The 1 Percent Solution

Seattle?Nick Hanauer toddled through his early years in a cramped Greenwich Village apartment. His mother waited tables at the Bitter End. His father worked low-level jobs on Wall Street and as an editor at a publishing house. When Nick was 5, his folks left New York to join a family pillow-making business in the Pacific Northwest. They raised their three sons in a three-bedroom house in the suburbs and sent them to public schools. After Nick, the eldest, earned a philosophy degree at the University of Washington, he went to work for his father. In his 30s, he scraped together $45,000 to invest in a small start-up that sought to revolutionize American retail. It was called Amazon.com.

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This is how Nick Hanauer has come to be standing in the owner?s box at a Seattle Sounders FC professional soccer game, snacking on chicken fingers, and listing the very expensive things he owns.

?I told you about Mexico,? he says, meaning the villa in Cabo San Lucas. ?Did I tell you about the fly-fishing ranch?? Meaning the 170 acres in Montana.

Yes, he did. He also mentioned the ski chalet in Whistler, British Columbia, the hideaway in the San Juan Islands north of Seattle, and the private jet. ?And,? he added helpfully at one point, ?we have a really big boat.? Last year, his wife and some of her friends decided they would like to renew their wedding vows. So Hanauer and a few buddies invited nearly 80 couples to Las Vegas for a vow-renewal ceremony featuring three officiants, followed by a private after-party in the rooftop lounge of the Palms Casino Resort. All captured by a professional filmmaker.

Hanauer is 52 and worth several hundred million dollars. His brown hair is thick and mossy, with just a fleck or two of gray, and he is fond of wearing dark denim pants and shirts with open collars. An ace venture capitalist, he is the founder of several companies, including one called aQuantive that he sold to Microsoft for $6.4 billion. On the day of the sale he personally banked $270 million.

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In 2011, Hanauer says he paid an effective federal tax rate of 11 percent. He occupies the upper echelon of an elite group of Americans, the top 1 percent of all earners, who have amassed the lion?s share of the nation?s wealth gains over the past several decades. Many economists expect he and his class of entrepreneurs to fuel the country?s next great engine of growth.

Like a lot of self-made rich guys, Hanauer has developed a theory on how to fix the ailing economy. He preaches it in op-ed columns, television interviews, political gatherings, and casual conversations with Seattle?s innovation royalty. He was invited to give a speech this spring by the organizers of TED, the nonprofit that has grown famous for commissioning ?TED talks? on such diverse topics as the nature of innovation, the science of global warming, and the need to spread contraceptives throughout the developing world. Hanauer?s pitch took five minutes at the TED University conference on March 1. Afterward, organizers seemed keen to post it on their website. Then in May, they abruptly told him his remarks were too controversial, too political for TED, and wouldn?t be published online.

The disqualifying notion at the center of Hanauer?s talk was that the innovators and businessmen are not, in fact, ?job creators??that the fate of the economy rests instead in the hands of the middle class. So Hanauer wants to tax rich guys like himself more, to pay for investments to nurture middle-class families.

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?We?ve had it backward for the last 30 years,? Hanauer said at the TED conference. ?Rich businesspeople like me don?t create jobs. Rather, they are a consequence of an ecosystemic feedback loop animated by middle-class consumers.? When the middle class thrives, he said, ?businesses grow and hire, and owners profit.?

Emerging research from high-powered experts across the ideological spectrum backs that economic inversion. Their work shows how America?s long-term prosperity is in jeopardy because the middle class is struggling and the super-rich are pulling away.

Widening income inequality helped drive us into the Great Recession and is holding back our recovery. It is tempting to view the stagnation of the middle class and the disappearance of middle-skill jobs as a problem for only some of us. That?s simply untrue. Mounting economic evidence? suggests strongly that Hanauer?s argument is correct and is, in fact, fundamental to America?s future. It?s not a do-good argument. It is a selfish one, both for innovators and for every other American counting on the innovator class to power growth for decades to come.

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The evidence suggests that the United States needs a vibrant middle class. Not for any of sentimental reasons, but because it?s a very dangerous thing not to have.

As Hanauer is discovering, that?s not something many American elites want to hear.

DOING LESS WITH MORE

Economists don?t even broadly agree on who is in the middle class. Some say it?s anyone within a 50-percentile ring around the U.S. median income. As good a general definition as you?ll find comes in a new paper summarizing the economic case for how the middle class spurs economic growth from economists Heather Boushey and Adam Hersh of the liberal Center for American Progress. ?A middle-class family has some economic security,? they write, ?be that a good job with health insurance and a retirement plan, or some savings in the bank to tide them over in an emergency or to send a child to college or even float a family member who wants to start up a business.?

By any definition, the middle class is eroding. Real median household incomes basically flatlined over the past 30 years. Each of the last three recessions has vaporized huge numbers of the middle-skilled jobs that used to pay a good family wage, on factory assembly lines or in customer-service centers or, most recently, in classrooms and city halls. This has led to what the MIT economist David Autor calls the ?hollowing out? of American jobs, with a few middle-skill workers finding training for high-skilled, higher-paying careers, and the rest shoved downward into low-wage, low-skilled jobs or onto the unemployment rolls.

If the decline continues, this is what research suggests the U.S. will look like in the years ahead: Roads and bridges will fall into disrepair. Public schools will struggle to graduate students prepared for the job market. Consumer spending will tumble. Small businesses will close, and fewer and fewer new ones will spring up to take their place. Corporations like Amazon and Apple will scrounge the country to cope with chronic engineering shortages. Rich guys like Hanauer will find themselves with fewer customers, fewer potential employees, and many more worries about the swelling ranks of the have-nots breaking out their pitchforks.

The timing couldn?t be worse. The United States was first a resource economy, then a production economy, then a full-fledged industrial economy. In the past two decades, globalization turned the nation into a consumption economy?we bought things from other countries and from one another, increasingly with borrowed money. That model collapsed in the financial crisis.

What comes next, economists often tell us, is the innovation economy. Our international trading partners will boast cheaper labor, laxer business regulation, lower taxes, more abundant resources, and, in the case of China and India, faster-growing flocks of new consumers.

?I do keep dreaming of the apartment I had when I was a teacher, full of plants and beautiful things.??Courtney Carbone, who continues to search for another teaching job

We?ll still have the best ideas. We?ll keep coming up with the best new products before anyone else does, and everyone else will be forced to buy them from us. That?s our comparative advantage.

Research suggests that this advantage flows directly from the strength of the American middle class, starting with its spending power. The super-rich don?t pay enough people to do enough things for them, or at least not enough to drive the economy. Middle-class families do. That?s the core of Hanauer?s argument, and research from the Census Bureau and the Brookings Institution, among others, support it. Middle-class families have more disposable income than low-income families, who largely buy only necessities, and they?re more likely to spend their disposable income than wealthy families are.

As Hanauer puts it, he and his rich friends, for all their lavish parties and jet-away vacations, don?t buy enough shirts, cars, and restaurant meals to match the spending that would occur if, say, their wealth was divided up among thousands of poor families. Studies on what economists call ?marginal propensity to consume? bear out this idea.

Hence Hanauer?s claim that middle-class consumers, not innovators, create jobs. Amazon didn?t create a new group of book buyers; it just peddled a more convenient way to buy books. Its success created lots of jobs in Seattle, Amazon?s hometown, but it also killed lots of jobs in strip malls across the country. Increasing the number of book buyers would boost sales and jobs in the industry, with no downside.

Middle-class families buy more than books. They invest heavily in two of the most important drivers of economic growth: infrastructure and human capital. The middle class demands the highways and the schools that boost the overall functioning of the economy. Unlike the Hanauers, those families can?t afford to bypass the nation?s air-transit system with a private jet, or to send their children to elite private schools. (Hanauer raises this point with his 12-year-old son, Cole, after picking him up from just such a school in the family?s Audi. Cole objects. ?Cindy?s kids go to public school,? he says. Nick nods. Cindy Crawford, he explains. The model. Their neighbor in Cabo.)

Statistics suggest that Cole Hanauer won?t grow up to be an entrepreneur. The risk-takers of tomorrow are growing up in today?s middle-class families. Data from the nonprofit Ewing Marion Kauffman Foundation suggest that seven of 10 American entrepreneurs have come from the middle class. Only one in 100 was born very wealthy or very poor.

The middle class incubates entrepreneurs because it offers a good combination of time, resources, and motivation to invest in skills and climb the innovation ladder. Put it this way: The comforts that flowed from the Pacific Coast Feather Co., his then-modest family business, provided Nick Hanauer with a house full of books and days full of time to explore big ideas. Think of those comforts as an investment. The eventual return was Hanauer?s venture-capital portfolio. Poor families just scraping by at the margins can?t make those investments, so their children struggle to achieve in school and pursue higher education. Children from rich families may, thanks to their extreme childhood comforts, lack the desire to build wealth and climb the economic ladder, which the Kauffman study found to be a key motivation for would-be entrepreneurs.

The economy sags when kids who could have grown up to be physicists end up spending their lives brewing lattes at Starbucks. Or when a young woman born to be a teacher finds herself babysitting, for peanuts, while she waits for a classroom to open up.

LOSING GROUND

Courtney Carbone, wrapped in a scarf and a nervous smile on a cool spring morning, is a transplant to the Northwest. She grew up in northwestern Connecticut, daughter of a carpentry teacher and a waitress who went on to teach preschool. Her parents were not so different from Nick Hanauer?s, actually.

From the age of 9, Carbone knew what she wanted to do with her life. She was bright and rebellious. At the prep school she attended on loans that her parents took out, she routinely skipped classes when she didn?t respect the teacher?s effort. ?That just made me want to be a teacher even more,? Carbone says. ?I wanted to be the one who made students want to show up.?

She got her wish after graduate school, landing a job teaching English at a Connecticut prep school. That was 2006. In 2009, the recession brought budget cuts crashing down on her school, and she lost her job. She drifted West in her teal 1997 Nissan Altima to live with a friend and look for a teaching job in Seattle.

She is still looking. Last year, she attended a regional job fair in Northern California, which she compared to speed dating. She got several interviews. No callbacks.

Carbone has nannied and babysat. She has applied for teaching jobs up and down the West Coast. She taught two composition classes at a community college for 11 weeks. She suffered from depression, lost her sense of identity, saw her relationship with her boyfriend dissolve. She moved briefly to Utah last winter to work in a child-care center at a ski resort, earning a season lift pass and less than $10 an hour. Now, back in Seattle, she is caring for a friend?s two special-needs children, for $15 an hour, in cash.

Carbone happens to be looking for a teaching job at the worst possible time. Washington state has shed 6,500 local education positions since 2009, due to budget cuts. ?I know that every time I apply for a job, I?m one of hundreds of people,? she says. ?But at the same time, knowing something and feeling something are different things. After a while [not getting a job] starts to eat away at your soul.?

Carbone isn?t spending money, isn?t feeding that great middle-class consumption engine of growth. She?s paying a very small amount in sales taxes, which largely fund the state?s road-building and school budgets. She?s not doing her part to support the institutions that help stabilize growth.

?I keep selling things and getting rid of stuff,? Carbone says. ?It?s freeing, in a way. But I do keep dreaming of the apartment I had when I was a teacher, full of plants and beautiful things that were mine.?

Carbone?s struggles aren?t rare, even in one of America?s most innovative cities. Seattle hides its erosion better than a lot of other places, away from the rain-soaked microbrew pubs and the towering new Amazon buildings near downtown. ?This feels idyllic,? says Jake Rosenfeld, a sociologist at the University of Washington. ?Seattle doesn?t seem like a place I?d worry about.?

Except, he does. State forecasters expect no net middle-class job growth in the next decade, The Seattle Times recently reported. The state Supreme Court has declared that Washington?s schools are failing their constitutional mandate to educate all children adequately. Tuition at Rosenfeld?s university now runs 20 percent of a median family income, up from 6 percent two decades ago. The Seattle-based real-estate data firm Zillow reports that middle- and lower-tier homes in the metro area lost an average of 38 percent of their value in the housing collapse, compared with 29 percent for top-tier homes.

ELEVATOR DOWN

Here, and across the country, the economy is suffering because people cannot fulfill their potential. Researchers at the University of Chicago and Stanford University published a paper this spring arguing that up to one-fifth of America?s wage growth over the past 50 years can be attributed to the knocking down of social barriers that prevented women and minorities from doing their best?clearing the way for waitresses to become lawyers, or African-American orderlies to become doctors.

Now, the reverse appears to be happening. Workers who once produced $100,000 a year of manufactured goods have been forced downward into jobs flipping $20,000 worth of burgers. Carbone, who once produced $40,000 in education services, now tends toddlers for half that value. That?s an economy-wide output loss. If the slide continues, ?growth would go down, no question,? says Chang-Tai Hsieh, an economist at Chicago?s Booth School of Business who was the study?s lead author.? True, a branch of economists and conservative politicians say that rising inequality isn?t bad for growth and might even be good. Edward Conard, a former managing partner of private-equity firm Bain Capital, argues in a book out this month that the income gulf should be even wider because it?s a sign that the economy is rewarding risk-takers. Conard contends that too many Americans today avoid risk-taking, settling into comfortable fields such as law. The only way to jar more smart people into the innovation game, he says, is to increase the rewards of success.

History contradicts that argument. For nearly all of the recorded economic past, rising national wealth went hand in hand with rising equality. A seminal 2000 study by World Bank economist William Easterly, ?The Middle Class Consensus and Economic Development,? found that countries with larger middle classes enjoy higher levels of growth and income, along with a variety of health benefits such as lower infant mortality rates and greater life expectancy.

In a 2011 paper, economists Andrew Berg and Jonathan Ostry of the International Monetary Fund studied nations? economic growth through history and concluded that ?longer growth spells are robustly associated with more equality in the income distribution.? The correlation was greater than for any other factor, including liberalizing trade and cracking down on corruption.

Widening inequality can throw the economy into crisis. Chicago Booth economists Marianne Bertrand and Adair Morse argue in a draft paper this spring that the rising income gap in the United States fueled a surge in recent years of what they dubbed ?trickle-down consumption??middle-class families drained their savings and maxed out their credit cards to keep up with the jet-set lifestyles of the Hanauers of the world.

Hanauer worries about the prospect of inequality expanding not contracting, in the years to come. If you extrapolate the trends over the past 30 years, he warns, in another 30 years, the richest 1 percent will take home 37 percent of U.S. income. The bottom 50 percent will earn a paltry 6 percent. ?If you let that happen,? he says, ?very bad things happen.?

Wide income inequality correlates to political unrest?the Arab Spring is a classic example?and just the threat of turmoil distorts the economy. Wealthy people who fear massive attempts to redistribute their wealth?we?re talking huge tax increases here, not a few extra points tacked on the top marginal rate?do inefficient things with their money. They wall off their houses and install high-tech security systems. They park money in offshore bank accounts. They don?t buy new equipment, or hire more workers, even if they see a chance to profit from those investments, because they worry that someone could come along at any moment, a mob or a cash-strapped government, or both, to take
it all away.

We aren?t there yet. Seattle was jostled by protests on May Day, when anarchists broke off from an Occupy march downtown and smashed store windows; by the next day, most people in town had shrugged off the damage as a small-group aberration. But Hanauer worries that the climate could change. Soon.

?Ultimately, taxes are a bribe rich people pay to poor people so they won?t kill them,? he says. ?People understand that. We?re an armed nation, you know. Things could get very fucking ugly.?

BEHIND THESE WALLS

The Hanauers live 50 blocks north of Courtney Carbone, behind a guardhouse and down a narrow road that hugs the emerald fairways of the Seattle Golf Club and winds through ferns, cedars, and tall Douglas firs.

Hanauer is a mammoth political donor who has given hundreds of thousands of dollars to Democratic candidates and just as much to push state ballot measures that would have raised taxes to support schools, fund teaching jobs to build the state?s human capital stock, and employ eager young educators like Carbone. (Lately, he has also picked a huge fight with the state teachers union over accountability, charter schools, and other components of education reform.)

On days when Hanauer and his wife host political events, a squad of valet parkers wait in their gravel courtyard driveway. Guests enter through a foyer into a library stocked with old books shedding their spines and tapestries on the walls. The back window opens onto a patio, a swimming pool, and, beyond a hedgerow, a sprawling garden.

The garden is one of Hanauer?s favorite metaphors to describe a well-functioning economy. He developed it over 20 years of reading on complex systems, chaos theory, and evolutionary biology. Eventually, he says, he arrived at a place where ?you realize that the economy is characterized by the same kind of circle-of-life, natural feedback loops that characterize natural ecosystems.? The plants need the bugs need the birds need the predators. Throw off the balance, and everything wilts.

This is the argument that Hanauer and coauthor Eric Liu made in their recent book The Gardens of Democracy, and the one Hanauer made in his TED talk. It is an abandonment of a moral argument?the rich really should care about the middle class because it?s the right thing to do?in favor of a self-centered one: Caring about the middle class is very good for business. The solution that Hanauer advocates, which jarred TED organizers, is to tax rich guys like him more and spend the money building up schools and other middle-class institutions.

That?s an incomplete prescription, at best. Just as the middle-class is essential for more reasons than the ones Hanauer talks about, so is the fix for the declining middle class more complicated than taxing the top earners. After all, Europe has higher tax rates but has also experienced widening income inequality in recent years.

But Hanauer has his argument, which he loves?loves?to make, on any platform he?s given. He penned a Bloomberg View op-ed in December in which he declared, ?I?ve never been a ?job creator? ? He celebrates that Bloomberg editors tell him the piece remains one of their most-viewed op-eds of all time. He has debated the theory on cable news with conservatives, and he and Liu defended it in an interview with Charlie Rose on PBS. He raises it with the members of Congress who call him to ask for money.

The day after May Day, Hanauer began extolling the middle class in his office at 3 p.m., starting with a profane tirade against Conard, the former Bain executive who argues that income inequality should widen even more to promote risk-taking. ?What risk did Sergey Brin and Larry Page take?? Hanauer demands, invoking Google?s founders. ?They got fucking Ph.D.s in computer science at Stanford. They got a bunch of venture capitalists to back them.?

He springs from a couch that backs up to a stunning view of Puget Sound and the Olympic Peninsula, with ferries chugging in between, and waves his arms.

?What?s the worst thing that can happen to those guys?? Hanauer shouts. ?Will they starve? Will they be executed? No!? He wheels around. ?We have to find ways to get people to innovate. But the idea that lower taxes lead to more innovation?wrong.?

And so it goes for two more hours in the office, and on the Audi ride to pick up Cole, and later in the owner?s box at the soccer match. No one can duck hearing about inequality and its evils, not Cole and a school friend; not Nick?s brother Adrian, who co-owns the Sounders FC; and not a handful of random visitors in the box, including a real-estate scion who may be in the market for a pro soccer team of his own. By the game?s end, Hanauer has been making his case for six hours, nearly half of them in a stadium where 40,000 fans screamed lustily for their team to score a third goal, because it would have meant a free haircut for everyone in the crowd.

Hanauer has a lot more hectoring left, for politicians and peers alike. Friends say that his evangelism has stoked anger in his social circles and pushed some acquaintances to avoid him. Hanauer was so stung by the backlash from other innovator types to his Bloomberg piece that he wrote a follow-up op-ed, as yet unpublished, titled ?If Not Job Creators, Then What Are We?? He is dismayed that President Obama talks about equality largely in terms of fairness (there?s that moral imperative again), and not in terms of good business.

Flaunting his wealth is Hanauer?s way of disarming critics of the guy who wants to raise taxes on the rich, but it also turns a lot of people off. ?When Nick alienates people, it?s generally because one of those lines about how much money he makes comes flying out of Nick?s mouth,? says J.D. Delafield, an investment banker who lives next door and vacations with him. ?He uses that as a provocative contrast,? adds Rich Barton, the executive chairman of Zillow and a cofounder of the travel site Expedia.com, who is another vacation companion. ?Sometimes it makes me squirm. Like, geez, Nick, don?t talk about your plane all the time.? But on the question of who creates jobs, Delafield and Barton both say Hanauer has swayed them.

But within Hanauer?s own investment portfolio, his record is spotty. Some companies he?s backed, such as Amazon, have driven middle-class workers to unemployment. Pacific Feather Pillow, where Hanauer remains chairman of the board, recently closed plants in Illinois and Pennsylvania to cut costs. For all his money, Hanauer isn?t going out of his way to overpay workers or to create a bunch of extraneous jobs just to prop up the middle class that holds his future earnings in its hands.

After all, he?s not in it to lose. His fellow entrepreneurs and CEOs share this conflict, the tension between competitiveness today and sustainability long term.

Henry Ford famously paid his workers enough to be able to afford a Model T. But he wasn?t competing against imports from Japan and South Korea and the onset of cheap labor from China. Today, Ford Motor pays new workers about half of what longer-tenured employees make, as part of a new union contract designed to boost competitiveness. No single business leader has the power to alter the trajectory of the middle class simply by sacrificing profits, Hanauer says. Which is why society needs to decide to do it, all at once, at the highest levels.

He pauses to reference a Business Insider column he read earlier this year that urged the heads of Wal-Mart Stores, McDonald?s, and Starbucks to boost the middle class by paying their service employees more. ?Here?s the thing: I know Howard Schultz,? the Starbucks CEO, Hanauer says. ?He?s a nice man. He?s never going to do this on his own.?

Nor, by extension, will Nick Hanauer. He?s simply the alarm, the Lorax warning of the dangers that lie ahead.

Courtney Carbone, she?s already navigating them. She sees the years without a teaching position piling up on her r?sum?. She knows the longer she looks for a job, the harder it will be to find one.

If she landed a teaching gig tomorrow, she?d return to boosting the economy in all the ways the middle class does. Carbone would maximize her talent and production, help cultivate the entrepreneurs of tomorrow, and pay more taxes for roads and schools. She?d buy more stuff, possibly from one of Hanauer?s companies. Maybe even a new pillow.

Carbone knows that to beat the odds and find a position, she needs any extra advantage she can find. So, this summer, when her nannying stint ends, she will return to Connecticut to attend a nine-week certificate course that will help her teach in 42 states. She will also be $4,000 in debt. After three years of job-seeking, the only way she can come up with the $4,000 is to borrow it.

This, Carbone says, is probably her last shot before she?s forced to give up her dream.

?I do see myself as a teacher still,? she says. ?There?s nothing else I?d rather do.?

She is 31 years old. Her whole future could depend on whether this works out.

In a way, all of ours could, too.

______

This story is part of a yearlong series that examines America?s crumbling foundations and how to rebuild them. Find more on the Web at nationaljournal.com/restoration-calls.

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