Investor class, investor nation: America is becoming an 'ownership society,' a seismic development.

IT was not hard to find, during our recent bear market, a certain schadenfreude abroad in the land. We had been warned that the previous boom was fated to end; that the boom was, indeed, an illusion, a bubble that would burst any day now; and that all the people who had put their money in the markets without a care would discover to their horror that they could go down as well as up, and pull out their money. When the market started to fall, everyone who had been a bear amid the bulls felt entitled to say: I told you so. Such people should not be begrudged what joy they are capable of experiencing.

Sometimes, the recriminations took on a more ideological cast. Liberals ridiculed free-market enthusiasts for having suggested that individuals should be free to put some of their Social Security money in the markets. They had supposedly made this suggestion based on the naive belief that the Dow would rise, without interruption, to 36,000 and beyond.

Also dismissed was the notion that the 1990s had seen an expansion of capital ownership that had shifted American politics to the right and would continue to do so. Nobody could deny that a change had occurred. The number of Americans who owned stock, either directly or through a pension plan, had increased from a fifth of households in the early 1980s to over half of them by the end of the 1990s. Richard Nadler, a conservative activist, called the new stockowners "worker-capitalists." The conservative economist Lawrence Kudlow gave them the more felicitous label "the new investor class."

By the end of the Clinton administration, most Republican politicians were happy to regard the investor class as a force that would work to their inevitable benefit. Few of them considered the matter more deeply or gave any thought to how to expand the investor class or make it more Republican. The media were interested by the idea of the investor class, although there was some healthy skepticism.

The bear market and the corporate-accounting scandals changed the conventional wisdom about the investor class. Now there was no such thing--or there was, and it was a voting bloc that favored more government regulation. "Instead of embracing conservative ideology, voter-investors are somewhere between jittery and angry," reporter Richard Stevenson wrote in the New York Times in August 2002, adding that "their reaction threatens to be bad news for Republicans on the ballot this November as well as for President Bush." The same summer, the respected political journalist Ronald Brownstein wrote in the Los Angeles Times that "investors have become a force for more government regulation of the markets." Regulation was necessary to restore investor confidence. The scandals were making 401(k)s look worse and traditional pensions that offer a fixed monthly payment look better.

Robert Samuelson, an economics columnist at the Washington Post--who is perhaps better classified as a pessimist than as a liberal or a conservative--summed up the new view in September 2002: "One casualty of the slipping stock market has been 'investor politics.' ... Greater shareholding leads to more--not less--government activism and regulation. It increases--not decreases--the political impulse to tinker with business and the stock market." The new investors were just another interest group who, when the going got tough, got going to the government for help.

These attitudes are persisting into the current recovery. In December, Los Angeles Times reporter Peter Gosselin wrote an article on the investor class that synthesized all the liberal views on it. The expansion of the markets has not changed anything, since wealth in stocks is concentrated. Direct ownership of stocks may change political behavior, but indirect ownership through 401(k)s does not. Nor do 401(k)s improve retirement security; they just confer tax breaks on saving that would have taken place without them.

THEORY AND PRACTICE

Before evaluating the claims and counter-claims, it might be helpful to take a step back. From this country's earliest days, there has been interest in having workers own capital. Albert Gallatin, Jefferson's Treasury secretary, said that the "democratic principle on which this Nation was founded ... should be applied to the industrial operation." He implemented a profit-sharing plan at his glass works in Pennsylvania. These early attempts at worker capitalism, based on the distribution of profits and company stock, largely failed, since their success depended on the fortunes of particular companies. When the companies went under, the experiments were over. The 1892 and 1929 stock crashes, for example, were devastating. Still, the idea survived. In 1939, the president of Sears, Roebuck and Co. told the Senate that profit-sharing "helps to avoid labor unrest and strikes, and gives the employee a feeling of greater security and unity of interest with the employer."

The theoretical basis for the hope was obvious. If workers owned the means of production, labor would no longer be "alienated" in the Marxist sense. The political economy of industrial society had been marked by the constant fear, and recurrent reality, of class conflict. Worker capitalism would diminish, perhaps even end, that threat. The Founders' idea that only property owners should vote could again become a reality--and be reconciled with democracy.

It was not until the last quarter-century that the conditions for widespread worker capitalism materialized. From the 1970s on, companies started shifting from "defined benefit" pension plans to "defined contribution" plans. Under the old-style plans, retirees received payments based on how many years they had worked for the company and how much money they made toward the end of their work years. The precise formula was often the product of negotiation between unions and management. The company was responsible for funding the promises (although the federal government played a back-up role).

Defined-contribution plans, such as 401(k)s, work differently. Typically, employees decide how much of their paycheck they want put into a plan. Employers often match their contribution. Under this arrangement, the size of a pension depends on how much money is put into the plan and how well the plan's investments do. The investment risk has shifted from the employer to the employee.

That was the first precondition for the new investor class. The second came when the federal government decided that contributions to these plans, from employer or employee, would be tax deductible. Third, employees in the defined-contribution plans started to buy mutual funds. Their fortunes as investors did not have to be tied to the fate of one company. They could own a small piece, not just of that company, but of the whole economy (or a broad sector of it). Fourth, the markets began to rise, especially in the 1990s, drawing more people to contribute to their pension plans.

Between 1983 and 2001, the percentage of households owning stock increased from 19 to 52. One might expect that the increased number of small investors would cause the median size of a portfolio to drop. Instead, the median value, adjusting for inflation, more than tripled, from $11,000 to $34,000. (In other words, half of all portfolios were worth more than $34,000 and half less.) The average is higher, swelled by the 29 percent of investors who, according to the Securities Industry Association, hold $100,000 or more. The investor class grew in depth as well as breadth.

Was the shift from defined-benefit to defined-contribution plans a raw deal for workers? In a forthcoming paper for the American Economic Review, Dartmouth economists Andrew Samwick and Jonathan Skinner show that "the trend toward 401(k) plans has strengthened the retirement security of current workers." Those plans may have exposed workers to investment risk, but the older, defined-benefit plans carried risks of their own. A worker's wages might not rise to the expected level before he retired. He might change employers several times. The chief policy recommendation that emerges from the economists' research is that it might be wise to require workers who have put little or nothing in their accounts to start contributing more. Debate continues about how much 401(k)s increase saving, but economist James Poterba has shown that workers who can participate in them accumulate more wealth than workers with similar characteristics who do not.

In a 1999 paper for the Cato Institute, Richard Nadler surveyed studies that suggested that worker ownership had produced the "unity of interest" that the president of Sears had sought. Stock ownership appears to increase employee satisfaction and performance, and to reduce layoffs and job turnover.

PORTFOLIO POLITICS

Stock ownership also seemed to make people more conservative in their political attitudes. Lending plausibility to this thesis is that voters have become more Republican as the investor class has grown. Over the last two decades, voters have been more willing to identify themselves as Republicans, and more willing to vote for Republican governors, congressmen, and state legislators.

Some evidence suggested that this was not a coincidence. A January 1999 Rasmussen Research poll of 6,400 people found that in almost every demographic category, people who owned more than $5,000 in stocks, bonds, and mutual funds were more likely than non-investors to support a capital-gains tax cut and to identify with the Republican party. Men who didn't invest, and made between $20,000 and $40,000 a year, favored the Democratic party by 12 percentage points. Men in the same income range, but with investments, favored Republicans by 3. Six percent of black non-investors supported Republicans, versus 21 percent of black investors. Republicans lost non-investing government employees by 21 points; they lost investors in the public sector by only 4.

The investors of 1999 were more likely to be Democrats than the investors of 1985 had been. The liberal financial journalist Daniel Gross wrote a whole book, Bull Run, celebrating that fact. But what was important was the change at the margin. Many Democrats had come into the markets, but some of them had turned into Republicans. The new investors were more Republican than they had been before they started investing.

Free-market theorists had long worried that the political logic of the welfare state was to grow at the expense of the economy. Public policies that imposed net costs would keep being enacted so long as their benefits were concentrated and their costs diffused. The diffusion of share ownership, however, had the potential to connect the direct interests of a mass of voters with the broad health of the economy. Investors were, for example, more well-disposed to free trade than non-investors.

As the new investor class grew, it became less interesting as a distinct group for purposes of polling: Its views converged with those of the electorate at large, because it increasingly was the electorate. Investors were, for one thing, more likely to vote than non-investors. The Voter News Service found that 70 percent of voters in the 2000 election owned some stock. They backed Bush by 5 points.

Right before that election, John Zogby did more extensive polling on the investor class. Nadler, who analyzed his findings for the Dean Witter Foundation, identified several variables that influenced the free-market proclivities of investors. Not surprisingly, investors with large portfolios tended to be more conservative politically than those with small holdings. Also unsurprisingly, investors who identified themselves as members of the investor class were more likely to be conservative than those who did not. The longer investors had been in the markets, the more conservative they were. Finally, it mattered how directly investors owned their stocks and how actively they managed them. Owners of individual stocks were more conservative than people who only owned 401(k)s, who were in turn more conservative than passive recipients of income from bonds.

Surveys suggested that the vast majority of investors were trying to provide for their retirement. The next most cited goal was to finance children's education. Other common goals included the financing of major purchases such as a home, and health care for elderly relatives. There were two interesting things about these goals. First, investors were thinking about the long-term well-being of their families--which suggested, among other things, that they might not panic about temporary reversals in the market. Second, the purposes for which most people invested were also the concerns which Clinton-era liberals exploited to beat conservatives. Social Security, Medicare, education: These were the issues that had ended the Gingrich revolution.

Conservative activists such as Grover Norquist began to see a way to fight back: by expanding the breadth, depth, and self-consciousness of the new investor class. When liberals proposed government spending programs or narrowly-targeted tax credits to meet one of these needs, conservatives would respond with tax breaks that let individuals save for the same purposes: medical savings accounts, education savings accounts, etc.

Conservatives and libertarians could support these policies because they thought that savings were subject to punitive taxation as it was. The tax code was biased against saving and toward consumption. When a person brought home income, it was taxed--and if he spent it all, all he had left to pay was the sales tax. He could save some of it instead. But when he used some of his savings to buy something years later, he would find that he paid not only sales tax, but also a tax on the return to his saving. Conservatives want the federal government to tax saving at a neutral rate. That was one of the major attractions of the flat tax and the national sales tax, which many conservatives were agitating for in the 1990s. From this perspective, 401(k)s and IRAs are not tax breaks. They are a limited exception to a general policy of overtaxing saving. Expanding 401(k)s, and creating education savings accounts and the like, are a move toward neutrality.

If the investor-class theory is correct, these policies would bring political as well as economic returns. They would increase both the breadth and the depth of the investor class: both the number of investors and the extent of their stake in the markets. They would appeal to members of that class. Finally, they would create a political dynamic that would tend to correct their own imperfections. At first, people would get a tax break for saving some money for some purpose (such as retirement). But the constituency created by that policy would come to want more. It would, over time, be possible to expand the tax break. The annual limit on IRA contributions could be raised. Withdrawals from IRAs could be allowed to pay for healthcare and educational costs as well as retirement. One of the great flaws of the flat tax, as originally conceived, was that it required comprehensive reform in one big-bang bill. An investor-class strategy could be pursued incrementally.

An April 1997 PaineWebber/Gallup survey illustrated both the problem and the opportunity. Investors, especially those with large portfolios, strongly supported a capital-gains tax cut. But President Clinton's Hope Scholarships--tax credits for college--also polled very well, and did better than the capital-gains tax cut among small investors and young investors. But the most popular policy, at all levels of wealth, was to expand IRAs so as to allow penalty-free withdrawals for first-time home purchases, college tuition, medical bills, and living expenses while unemployed. All of these policies were more popular than the flat tax has been in any poll.

The investor class had other strategic implications for the Right. One, which Norquist has seized upon, is that employees of state governments should join the shift from defined-benefit to defined-contribution plans. The biggest implication concerned our biggest government program: Social Security. It is a defined-benefit pension plan. Liberals have denounced proposals to add a defined-contribution element to it--by allowing workers to invest some of their payments to it for themselves--because it would reduce the government's guarantees and expose workers to investment risks. But as with other defined-benefit plans, the current system exposes them to hidden risks of its own: notably, the very high probability that the government will not be able to make good on its "guarantees."

Everyone knows that Social Security has a financing shortfall. But, for conservatives, the program has two additional problems. There is the return problem: The program offers a lousy deal for young workers. And there is the political problem of an entitlement-oriented electorate. There are ways to solve one problem while exacerbating the others: You could, for example, hike taxes and slash benefits to bring the program into fiscal balance, but that would make it a worse deal for workers. Creating personal investment accounts is the only way to make a dent in all three problems simultaneously. It, too, could be done incrementally. Workers could start out being able to put 3 or 4 percent of their wages that now go to Social Security in a limited number of investment options. Over time, voters would want more say over more of their money.

Conservative think tanks had been churning out papers about the program's insolvency since time was. Nobody much listened. But as Americans grew more comfortable with investing their own money and more financially sophisticated, support for a free-market reform grew--to the point that George W. Bush was able to run on the idea in 2000. That stance would have cost his father the election in 1988, but it helped W. reduce the normal Democratic advantage on entitlements. Social Security reform is the key goal of an investor-class politics, since it would bring almost the entire population into the class.

The Right's internalization of the investor-class theory was, and remains, incomplete. There have not been many attempts to organize the class--to rent brokers' client lists for direct mail, for example. Major investment houses run television advertisements to get people to give them their money. Candidates have not run investment-oriented advertising campaigns that ask people for mere votes. Even President Bush's 2000 campaign, bold as it was strategically, was tactically defensive. It responded to Gore's last-minute ads against Social Security reform by stressing that nobody would have to invest who did not want to. The message was fine as far as it went, but there was nothing to galvanize potential supporters, no explanation that people would be able to build up money in their Social Security accounts just as they did in their 401(k)s.

The debate over the Clinton-Gore proposal for "universal savings accounts" revealed the persistence of old categories of thought among conservatives. The Clinton idea was to encourage savings and investment among poor people by creating a kind of 401(k) with a tax credit replacing the employer contribution. The credit was to be larger the poorer you were. Most conservatives, especially in the think tanks, were hostile to the idea. Some of their objections may have had merit. But many of them failed to account for the potentially transformative effect of a larger investor class. One conservative complaint was that the new accounts would do nothing to fix Social Security. Nothing? That could be true only if you ignored its political effects--if, that is, you took the existing electorate as a given. But changing the mindset of voters by making them investors is a step toward fixing Social Security.

Some analysts on the left misunderstood this point, too. Ruy Teixeira is one of the smartest political strategists on the left, and a skeptic about the idea that the investor class will move politics rightward. He favors the Clinton-Gore idea, and another that would give every American child $500 to start an investment account. He argues that these policies "would build an investor class," but one that favored government activism rather than taking "an individualist approach." But would a tax credit really do much to increase public dependence on government? Capital accumulation would quickly create a property interest larger than the government program that formed it. As Nadler puts it, "A shareholder with $50,000 at market isn't going to vote for anti-market candidates because of a $500 subsidy given at birth. He's looking for a 10 percent rate of return, not a 1 percent subsidy."

OUTRUNNING THE BEARS

Three years of market declines put both the economics and the politics of the investor class to a severe test. The investors had told researchers that they were long-termers who would see dips more as buying opportunities than as occasions to panic. During the 1998 "Asian contagion," they had kept their nerve--a performance that compared favorably with that of most financial journalists. But what would they do when a sustained bad spell came?

First and foremost, they lost money. The average 401(k) plan lost about 10 percent of its value. Investors limited the damage by pulling money out of tech funds and, to a small extent, out of stocks generally and into bond funds and other lower-risk investments. But there was no mass withdrawal from the market, and no panicked sell-off. At the low point of the market, the Employment Benefits Research Institute reported that participation rates had fallen--but were still well above what they had been as recently as 1998. The new investor class actually grew by 7 percent, from 49.2 million households in 1999 to 52.7 million in 2002.

Neither did "investor confidence," as measured by the price-earnings ratio investors were prepared to tolerate, plummet. Stock prices fell as earnings did, then started to rise when they came back.

During the summer of 2002, everyone in Washington took the view that the markets needed the reassurance that government was increasing its regulatory oversight of corporate accounting, and then the markets would start rising again. It's not clear how much of the demand for regulation was genuinely investor driven and how much of it was media hysteria. I doubt that investors would really have voted against the Republicans if the latter had voted against regulations. If investors weren't panicked, however, the Republicans were. They kept the question of voters' desire for regulation from being put to the test. Congress passed a major regulatory bill, and the president signed it, in late July. The Dow Jones signaled its approval by falling another 1,400 points over the next ten weeks.

Democrats still hoped to win the midterm elections by casting themselves as more eager to regulate the capital markets that had allegedly failed Americans. They also charged that the Republicans wanted to run Social Security the way Enron's pensions had been run. But as it turned out, national security dominated the election, investors favored Republicans, the Republicans slaughtered the Democrats, and the perfidy of Enron had no apparent effect.

Social Security didn't win the Democrats an election anywhere. The bear market had caused public support for Social Security reform to dip only slightly. In most opinion polls, it fell from the mid 60s to the high 50s. Advocates of reform cleaned up. Voters elected new senators such as Norm Coleman, Elizabeth Dole, Lindsey Graham, John Sununu, and Jim Talent, all of them committed to free-market reform. A similar, though less dramatic, story could be told about the House races. The Republicans who repudiated private accounts, on the other hand, generally lost.

Other issues suggested that a conservative investor politics was alive and well. President Bush's 2000 campaign had included a tax-cut proposal with few pro-investor elements. A near-unanimous Congress added an expansion of IRAs and 401(k)s to his plan in 2001. In 2003, President Bush enacted two more pro-investor policies: reductions in the capital-gains tax and the dividend tax. The dividend tax was a new issue for most people, even in Washington, and was academic for many voters since dividend payments to 401(k)s aren't taxed. But it passed, which it probably would not have done ten years before. The capital-gains tax cut passed with very little debate, as a previous, larger cut had passed in 1997 under a Democratic president.

'AN OWNERSHIP SOCIETY'

The White House believes that the investor class is for real. In his State of the Union address, President Bush renewed his call for Social Security reform. He has also revived an earlier proposal for "lifetime savings accounts" and "retirement savings accounts." Aides say he wants to build "an ownership society."

The new accounts would consolidate and massively expand existing savings vehicles such as IRAs and 401(k)s. Contributions to these accounts would be taxed--the administration wanted to avoid any immediate revenue impact--but withdrawals would not be. This policy may prove popular, based on past polling and congressional behavior. The Left is denouncing it for increasing the deficit, unfairly subsidizing the rich, etc. The most promising tactic for opponents will be to say that the new accounts might lead some employers to drop their 401(k)s. That critique is actually even true. Once the tax code allows workers to sock away savings tax-free independently from their employers, it will in some cases make more sense to raise wages and let workers save for themselves. But few people would lose out from that shift.

The savings accounts would not increase the number of investors as much as Social Security reform would--you have to have spare cash to save to use the accounts, whereas Social Security reform would involve investing taxes you already pay--but it might help prepare the ground for it. The president seems prepared to campaign for re-election on these ideas. If the House Republican leadership is reluctant to do so, too bad for them: The president is dragging them along.

Democrats still think they can run successfully against an investor-class politics. John Edwards, in particular, has been taking Bush's policies head-on. Bush, says Edwards, values "wealth" over "work." Republicans want to tax labor income, but not capital income. This theme, Edwards and other Democrats think, usefully highlights Bush's patrician background and "anti-worker" agenda. At the same time, the Democrats may try to come up with policies to help small investors. But what has always been true of the politics of income taxation in America--low-income voters don't want to punish the rich, they want to be the rich--may be even truer of the politics of wealth taxation. Can Democrats really appeal to small investors while also casting doubt on the moral and social worth of the enterprise in which they are engaged?

When Robert Samuelson wrote that investor politics had been a casualty of the bear market, he said that the proposal to cut dividend taxes was evidence that "expanded shareholding abets political activism, not restraint." There may be no inexorable economic laws of history. But my guess is that we are likely to see more such free-market "activism" in the future. The investor class is well on its way to becoming an investor nation.