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Over the last 30 years, we have all lived in an economic fantasy-land where many workers came to expect 5-15% annual pay raises. In some industries, it’s less, maybe 3% to 5%, but most of us had the expectation that we were going to make more money year in and year out, especially when we performed well. It’s part of being American – we've always had a culture of optimism, which generally speaking, is a good thing.
The "Wealth Effect"
In addition to our salaries, we came to expect that our single biggest asset, our house, would also increase in value each year. The conventional wisdom propagated by the real estate industry had us all believing that our houses would go up by inflation plus a few percentage points each and every year. If you followed the prophesies of the real estate gurus in hot areas like San Fransisco, New York, or Los Angeles, you would bank on long term appreciation equivalent to double the rate of inflation.
This economic illusion created a phenomenon known as the 'wealth effect.' If your house increased $30,000 a year and your mutual funds added another $20,000 - that felt like you 'earned' another $50,000. And if your normal gross pay was already $70,000, many consumers started spending like they were actually making $120,000.
And the fact is, you did make $120,000 if you'd locked in your profit and sold the house and the stocks and moved into a rental. But, in too many cases, people started refinancing and using their equity increases to subsidize their standard of living. And unfortunately, unlike your salary, the 'wealth effect' disappeared overnight when the stock market and housing started declining in 2007. And by late 2008 - we had another phenomenon at work - "the poverty effect."
Living beyond our means always seems like a temporary situation that can easily be remedied by future salary increases or an increase in the value of our assets. Forward spending in anticipation of an increase in income or wealth is one of the main reasons why people have so much credit card debt. That is essentially what credit card debt is: an accumulation of transactions and purchases that could not have been made out of current income or savings.
What About Salaries?
In the past, companies have been able to continue increasing salaries through a combination of productivity increases and price increases on their products and services. Of the two, it’s fairly easy to understand that most industries today are very restricted in their ability to raise prices. In most industries, we’re actually seeing price decreases due to competition and diminishing demand.
During the 1990s, we saw massive productivity increases by people as the workforce became more skilled with computers. During the late 1990s and early 2000s we saw the same thing with the Internet. These productivity bumps have already taken place and we are indeed far more productive. If anything, there is a question now with the rise of Social Media, of whether employees are becoming less effective and productive because of the distractions from the Internet. In any case, there’s nothing on the horizon that tells me where the next productivity bump is going to come from. Sure, it may spring up out of nowhere, but its not obvious like computers were in the early 1980s. The recent quarterly increase in productivity is likely due to one overriding factor, fear. Employees who still have a job right now, are focusing on keeping it, which means longer hours for salaried employees with no additional compensation.
If you’re an hourly, non-exempt employee counting on longer hours, think again. The number of hours are actually decreasing with many employers cutting back on overtime. The average hours in the work week is the lowest it’s been since the Great Depression and nearly ten million people who would rather work full-time are working part-time. Realistically, right now, we are at 17 to 20 percent unemployment: not exactly the kind of labor environment where employers feel obliged to increase hours or raise salaries.
The bottom line is if you’re anticipating a 10-15% raise in 2010 or beyond to pay for your current purchases, think again. Don’t expect your boss to bail you out because most likely he won’t be able to.
A Reasonable Approach
What's a reasonable approach? First, you have to factor in that at some point in the next ten years, you might have a major interruption in your employment or the employment of your spouse or other people that you count on for income. If you are following Rule #2, Being Your Own Tax Man, you will have amassed a solid rainy day fund. While you are building up your assets, you shouldn't be incurring any debt outside of a mortgage and whatever transportation you need to get to work. Realistically, you shouldn't be buying a house until you have enough for a 20% down payment and your total monthly payments are no more than 28% of your current base salary. That may seem old school, but it worked very well for over 50 years until everyone got crazy starting in 2003. And credit cards? Simple, if you can't pay off the entire balance every month and its not for a true emergency, you should just stop using them.
Now if you have your house and you have your transportation and you are socking away 10% of your salary and you've already maxed out on your 401(K), have at it. Pick up some of the biggest bargains in the last 75 years and negotiate like a pro. But whenever you find yourself or your significant other saying, "I know we're stretching, but we'll make more next year," stop the conversation cold. Your setting yourself up for a potentially painful situation. If you do get the raises and you do continue on an upward path, consider yourself fortunate. If whatever you crave is something you feel you 'must have,' you should have enough incentive right there to save for it before buying it. The delusion that you will be able to pay for it out of an anticipated future increase in your income will run into a brick wall of economic reality.
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