When we talk about income inequality in America, we are really talking about two distinct problems. The first is runaway incomes at the top of the earnings scale. The second is widespread income stagnation. Economists, policy-makers and the media typically treat the problems as one. In fact, the two problems require two different solutions.

The financialization of the economy is a major cause of the soaring incomes at the top. Financial companies account for about twice the proportion of GDP as they did thirty years ago, and up to 40 percent of corporate profits. And they pay their people ridiculously well—often two-thirds of their profits. What other industry does that? In 2006, before the markets began to totter, at least fifty people at Goldman Sachs made $20 million or more. Somewhat less prosperous Merrill Lynch paid $500 million to 100 people that year, an average of $5 million each. But the true rub was when Wall Street paid $145 billion in 2009, a near record, when the rest of America was mired in the worst recession since the 1930s and one out of six Americans couldn’t find a full-time job.

Financialization also made the CEOs of industrial and services companies, and their cadre of executive subordinates, far richer than ever before. The ratio of CEO pay to that of the average worker soared. With giant stock options, a historically new phenomenon, CEOs’ loyalty was now to the financial community, not to the machine tools, retailing or light bulbs that are their business—or to their employees. The surge of incomes to the top was supplemented by a natural tendency in a mass-market economy for "celebrities"—athletes, movie stars, bestselling writers—to earn outsize incomes. It is also likely that high incomes at financial firms forced companies to pay more competitive salaries to lawyers, accountants and other business-related professionals as well. Thus, the top 1 percent of families made 23.5 percent of all income in 2007, including capital gains, compared with less than 10 percent in the early 1970s. It hadn’t risen nearly to that level since 1928.

Others in the top 20 percent also made more than the rest of America. But without that surge, the incomes of the top 20 percent of Americans would not have risen so much faster than the rest. In sum, the top fifth of families increased their share of total income from 41.1 percent in 1973 to 47.3 percent in 2007. The bottom 80 percent lost share.

To put a finer point on income stagnation, we should look at how wages have fared for the typical worker. At the New School, Nikolaos Papanikolaou and I found that the median wage for a high school–educated man working full-time today is, adjusted for inflation, roughly the same as it was in 1969. We found that even for those with college degrees, incomes stagnated for periods of twenty and thirty years at a time and are today only modestly higher than in 1969.

Incomes for full-time female workers rose, but not robustly, and they remained below male levels. Even when adding employer-provided healthcare and pension benefits, the hourly wage in America has largely stagnated for thirty-five to forty years. All the while, the costs of key middle-class services such as adequate healthcare and education—the products that define the contemporary middle class—have risen far more rapidly than the economy. Against these key costs, incomes fell.

The problem, then, is not inequality per se but a far bigger one—the lack of adequate jobs for the broad category of earners at the middle and lower-middle levels. The debate over income inequality is too often a diversion from this primary concern. The most misleading such diversion was made by mainstream economists, who repeatedly asserted that the jobs were there but that Americans weren’t adequately educated. New technologies raised the need for increasingly well-educated Americans.

This was moderately true in the 1980s, but it has been a far less important factor since the early ’90s. A good education is surely not the reason fifty people recently made $20 million or more at Goldman. Harvard economist Lawrence Katz has found that his school’s graduates earn far more if they go into finance, even when they have the same intellectual and educational background and qualifications as those who do not.

What’s more, the pay for college grads has stopped rising faster than pay for high school grads. If education was in such demand, why did that happen? And the pay for those in the fiftieth percentile, who are on average better educated than those nearer the bottom, is not growing faster than those at the bottom. The 50/10 gap—the income at the fiftieth percentile compared with the income at the tenth—has actually fallen since the mid-1980s. If education was the issue, that gap should have widened substantially.

Economists like Katz claim that jobs in the middle are the ones being offshored, which is why wages for the median worker are not rising faster than at the bottom. But there are other, more convincing explanations, among them that the minimum wage was, after many years of inaction, at last raised a couple of times in the 1990s, enabling low-end workers to make more. And the collapse of unions kept the middle from rising as well.

We need two sets of solutions. No economic theory, right or left, endorses exorbitant pay that exceeds by far the contribution made to the economy. NYU economist Thomas Philippon has persuasively shown that remuneration on Wall Street has been far higher than any economic contribution from these financial professionals could warrant. Their pay was not a function of skill or unusual talent. To the extent that Wall Street makes undue profit through oligopoly pricing power, market manipulation and the abuse of inside information, it should be taxed away.

Many are suggesting a transactions tax or a tax on financial assets. I’d propose a straightforward excess profits tax. The money could be used to invest in transportation, healthcare and infrastructure or to keep policy-makers’ hands off Social Security. Such a tax would also dampen the persistent tendency of Wall Street to invest money where it is not needed but where financiers can generate the most fees. Trillions of dollars were misallocated in the housing market in the 2000s, an amount nearly comparable to the high-technology fantasies of the late ’90s. Wall Street investors made fortunes, while the speculative bubbles only damaged the overall economy.

None of this is to say that a good education does not matter. College grads still do far better than high school grads; it’s just that the gap is no longer widening. But a good education is now very much related to a youngster’s relative privilege—the education and income levels of his or her parents. The better-educated are, in part, merely lucky to have that access and get better jobs. This is a good justification for raising income taxes on wealthier people.

Regarding executive compensation, shareholders should have more say. Stock options have been abused, and should be adjusted for any general increase in stock prices, so that CEOs don’t merely benefit from a bull market. They should also be more tied to a company’s actual earnings.

But stagnation of wages should be the nation’s priority. It will require a multifold attack. First, there should be immediate fiscal stimulus, regardless of the federal deficit, preferably in the form of aid to the states and unemployment insurance. Even mainstream projections show there would be only a trivial increase in the deficit but enormous benefits in terms of mitigating the pain of the recession. There is a growing body of literature that indicates that recessions have long-term consequences—they reduce long-term rates of income growth [see Katherine Newman and David Pedulla’s contribution to this forum]. So more deficits now may well reduce deficits in the future.

Second, the nation needs a serious industrial policy, directed at infrastructure and energy technologies. These produce double benefits: they create jobs at a time when Americans are in dire need of them, and they rebuild the foundation of the economy for future growth.

Third, trade policy has to include a lowering of the dollar to make US manufacturers more competitive and a continuing effort to persuade developing nations to improve their wages to build their domestic markets and thus level the playing field with the United States.

Fourth, education does still matter; it is just not the entire matter. There must be a renewed commitment to financial aid, at all levels, to equalize educational opportunities.

Finally, the government has to consider its role as employer of last resort. Ten percent unemployment rates, record levels of long-term unemployment and huge numbers of discouraged workers require such a "radical" solution. More than one out of six Americans can’t find full-time work. These are wasted resources, and the longer they are neglected, the deeper the hole in which America will find itself.

It is not an accident that Wall Street has done well while much of the rest of America has not. The high dollar—a Clinton administration policy—punished manufacturing workers by placing exports at a price disadvantage. And it allowed Wall Street to channel huge dollar reserves, built up by China and other nations, to finance mortgage, auto loan and credit card securities and corporate takeovers. The Wall Streeters in the Clinton administration pushed for the policy. While the high dollar kept wages down, the flow of cheap debt encouraged Americans to borrow to keep their standard of living level—and perhaps mollify their political resentment. Meanwhile, the takeover movement stimulated rounds of worker firings to pay for the massive debt service taken on by these companies.

Will the government do what it must? Probably not. The nation is now squeezed by the enormous federal debt that was incurred to bail out Wall Street; this is the final blow dealt by Wall Street in this crisis. Markets turned up sharply from the desperate lows and bonuses soared again, but most of America kept on suffering.

Also in This Forum

Robert Reich, "Unjust Spoils"

Dean Baker, "The Right Prescription for an Ailing Economy"

Katherine Newman and David Pedulla, "An Unequal-Opportunity Recession"

Orlando Patterson, "For African-Americans, A Virtual Depression—Why?"

Matt Yglesias, "A Great Time to Be Alive?"