Okay, about yesterday...

Big stock market drops force financial reporters to crank out the cliches. Back when I did more of this kind of thing, I used to joke with my editors that I should set my word processor to enter a few time-saving stock phrases with just a few keystrokes. Like so:

Alt + Shift + F1: "Investors are taking some money off the table."
Alt + Shift + F2: "Sellers crowded the exits."
Alt + Shift + F3: "Two forces drive the market, fear and greed. Fear was in the driver's seat."
Alt + Shift + F4: "Stocks just went on sale."
Alt + Shift + F5: "A technical correction on strong fundamentals."
Alt + Shift + F6: "It's like somebody somebody blew the dog whistle/snapped their fingers/lit a match."
Alt + Shift + F7: "Although today's drop in the Dow seemed large in terms of points, in percentage terms it was only..."

Today I've been thinking about another cliche we money journalists use a lot: "zig when the market zags." (By "we" I mean, of course, me.) We say this when we're trying to explain the benefits of diversifying your portfolio across lots of different kinds of assets. If you hold shares in a Fredonian Freedonian duck soup manufacturer, maybe that stock will zig up while your Dell shares are zagging down.

Well, yesterday China's stock market zaaaaaaaaged.... and European and U.S. markets got pretty well zagged, too. This is unusual only in degree: Over the past several years, global markets have become more correlated with one another. That's partly because technology and financial innovation make it easier for investors around the world to invest, well, around the world. Maybe it's partly because of hedge funds. (That's another popular cliche these days. Hedge funds also kept me out of Harvard, maxed out my credit cards, and made me miss my deadline last week.) And it's probably also because most assets have been pumped up by the same two global trends: easier money and higher investor risk tolerance. (Time's Justin Fox has a sharp, brief sum-up here.)

There are two common rationales for diversification:

--Over the long run, you will get a better return with lower risk. My guess is that this is probably still true as regards international diversification, though of course we won't know that for sure until some kind of "long run" is over and we can run the numbers. But recent experience strongly suggests that just buying some European and Japanese blue chips probably isn't enough to diversify away from your S&P 500 index fund. If you want a really low correlation, you'll have to be more adventurous, and should consider assets besides equities.

--In the short term, it might keep you from panicking. The idea here is that if you have something in your portfolio going up or holding steady when the U.S. market falls, you won't be so tempted to sell in a frantic effort to hold back your losses. This is a rationale cited more often by the brokers and financial planners I talk to, and not so much by economists. I don't know if there's any real proof that this actually works, even when you get the zig/zag effect. (I'd be delighted to hear from you if you have some.) But diversification clearly didn't protect your sanity yesterday. If you had 10% of your portfolio invested in an Asian emerging markets fund yesterday, I'm pretty sure you felt worse than the rest of us. As another Wall Street cliche goes, diversification only works when you don't need it.

If you want to avoid panic, here's a better idea: Set up a well diversified portfolio that suits your risk profile and then do your best to ignore the thing. (You can rebalance once a year or so.) Make it rule than when the market drops more than, say, 200 points, that's the one day you will absolutlely NOT check your account.

"Draw a chart of tax rates--if that was a stock, you'd buy it now," says Robert Gordon of Twenty-First Securities in New York City. I spoke with Gordon, an expert on tax-efficient investing, for a story I wrote for Money last month.

And last week I finally got around to drawing that chart. The result is at left; it's based on records from the Urban-Brookings Tax Policy Center. Let it be said that buying a stock just because it's dropped sharply is actually a seriously dopey thing to do. (I'm sure Gordon would agree.) But as they say on Wall Street, this particular "stock" also has the fundamentals in its favor. Besides the current budget deficit, future lawmakers are going have to wrestle with the mounting costs of Social Security and Medicare. And whatever "peace dividend" we may have enjoyed after the end of the Cold War has been spent, and then some. We're going to be spending a lot on defense for the foreseeable future. The financial outlook points strongly to higher taxes.

And, increasingly, so does the political outlook. The cover package ($ required) in Feb. 12 issue of the National Review, headlined "What Now?", reconsiders the conservative political agenda. NR senior editor Ramesh Ponnuru says that Republicans have already squeezed most of the political juice they're ever going to get out of cutting marginal rates:

Taxes have been the most powerful domestic-policy issue for conservatives for a generation.... The top federal tax rate has been cut from 70 percent to 37.9 percent. The top tax rate may be too high, and cutting it might boost economic growth somewhat; but these rates are demonstrably compatible with robust growth.

Ponnuru concedes that cutting taxes--or even keeping them level--is going to be tough as spending on Social Security and Medicare rises. (And he's admirably realistic about how hard it will be to cut back those programs.) What's more, a significant chunk of Americans don't even make enough to pay federal income taxes, other than payroll taxes. "Without the ability to cut taxes," writes Ponnuru, "conservatives seem to have nothing tangible to offer the public." So here's what he wants to offer instead: A $5,000 tax credit per child, open even to those liable only for payroll taxes. Technically, that's a tax cut, too. But as a matter of accounting, it's no different than any other spending program in which the government writes a check to a politically favored group--in this case, parents. If you aren't in that group, you'll be paying for those checks in higher taxes.

Just as conservatives may have lost some of their zeal for across-the-board tax cuts, liberals are becoming less scared of talking about straight-up tax hikes. Check out this article from The Washington Monthly, the bible of Democratic policy wonks. Mark Schmitt says the 30-year era of tax revolt is over. He writes:

In 2006, New Jersey governor Jon Corzine raised taxes.... his approval ratings actually went up from the mid-30s to above 50 percent. In 2004, Gov. Mark Warner of Virginia formed a bipartisan coalition to raise taxes and left office in 2005 as one of the most popular governors in state history. This year, the movement to impose limits on state taxes using ballot initiatives (known as Taxpayer Bill of Rights or TABOR), failed in three states.... In fact, shortly before the election, voters said they trusted Democrats over Republicans on the issue of taxes by 12 percent--a result almost as unlikely as preferring Democrats on national security--even though they fully expected Democrats to raise taxes.

Schmitt urges Democrats to seize the initiative and raise taxes as fast as they can:

....if politicians aren't willing to talk honestly about the magnitude of the changes necessary, the default will be excruciating: In a few years, we will enter a period of chronic crisis, scraping by each year with a painful series of budget gimmicks, fee increases, and disguised tax hikes--just enough to get by for the year before the dreary cycle begins again. After a few years, the public impression would be of a government that is constantly raising taxes, constantly cutting services, yet never solving either the fiscal crisis or other problems.

How you feel about all this will depend on your politics. But in my years working at a personal finance magazine, I've learned that nobody--no, not even a Democrat--wants to pay more taxes than he owes. So if you think taxes are going up, is there anything you can do to plan ahead?

I generally defer to my sagacious and thrifty colleague Walter Updegrave on these matters. His advice is to "tax diversify." That means putting at least some of your savings into a Roth IRA, where you pay taxes up front but can later withdraw your savings tax free. In theory, that money is safe from the IRS no matter what happens to tax rates.

But here's a twist: The big tax ideas Schmitt discusses don't have anything to do with income or capital gains taxes. He's talking about energy taxes, favored by conservatives like Greg Mankiw, or a value-added tax to pay for universal health care. These are consumption taxes--you pay them when you spend your money. Putting your savings in a Roth won't help you. "Money taken out of the accounts will be taxed either way," NYU tax law professor Daniel Shaviro tells me in an email. "The incentive effect of anticipating a shift to these taxes is to spend more and save less today." Which isn't a very good financial plan, at least as long as the possibility of consumption taxes is speculative. So stick with tax diversification for now--and, if you can, save enough so you have some wiggle room if taxes turn out to be higher when you need the dough.

Update 2/27: A few commentators point out that using top marginal rates overdramatizes the changes in the tax code. Most people have faced far lower marginal rates, especially once you factor in deductions, credits, etc. (The marginal rate is the tax you'd pay on your next dollar of earnings.) But the trend runs in the same basic direction. According to the Tax Policy Center the marginal income tax rate for a family of four in the middle of the income distribution fell from a high of 25% in 1978 to 15% in 2005. For a family with twice the median income, marginal rates are down from 43% to 30%.

If you just want to look at the overall tax burden for a typical family--what we actually pay on what we really did earn--the chart below shows how it has changed since 1979 for those in the middle 20% of the income distribution. Again, the source is the the Tax Policy Center. "Social insurance" is payroll tax for Social Security, etc. Note that for Americans in the statistical middle, payroll taxes are now the vast majority of their tax burden.

Nouriel Roubini of Roubini Global Economics is making the case. (See also here.) Blame those nasty subprime mortgages that we've been hearing so much about lately.

Roubini writes for financial pros, so these posts are loaded with technical language. But his argument is pretty simple: Mortgage borrowers with the worst credit are defaulting, and the financial institutions that own these loans are taking a hit they didn't see coming. That's going to make them more cautious about lending money--and not just to subprime borrowers, but even to those of us with sparkling credit scores. What's more, Roubini observes, even many prime borrowers are low on savings and haven't had a serious raise for a while. And falling real estate values have taken some of the air out of their home equity.

Stir this witches brew together long enough and you get a very unhappy consumer. We're about due for an economic slowdown as it is. Roubini thinks the credit crunch might turn that slowdown into a "hard landing."

Roubini's a bigger bear than most, for what it's worth. UPDATE 2/23: And here's an opposing view from Morgan Stanley. Richard Berner writes: "...the balance sheets of most prime lenders are strong, investors are differentiating among rungs of the mortgage credit ladder, and a limited incipient spillover into prime loans and other asset classes signals that a credit crunch is remote." Again, here's the translation: As long as the bankers and Wall Street are still making good money, you'll still be able to get a mortgage at a decent rate.

In other news: Lou Dobbs rips into the "New Rules" report on the middle class that drew so much comment on this blog. He's taking this "Lou Dobbs Democrat" thing pretty seriously. As Nixon asked Rather, "Are you running for something?"

A new study by researchers at the agency that runs Medicare estimates that health spending will hit $4 trillion by 2016, eating up 20% of the economy. (Here's the link; and here's the subscription-required WSJ story on the report.) By that time the government will be paying close to 50% of the nation's health care bill. If that sounds shocking, consider that the government already pays about 45% of health care costs--or maybe as much as 60% if you count various tax subsidies and some other spending, according to calculations by med-school professors Steffie Woolhandler and David Himmelstein. Who says we don't have nationalized health care?

These are big numbers, and it's not easy to keep them in perspective. Is 20% a lot? Is it something we, as a nation, can afford?

Here are some important things to keep in mind:

--It's not surprising, in and of itself, that we spend a lot on health care--or that we'll spend more in the future. As the economy grows, we get to have more choices about where we'll spend our money. And on the list of worthwhile things to spend extra money on, health care is pretty high up there. A few years back, University of Michigan economist Richard Hirth calculated that if health spending grew one percentage point faster than the economy over the long-run, it would be a whopping 38% of GDP by 2075. But we'd still have more to spend on everything else than we did in 2000.

--That doesn't mean there isn't a problem. We already spend much more on health care, as a percentage of GDP, than any other developed economy. But unlike nearly all those other countries, we haven't managed to guarantee access to care to every citizen, or even to every citizen with a full-time job. And there's pretty good evidence that lots of the health care we buy is a waste of money. I'm feeling lazy, so I'll just cut-and-paste from the 2003 article of mine which I'm shamelessly recycling for this post.

"Across hospitals that are very similar in quality, people can be treated in very different ways," explains Dr. Elliott Fisher, a lanky 51-year-old Dartmouth professor who also works part time as an internist in the veterans' hospital in White River Junction, Vt. "You can get the same technical care, the same discrete treatments. The same chemo, the same careful monitoring of blood tests," he says. "But in one setting you'll get twice as much care -- more physician visits and more specialists involved in your care."

I visited Fisher this summer at Dartmouth's Center for Evaluative Clinical Sciences, which during the past 14 years has been studying the weird regional variations in how doctors in the U.S. decide what care their patients need. For example, even after adjusting for obvious demographic differences, annual Medicare reimbursements in 1996 added up to $8,414 per enrollee in Miami vs. just $3,431 in Minneapolis. Earlier this year, Fisher and a team of five researchers produced a study that suggests Minnesotans might actually get the better care....

Intuitively, you'd guess that you would be better off getting sick in a high-spending city. But you probably wouldn't -- not, at least, if you are on Medicare and have a heart attack, colon cancer or a broken hip, the three conditions the researchers studied. It turns out that, after adjusting for health and socioeconomic status, patients in all three groups have a higher risk of dying within five years in the places that spend more money.

What's going on? As Fisher admits, this study can't show what high-spending areas are doing wrong. But it supports the notion that doctors base many decisions on factors other than strict medical need.

And that's not only because they're paid more for doing more. When they're making what Fisher calls "gray area" decisions -- "Well, you have a headache, so should you get the MRI today or see how you feel tomorrow?" -- it's often easier for them to book that test or call in specialists if they're available. And in places like Miami, they usually are.

--One man's "waste" in another man's salary. Or, as Canadian health economist Robert Evans puts it, "cost control is always income control." Every politician with a health care plan claims he or she can hold back costs just by cutting back wasteful spending. That's fine. But you should be skeptical of any reform plan that relies too much on technical fixes to uncover some hidden pile of free money. Every one of those fixes will require a confrontation with powerful economic interests. A realistic plan will lay out exactly which stakeholders in the health care system--doctors, insurers, hospitals, employers, taxpayers and, oh yeah, patients--will bear the cost of change.

In today's Washington Post, columnist Robert Samuelson urges readers to stare at the following figures. Keep your eye on the bolded second line:

Federal budget, 1956
Defense: 57%
Social Security and other payments to individuals: 21%
Other programs: 14%
Net interest on debt: 8%

Federal budget, 2006
Defense: 19%
Social Security and other payments to individuals: 59%
Other programs: 15%
Net interest on debt: 7%

Note that "other payments to individuals" includes Medicare, Medicaid, food stamps and the earned-income tax credit, among other things. It's a neat comparison, what with the way the numbers for defense spending vs. Social Security, etc. have flipped almost exactly. So what's the point? Samuelson says this helps explain why Washington's budget battles are now, and will always be, intractable: So much government spending is so important to so many constituents that it's hard to cut anything big. And nobody wants taxes raised, of course. This isn't a bad political analysis, and I like his point about the futility of the media raging against some wasteful but comparatively dinky $20 million program. But why contrast today with 1956? Was defense spending not important then? Would it have been any easier to raise taxes? (The top marginal rate was 90%!)

Implicit in all this, I think, is that what Samuelson calls "the welfare state" has grown out of control. Even if that's not Samuelson's point, I'm pretty sure that's what most readers will take away after the first couple of paragraphs. And you are perfectly entitled to think that. But some context would help. Consider this oversimplified comparison:

Joe Schmoe's monthly budget, 1996
Rent and utilities: 70%
Food, clothes, entertainment, and other discretionary spending: 30%

Joe Schmoe's monthly budget, 2006
Rent and utilities: 35%
Food, clothes, entertainment, and other discretionary spending: 65%

Wow, Joe's consumer spending more than doubled! He's suddenly turned into quite a spendthrift, right? Well, Joe should certainly start thinking about putting some money into a 401(k). But what really changed here is Joe's income. In 1996, young Schmoe was just out of college and had to devote the better part of his temping paycheck to the rent on his fleabag apartment. But he's done a lot better since then--he got a real job, a few promotions, and now his income is way up. He's been been able to move to a better apartment, but even so, Joe doesn't have devote so much of his resources to covering the basics. He can afford to go to the Pottery Barn and buy some decent furniture.

Likewise, America is richer than it was in 1956. Despite the growth of "welfare" programs (blogging economist Mark Thoma quibbles with the label here) the size of government, measured by spending, hasn't really changed relative to the size of the economy. Accoding Gene Steuerle's invaluable guide, Contemporary U.S. Tax Policy, total tax receipts, including state and local, have gone from about 23% of GDP to about 26% since the '50s. A richer country can afford to do more than pay for basics like national defense--it can help to provide for its aged and disabled, offer food aid for poor children and their families, and provide at least a floor benefit for health care. Yes, it can also waste a lot of money in the process, or create bad incentives. And given the projected growth of Social Security and Medicare, spending decisions about what we can afford are going to get more difficult in the future. But if we're doing historical comparisons, let's have some perspective about what the past really looked like. Anybody want to go back to the economy of 1956?

Wow. Quite a response to to Monday's post. Two big (opposing) themes in the hundreds of comments:

--People should stop whining. If middle class people feel pressured, it is only because they have unrealistic expectations about what they ought to be to afford. "Two people don't have to work [to maintain a middle class lifestyle]," says Jeff from Cary, NC. "They choose to to support all of the things middle class families didn't have years ago. Two cars, three, four or five TVs, microwaves, dishwashers, surround sound, air travel (once only for the rich)." Many people used themselves as examples, pointing out that they'd been able to do quite well thanks to good savings habits that most of their neighbors seem to lack.

--Simply comparing household incomes from 30 years ago to those today misses a lot of the story. In countless other ways--added work hours, the strain of raising kids when both parents work, the decline in benefits and job security--middle-class life has become more stressful and demanding. Says Trudy from Daly City, CA.: "Most people aren't going bankrupt because of $3 lattes. They're going bankrupt because the job market is much more fluid and unpredictable, and because home prices/mortgages are much higher, and the need to educate their children in the best way possible is more important than it's ever been."

Regular readers of this blog (Mom, Dad, Uncle Paul...) may know that I lean toward the second view. (This wasn't obvious to everyone who read the last post. Some thought I was endorsing David Brooks' cheery take, rather than rebutting it. I blame my clumsy, bait-and-switch headline.) It's right to point out that the typical American is richer now than he or she was 25 or 30 years ago. But let's also acknowledge that in many middle-class people have legitimate reason to fear that they could fall into financial trouble despite their best efforts. Unlike Brooks, I don't think it's vulgar class warfare to talk about this.

But enough about what I think. I'd like to keep up the conversation about what you think. So I have some questions for the folks who've already posted so far, and of course anyone else who wants to chime in:

--For those in the "stop whining" camp: You're right that people seem to be awash in consumer goodies. But that's partly because a lot of products that used to be luxuries (microwaves, second and third TVs, sound systems) have gotten to be insanely cheap. Meanwhile, many more important things, such as health care and quality education, just keep getting more costly. Do you think that's a problem? Or do you think more middle-income families could deal with education and health costs if they just bought fewer gadgets and baubles from China?

--For those of you who think the middle-class is in trouble: What would you actually do to fix this? You can't have opportunity without risk, and I don't think most people would want to emulate Europe, where job security (for those who already have jobs) and relatively high unemployment rates seem to go hand in hand. Are there other choices?

So says David Brooks in his Sunday New York Times column, summarizing a paper from the Democratic activist group Third Way:

The first myth, [says Third Way], is the myth of the failing middle class. It's true there are more households headed by young and old people, who tend to have lower incomes. But if you take households headed by people in their prime working years, 25 to 59, you find those people are not failing. Their median income is $61,000. If they are married, their median income is $72,000. Those are decent incomes in most parts of the country.

Moreover, their living standards are not stagnant. Between 1979 and 2005, the percentage of prime-age households making over $100,000 in current dollars rose by 12.7 percentage points....

The Third Way authors also dispute warnings of increasing income volatility. The main reason incomes have grown more volatile over the past decades is motherhood, they write. As women play a more significant role in the economy, their movements in and out of the labor force to care for children increase volatility.

You can read the entire Brooks column here. Brooks' point is that Democrats are crazy if they think American voters will respond to a "populist" economic message in 2008. But what he barely hints at is that even this report (read it here), from a decidedly centrist group, describes breathtaking economic changes since 1979. At one point, the report's authors compare the "old rules" of the economy to the "new rules" Here's a sampling:

Old Rule: "Success required a high school diploma."
New Rule: "Success requires a college degree."

Old Rule: "Climbing the ladder meant rising up the ranks within a single company."
New Rule: "Climbing the ladder means chasing opportunities with multiple employers."

Old Rule: "Wealth was managed on behalf of workers."
New Rule: "Workers need to manage their wealth."

Old Rule: "Most mothers expected to stay home."
New Rule: "Most mothers expect to work."

Old Rule: "Competition was limited."
New Rule: "Competition is fierce."

To sum up: The American economy offers you a much higher standard of living than it did in 1979. But to fully enjoy the fruits of this success, you'll need to spend four more years in school, be savvy about switching jobs, carefully manage your stock portfolio, and tap into two incomes, with all of the child-care worries that entails.

Update (2/13): This post is generating an amazing number of comments. For a quick summary of the debate--and some further provocations--check out my "Talking back" post today.

Well, some index funds.

In an op-ed in the Wall Street Journal today, Vanguard founder Jack Bogle tees off on exchange traded funds. (The link is subscriber-only, but a PDF of the story is available here.) ETFs, if you need a refresher, are funds that simply track some index of stocks or other securities. Since they don't have a manager actively buying and selling stocks, they can be cheap. Unlike regular mutual funds, ETFs can be traded instantly on the stock exchange, and you can even sell them short or buy them on margin.

And in past few years, they've been spreading like wildfire. Or, to use a simile Bogle would probably prefer, like a rash.

Bogle created the first index mutual fund, so his essay is sort of a Frankenstein's lament. He's clearly peeved about the new ETFs that follow a fundamental indexing strategy--which isn't surprising, since the whole idea behind such funds is that Bogle's straightforward, buy-the-whole-market approach is subtly flawed. He also thinks that the many hyperspecialized ETFs that have come on the market--like the "HealthShares Emerging Cancer" ETF--completely miss the point of indexing, which is that most investors should give up on the idea that they can outsmart the market.

Bogle points out that of 690 ETFs that exist today, only 12 track broad market indexes. In a way, that's just proof of how well ETFs can work: Once one company creates an ETF that effectively tracks a given index, there's really no need for anyone to start another one. So Wall Street firms that want to tap into the ETF fad soon have to start building index funds to track Bangladeshi butter futures or whatever. I'll say this much for ETFs: They've made it even more obvious that most actively managed mutual funds, and especially sector funds, are overpriced.

At Money, we keep hearing that ETFs are soon going to play a bigger role in 401(k) plans. Watch out. The ETFs that make the most sense--the ones that track broad indexes--aren't really an improvement over classic index mutual funds if you are going to be a buy-and-hold investor putting a little bit of money in at a time. And most of the ETFs that really differ from what you can get in regular funds just make investing more complicated than it needs to be for most people. If we learned anything after the crash of the 2000s, it's that having lots of options in 401(k) plans didn't help and probably hurt.

In the February Money, I wrote about the Anxiety Economy and made the case that by some measures life has gotten harsher for middle class Americans over the past several decades. For example, family incomes have become a lot more volatile. And college educated workers are taking bigger hits to their income after they get laid off.

But in the upcoming March issue of the magazine, I write this about baby boomers:

Your adult life coincided with the one of the greatest investment booms in history. Over the past 30 years, large-company stocks returned 12.5% a year compounded, enough in theory to turn $1,000 into $34,000. In real life it wasn't so simple-- besides taxes and expenses, most of us eat away returns trying to outsmart the market--but that's a heck of a wind to have at your back....

Now remember what the world looked like in the mid-1970s, when you were just getting started. Vietnam and Watergate were fresh national wounds. The Arab oil embargo had pushed the economy into a deep recession. The stock market was still recovering from a major crash--the Dow had tumbled 45% from peak to trough--and annual inflation topped double digits. A cover story in this magazine offered advice on coping with the soaring price of meat, milk and margarine. Seriously.

America's economy--and even more so its markets--has traveled a long way in three decades.

Alright, Regnier, which is it? Has the economy gotten better over the past few decades, or worse?

Better. No contest. But the picture I painted last month isn't actually contradicted by what I wrote this month. To the contrary, the increased volatility and risk that we live with as individuals may just be the flip side of the same forces that have made the overall economy more stable. Or that's what Congressional Budget office director Peter Orszag suggests--rather tentatively--in his recent testimony before the House Ways and Means committee. Here's Orszag:

To the extent that earnings and income variability has increased, the phenomenon may be consistent with--and indeed perhaps part of the explanation of--the decreased macroeconomic volatility described earlier. For example, more-flexible labor markets could enable the economy to adjust to changes in the economic environment more quickly but also could mean that individuals change jobs and have their wages change more frequently.

Some economists call the smoothing out of the economy since the 1970s "The Great Moderation." Nobody is entirely sure what caused it--it could partly be luck--and it would be way, way too much to say that lower inflation and more-predictable economic growth has simply come at the expense of ordinary people. Rapid inflation hurts anybody who saves or who wants to plan for the future, and Americans' standard of living has clearly improved since the 70s. And, of course, economic stability has probably been a plus for the stock market, and lots of regular people own stocks in one form or the other. One reasonable argument for government programs that expand stock ownership--whether through Bush-style private accounts in Social Security, or through the "add-on" accounts Democrats favor--is that it can, in a sense, diversify people's economic exposure. Gene Sperling, a former economic adviser to Bill Clinton and a passionate advocate of the Universal 401(k), put it to me this way: "If more of the gains from higher productivity and globalization are going to investments and capital as opposed to wages, it cushions the blow if you have investments."

But the Great Moderation also complicates your investment outlook a bit. As this story in yesterday's Wall Street Journal points out, yields on bonds are way below their long-term average. That's wallstreetspeak for saying that bond investors are confident about the future and so are willing to pay to pay quite a lot for bonds these days, which means you can't expect to make very much on them in the future. (Yes, inflation will probably be low, too--but not in health care, which retirees care about a lot, the Journal observes.) The same is probably also true of stocks--over the past century or so, equities have earned better that 10% per year compounded, but many economists and market watchers expect long-term gains will go down in the future. Did the Great Moderation help drive up asset prices? It's arguable, but tough to rule out.

In every silver lining, a cloud.

The editors of the Wall Street Journal opinion page may have their doubts, but Federal Reserve chief Ben Bernanke sounds convinced that economic inequality really is on the rise. In this Feb. 6 speech, Bernanke lays out the evidence and also considers some possible explanations. Given the huge economic changes he describes--the rapid pace of technological change, the increasing rewards for skill and education--it would be shocking if inequality hadn't increased. Bernanke also discusses another important factor, the "superstar" effect. Here's Bernanke:

...some advances, such as those that have swept the communications industry, may have contributed to the rise of so-called "superstars"--a small number of the most-gifted individuals in each field who are now better able to apply their talents in what has increasingly become a global marketplace.... For example, two decades ago, the highest-paid player for the Boston Red Sox baseball team (and in the American League), Jim Rice, earned (in inflation-adjusted terms) just over $3 million. In 2004, the highest-paid player on the Red Sox (and in all of major-league baseball) was Manny Ramirez, who received $22.5 million for the season. The number of fans who can fit into Fenway Park has not increased much since Jim Rice's day. But presumably the Red Sox owners believed that Ramirez's higher salary was justified by the increases in broadcast and merchandising revenues he might generate as a result of the confluence of new distribution channels (such as Internet-based broadcasts of games) and a larger and wealthier potential global audience. The earnings potentials of superstar entertainers, investment bankers, lawyers, and various other professionals have likewise risen sharply as technological innovations and globalization have helped them leverage their talents over a wider sphere.

But the "superstar" effect may not only create bigger winners. There can also be losers, a point made by economists Robert Frank and Philip Cook in their work on "winner take all" markets. Here's an example: When I was a kid, my dad worked for a savings and loan in a small Illinois city. In those days, banks and thrifts were a 100% local business, thanks in part to strict banking regulations as well as obvious technological limits. (You had to actually walk into to your own bank to get your money.) So there were five local banks in my little town, which meant there were five bank CEOs and maybe 50 bank officers living there too. Today, all but one of those banks has been merged into a regional or national bank. Now my hometown has one bank CEO, four branch managers, and a bunch of tellers.

I don't want to sound too nostalgic about some long, lost Bedford Falls bulding and loan. On balance, the creation of a national market for banks has probably been good for the economy, and according to the FDIC the number of banking jobs has actually risen over the past several years even as the number of banks has declined. This isn't a zero sum game. But it's a fact that if your life's ambition is to become the number-one guy at a bank, this has become harder--even as the rewards for making it have become even greater. The same is true if your goal is to run a hardware store, a book shop, or a local newspaper. Increasingly, you can either be Bob Nardelli, or be the guy Bob Nardelli runs out of business.

Bernanke ends his speech on inequality be calling for greater investment in education. Can't argue with him there. But I don't see education doing much to counter the "superstar" effect. There's no shortage of skilled bankers or booksellers in America, but there will always be a shortage of room at the top.