and supplements that with cleaning jobs for construction and management companies. She has two helpers, whom she pays about $10 an hour, and pays only for her own equipment. I estimate that she probably nets about $25 an hour after paying her help and paying for gas, materials, and repairs. She works an eight to ten hour day, five days a week, avoiding working on Saturday, she says, “if I can help it.”

If she makes $25 an hour and gets paid for six hours a day (the rest is travel time), five days a week, she would make $3,000 a month. That allows for some time spent caring for her granddaughter each day, with weekends free.  That’s not much, especially for a woman with a daughter and granddaughter living at home. At that level, she might only be able save a few hundred dollars a month, which would still amount to about a half a million dollars in savings if she had started 30 years ago.

Of course, my example does not account for vacations, or for taxes, or for exceptional expenses, such as replacing her GMC wagon every five or six years. On the other hand, it does not account for the fact that over time most people are able to increase their earning power – even cleaning ladies. I asked her (for the purpose of this article) how many jobs she has each week, and she told me that in addition to her own cleaning jobs, she runs three other cleaning crews around town. Part of her time each week is spent traveling between commercial jobs (apartment complexes), checking on her workers. Now her income increases by some factor that I cannot account for without prying, but the additional income she makes managing others certainly would make a savings plan of a few hundred dollars a month realistic.

I mentioned the low rates of stock ownership and the success of the housing market as an investment vehicle to emphasize this point: people will only invest over long periods of time in something they believe will make money. My cleaning lady probably never really believed that having an investment account worth $500,000 was possible for her. In other words, the idea that she could achieve financial independence was really the key ingredient missing in her retirement plan. She had what she needed thirty years ago, but was unaware of its value. That was: a few hundred dollars a month and lots of time.

The best part of the story comes at retirement. If your portfolio is worth half a million dollars in twenty years, and it generates an average annual return of 8% in interest and dividends, that is $40,000 per year. You own that account. It is not welfare, or money taken out of other people’s wages. It is yours, and you can use it to generate an income of approximately $40,000 per year while holding the balance constant. You can will the balance to your children; use part of the money to pay off the mortgage on your house; set up a charitable trust; or anything else you want. Those are the advantages of ownership.

You do not have to squeeze every penny from now through retirement to make this work for you. There are lots of people who have achieved a comfortable retirement by simply following a program of monthly investment over the span of their careers. I worked for an investment firm in the 1980s and saw the proof in our clients’ mutual fund statements. Monthly investing in mutual funds works.

For more information, search the web on key words “retire rich,” or something similar. You will find things like this:

Don't be paralyzed by the astronomical figures, says Christine Fahlund, senior financial planner at T. Rowe Price. When you save money in an investment vehicle such as a 401(k), you earn a substantial rate of return, as your dividends are reinvested tax deferred. So if you're 30 years old, and you'll need $1 million at age 65, you can set aside only $314,000 during your working life. The money your investments accrue should provide the remaining $700,000.  (5)

Notes:

1. John Milton Cooper, Jr., Pivotal Decades: The United States, 1900 – 1920 (New York: W.W. Norton & Company, 1990, 10)

2. See http://www.acep.org/webportal/Advocacy/Federal/CurrentLegislativeEfforts/FederalAnalysisofMedicarePrescriptionDrugAct.htm.

3. See Economic Policy Institute, The State of Working America 2004-2005: Introduction and Executive Summary, downloaded from http://www.epinet.org/static/books_swa2004_main.cfm on July 23, 2005.

4. The Bank Credit Analyst, July 2005, 29.

5. See http://www.bhg.com/bhg/story.jhtml?storyid=/templatedata/ljh/story/data/LHJ062005retirerich_05162005.xml, downloaded 7/12/05.