The new report from the Adva Center on the socioeconomic picture of Israel made headlines last week. The biggest were on the pay gap between Ashkenazi and Sephardi employees. But this gap is hardly surprising given the large education gap which exists between the two, also carefully documented in the study. The news media should have given more prominence to the cause than to the effect. One ironic result of this omission was that the attention surrounding the report was used for electioneering by a party that endeavors to even further decrease the educational attainments of Sephardi youth by encouraging them into an educational system where they don't even obtain a bagrut, or matriculation exam. One of the most important and neglected findings relates to Israel's shrinking middle class. This phenomenon is clearly visible in the report's description of the changing allocation of Israel's economic "pie," but Adva's 2004 report, released earlier this year, describes the phenomenon even more clearly. The 2004 report opens this topic with a value judgment, but one that is not very controversial: "Good public policy should aspire to increase the size of the middle class, so that it encompasses a large part of society, leaving small minorities in the lower and upper classes." The report continues: "This is not what happened in Israel. In 1988, a third of Israeli households were middle class; in 2002, their proportion dropped to 28.1 percent - a decrease of 15%. The middle class lost households to both the upper and lower classes." The report defines middle class as earning between 75% and 125% of median income. This statement is also, to the best of my knowledge, not controversial. The implication seems to be that the shrinking middle class is due to poor public policy - this would indeed be controversial, as we shall see. In this article, I want to prove that this has been happening, present a few reasons why it has been happening, state why it is likely to continue to happen, and why it is in my opinion even more alarming than the alarmists claim. The middle class is shrinking all over the developed world. One of John Kerry's key campaign topics in last year's election was the "shrinking middle class" in the US. It is remarkable that the facts were not in dispute. Kerry supporters claimed that the rich were getting richer and the poor were getting poorer, while detractors argued that the rich were getting richer, and the poor were also getting richer but not as fast. But all acknowledged a thinning middle. One Kerry-critical organization, the Employment Policy Foundation, acknowledged that the fraction of families between 40% above and 40% below median income dropped by about 20%. They just asserted that it is mostly due to ascent rather than descent, but the fact remains that the middle class is shrinking. Using Adva's 75/125 definition, the American middle class is less than 25% of households - significantly smaller than in Israel. Adva's report gives the impression that the decline is due to bad policy and that more humane policy would reverse the trend. I think many of their policy suggestions are worthwhile, but I don't believe any of them will have a significant impact on income polarization, which I see driven by the following very basic fundamentals: 1. Increasing return to education. A generation ago, college graduates in the US earned about 40% more than high school grads. Today the ratio has increased to at least 60% and, according to some estimates, even more. In Israel, we see a similar trend. In 1985, a college education (16+ years of schooling) provided a wage premium of about 65% over with a high-school level education (11 or 12 years). By 2003, the college premium jumped to 83%. 2. Increasing cost of education. At the same time, the expense of getting a college or graduate school education has gone up - as the laws of supply and demand would suggest. In Israel, the opening of the private colleges has significantly increased access to higher education, but these institutions are very expensive compared to traditional ways of increasing earning ability. 3. "Effort polarization" has increased. In the bad old days, high-wage people could enjoy lots of leisure while low-wage people had to work crushing hours to make ends meet. But today the situation is reversed: Work force participation, employment ratios and average weekly hours worked are all far greater for high-wage workers. Employers refuse to pay premium wages unless workers are willing to put in long hours as well. In 1985, college-educated employees in Israel put in fewer than those at a high-school level, but in 2003 they worked more. (The picture is far more dramatic if we include those who don't work at all.) 4. Women's work. Women's work used to be an equalizer. Wives in richer families stayed home, but poor families couldn't afford a housewife, so the wife went to work. Today it's the opposite as the wealthier families are more likely to have a well-educated wife who has a full-time job, and the effect has been to skew the income distribution even more. Over the last 10 years, the fraction of low-education women at work increased by about 11%, but the fraction of high-education women at work has increased about 37%. Result: A "winner-take-all" economy. A generation ago, a little education or training went a little way. A young man could spend a relatively small amount on a college education which would give him a relatively small premium over high-school graduates, or he could go straight to work and earn a little less but be making money for more years and obtaining seniority. If the salary was disappointing, his wife could go to work and close the gap a little. Both choices would launch the family into the same middle class. Today, it's all or nothing. Either both partners make big commitments to devote many years to schooling, cope with big debts and be committed to working very hard and the family ends up in the elite, or else they decide to stay in the low-wage sector, start working right away - no need for debt or 60 hours weeks but it will be almost impossible for this family to break into the middle class. Note that this picture is non-judgmental, and there is nothing "right" or "left" about it. The rich aren't exploiting anybody - they are deserving of their high salaries, since they invested considerable effort and risk to obtain them. The poor, meanwhile, can hardly be condemned as lazy or guilty for not wanting to pile up tens of thousands of dollars of debt and years of overtime in order to have a whack at the upper middle class. This is just the structure of the labor market developing now in advanced countries, including Israel. I agree with Adva that there are a lot of ill-conceived policies, but these are the small change. The Russian immigration here, like the Vietnamese and Korean immigration in America, showed that there are no structural obstacles to upward mobility here. But upward mobility is not automatic and it's not easy. People are being left behind, and not in the middle incomes but in the lower incomes. What are the consequences for democracy? Not very encouraging. Israeli politicians love to call this "a social time-bomb," referring to some anticipated explosion of rage among the dispossessed. I am assuming that that won't happen, because I think people are aware that this is not a situation of the rich "exploiting" the poor. The richly paid high-tech managers are not exploiting the low-wage workers in other industries - they are involved in a completely separate global economy. If all the low-wage workers disappeared, the high-tech managers would hardly notice. It's barely accurate even to describe this as division of the national pie. To a remarkable extent, there are not only two classes of people eating the pie, but in fact two distinct pies. Another possibility is that, even without unrest, there will be widespread poverty. There is a lot of evidence that this is happening, and even if living standards continue to rise it's just not pleasant to live in a country with wide socioeconomic gaps. On the other hand, even the low-wage sector could see its wages rising, though more slowly than the rich, and this could be enough to prevent poverty. But even assuming no direct social unrest or gnawing poverty, it's just unhealthy to have a polarized country. Democracy works well when you have a kind of bell curve distribution of voters - lots of people in the middle and few at the tails - so that parties tend to gravitate towards the stable middle, just as the Adva report asserts. It can also work when you have a lot of different groups. Singapore is a successful multi-ethnic democracy, but it is fortunate enough to have three main ethnic groups. Three is the magic number. Two makes democracy very difficult - just ask the Lebanese. Bulking up the middle class is going to be hard, but narrowing the gap between rich and poor will help matters. Traditional social welfare measures, like those advocated by Adva, have their place even if they are not driving the phenomenon. Improving education will improve the situation, too. The laws of supply and demand suggest that high supply of highly educated workers will lower salaries a bit in the high-skill sector while lowered supply in the low-skill sector will raise those. The result will be a more manageable gap. If populations which now have very low participation rates (such as ultra-orthodox men and Arab women) increase their work effort, we could also have a generation of respite as this influx will tend to move more of these bulging underclasses towards middle-class lifestyles. Who knows, by then the structural trends may have reversed themselves and the middle class will return! It's like the poor man in the old Jewish joke explaining why he agreed to teach the nobleman's dog how to talk if he was given seven years to do it. "I could die, the dog could die, the paritz could die, or the dog could learn how to talk." firstname.lastname@example.org The writer is research director at the Business Ethics Center of Jerusalem (www.besr.org), an independent institute in The Jerusalem College of Technology. He is also a rabbi.