Tuesday, November 29, 2011

The Myth of Trickle-Down Economics

Here's a post I've been working on/thinking about for a while, and I think it's more relevant now than it was when I first wrote any of it. It's about trickle-down economics, or supply-side economics, if you want the hype.

What is supply-side economics? Well, it's a nice coating for the more pejorative "trickle-down" theory. Both of them essentially state that economic prosperity flows downward from the top to the bottom, and if you give tax breaks, subsidies, or whatever else, to those at the top of the income brackets, it will raise the general economy indirectly, which will benefit the poor and middle-class. You hear all sorts of rhetoric in relation to this idea, such as "a rising tide raises all boats." While that quote was originally spoken by John F. Kennedy, responding to criticisms that a dam project was just pork barrel spending, it has been taken over by supply-siders to defend their theory.

So, the basics are, if you cut tax rates or give fiscal benefits to top earners, this will improve the economy (through several means we'll explore in a bit), and when the general economy improves, everyone gets a lift, so the poor and middle class benefit eventually.

To me, however, this is all a scam, and built on bullshit. We'll explore that after the jump.

Let's examine some basic evidence.

The Great Depression and the Golden Age of the 1950's

Conservatives today seem to revere the post-war 1950's in America as a time when you could walk down the street, and if you dressed sharply and were persistent, you could get a job just about anywhere. They also believe that social mores were stronger, that the nuclear family was held as an ideal, and that everything was just plain "good."

Well, that's not entirely true...if you were a straight, white male from a Protestant background, the 50's were probably very good for you. If you weren't...things weren't that great. But let's examine the situation. The economy was indeed better than it is now, and there was significant growth throughout that period. That's great, and Republicans say that they want to get back to that growth (later also seen in the 80's and 90's for very different reasons), but let's review what was really going on, and if we're actually replicating any of that.

The Crash: Or, How the 2000's Mirrored the 1920's

A few decades prior to the Golden 50's, the stock market crashed, causing (or perhaps was merely a symptom of) a trickle down (more of a deluge, or flood) through the rest of the economy, wiping out people's savings, creating massive runs on the banks, destroying businesses, and sending us into the Great Depression. The Great Depression was a massive shock to the system, and is still not fully understood. There is likely no single cause that led to the Depression, but there are a lot of factors which we share with that period today, and understanding those are really key. The response to the crash and the change of those factors eventually pulled us out of the Depression, but we seem to have forgotten its lessons.

For one, debt had massively increased before the Great Depression, both individually, commercially, and federally. In one eerie similarity, the banks and brokerage firms at the time were massively overleveraged, with margin requirements at only 10%. This meant that for every dollar they took in, they could loan out nine. When the economy started to slow, brokers demanded payment on the loans, which created a massive problem - the capital was not present to pay them. A lot of people and institutions defaulted, creating a massive shock through the system. We saw the same thing in the mid-to-late 2000s, where banks had massively overleveraged bets, creating a huge housing bubble that eventually burst when those bets were recognized as being shoddy and called in. Today, overleveraging is even worse, and financial industries want the margin requirements to be even lower. In addition, many theorists from the monetarist side and the Australian school (similar in many ways to the supply-side today) blame policies of the Federal Reserve for causing the crash, and today we have many people who blame the Fed for fueling the Recession. I blame the Fed for the back-door bailouts and continued idiotic policies today, so I feel some sympathy for them. The period before the Great Depression had also seen massive surges in productivity, and may have caused a sort of "productivity shock," where there was excess output and not enough demand or purchasing ability to consume it. This should obviously produce some caution for supply-side theory, but it's a lesson that has been lost.

In response to the crash, and the resulting Depression, we tried a lot of policies to get the economy going again, and to prevent something similar from ever happening. Legislation such as Glass-Steagall Act, enacted after the crash, separated investment banks from commercial banks. This meant that the bank that you go and deposit your money in would not then use that money to make bets in the stock market - investment banks would have to use the money of their investors, specifically designed to be gambled with in the markets. Glass-Steagall likely had a huge influence on stabilizing the economy and preventing another crash for the next 70 years, until the last bit of it was finally repealed by the Republican-controlled Congress under Clinton in 1999. Following that, investment banks and commercial banks merged and gobbled up as much as they could, using depositors money to make gambles, and investing in mortgage-backed securities and collateralized debt obligations, which eventually led to our more recent crash. Added to that, banks also bought up credit-rating agencies, so they could package shoddy loans and have their in-house raters rate them as triple-A. Corruption at its finest. While Glass-Steagall, given the context of the times, may not have prevented a crash entirely, it likely would have lessened the blow. But, the repeal was essentially the final straw in a period of poorly informed Keynesian spending and deregulation.

Let's look at some other similarities: for one, income inequality has now hit its highest point since just before the Great Depression. And I don't mean, "oh, it's been close the whole time and is just now starting to get back into that narrow range," I mean more that it has been skyrocketing recently. Take a look here to see what I mean. You can read the full story here. I'll wait.

Tax rates for the top bracket are also massively lower than they have been for much of U.S. history. Coincidentally, tax rates for the top bracket also fell to very low levels in the years leading up to the Great Depression, as you can see here. It's also interesting to note that the top marginal tax rate in the 50's, that period of massive economic recovery/expansion, was 91%. 91%! And here we are at 35%, excluding capital gains taxes, estate taxes, etc, which are much lower. So today, if you're already massively wealthy, or the majority of your income comes from capital gains (e.g., dividends from investments), you may end up paying less, as a proportion of your income, than say your secretary. Great news if you're wealthy already.

Given all of that, and given the massive deregulation campaign that has been waged since the 80's, we should be in a supply-side paradise, right? Well...obviously not.

How We Recovered

Here is part of the important thing about the economic recovery following the Great Depression, which led to a period of economic expansion through the 50's and 60's: the period after the crash saw a massive hike in taxes and massive amounts of spending on domestic issues. We also had the War spending starting in the 40's, which provided a huge boost to the US economy. During the 30's-50's we invested in the country - in infrastructure such as the Tennessee Valley Association, the interstate system, bridges, public parks, and basically anything to put people back to work. We invested in education, perhaps most importantly with the G.I. Bill to send soldiers back to school. When the Soviet Union launched Sputnik, we poured massive amounts of money into science and mathematical education and funded the Space Race. We invested in our people with the New Deal and later programs by creating Social Security, Medicare, and Medicaid. You pay into those programs so that there will be a safety net to fall back into if something traumatic happens in your life, and to support yourself as you age and retire. To be honest, we've kind of been living and resting on the laurels of those investments, and our politicians have steadily been working to undercut many of them since they were created.

Republicans today want to have the war spending and the social morality of the 50's, but they don't want to raise taxes or invest in domestic issues. They're happy to do deficit spending if it's to fund a war or tax cuts (a really terrible misinterpretation of Keynesian theory), but programs which are deficit-neutral, which you pay into and are entitled to the money back (that's why they're called entitlement programs), well, we just can't afford those any more. This is the fundamental misapplication - if you want to live in that Golden Age, you have to have similar economic policies and investments. You can't completely invert the economic and investment policies and expect to see identical growth. What you end up with, instead, is the bubbles of the 80's and 90's. Yes, I will say it here, supply-side economics ultimately leads to a continuing boom and bust cycle. It works, occasionally, but only very briefly before it crashes again.

Now, why would they want to do that, and what does all of this have to do with supply-side economics? Well, that's a rather complicated topic. Follow me, if you will.

Arguments for Supply-Side

The Government is Incompetent

First of all, let's take a look at the standard arguments. We've all heard a lot that the government shouldn't be in the business of picking winners and losers, and that the government isn't smart enough or agile enough to spend effectively to induce economic growth. While in specific cases that argument is basically impossible to refute, I'm not sure that it's correct in the general picture. Certainly, our past investment in infrastructure and education spurred a great deal of growth, and a government-created job is just as much a job as a privately-created one, despite what Republicans will say. Many will argue that the government creates do-nothing jobs, but, again, while that may be true in specific cases, it doesn't hold in all cases. For that argument, I'll give them a half point for having some truth, but being in general misleading.

Tax Cuts Spur Growth

Now we go to the argument we hear the most today - that we have to put more money into the hands of the "job creators," i.e., the richest in the country. The argument basically follows from the above, saying that since the government is incompetent, we need to empower those who have proven themselves to be successful - basically, give them more money and opportunity to do what they've been doing, only more so. That's the stated reason for all the tax cuts to the top bracket - these people are successful and run businesses, so if we give them more money, obviously they'll grow their business and hire more people. Right? Well...not so much.

See, we actually know from past experience that cutting the top tax rate does not automatically mean more investment in business at home. It actually leads to several different things - for one, people will simply pocket the money or put it into savings. They will also invest it in the stock market, which doesn't so much create jobs as institutionalize and legalize gambling - it's a great way for a CEO to pad his bank account, but it creates nothing aside from more money for people who get lucky. It also leads to massive investment overseas. Tax cuts will create jobs alright, they just don't create them here. For more evidence that tax cuts do not lead to job creation, you can check out here and here.

What this has led to is a massive income disparity, and positive income growth for pretty much only those at the top.

To add insult to injury, the Bush tax cuts, which were billed and promoted as an across-the-board cut that would benefit all, really were weighted toward the top, to the end result that the average tax cut for the top 1% this year will be greater than the average income of the rest of the 99%. Now, before you statisticians begin clamoring that it's reporting the average (i.e., the sum of all household incomes divided by the number of households) and not the median (i.e., the income at which 50% of incomes are below, and 50% are above), yes, the median income is even more depressing (in 2004, the median US income was $44,389). In this year, the average income for the 99% is $58,506. Hey! I'm above the median but below the mean...awesome?

Creeping Influence and Starving the Beast

Why would this happen? Well, you have to understand that there has been a progression of decisions since around the 70's that allow for massive corporate donations and lobbying of Congressional members, culminating in 2010's Citizen's United decision, which basically removed the last restrictions on donation amounts. Our representatives don't really represent us, they represent the people who pay them the most, which is not their constituents. It makes good fiscal sense, but it's playing havoc with our system. Beyond that, conservatives since the 80's (at least) have been promoting a strong stance against government spending for all the above reasons - they want to throw the reins to the private sector, who pays them very well for their work. They also really can't stand entitlements and have wanted to do away with them basically since they were enacted. Now, you can't make a campaign (typically) out of saying that you want to eliminate Social Security and Medicare directly, so what do you do?

Well, if you're smart, you start modifying them and using them as piggy banks that you can spend from whenever you want. Social Security, on its ledger, is running a huge surplus, but that money isn't actually there anymore. Where did it go? Well, the wars in Iraq and Afghanistan, and the Bush Tax Cuts. And now they don't want to pay it back. You create a crisis by stealing the money from the account and then complaining that its bankrupt. You also cut taxes to reduce revenue, and without that money coming in, the crisis deepens. All of a sudden you have a budget and deficit crisis because you've been engaging in massive deficit spending while cutting revenues. At that point, no one wants to cut Defense, right? So, what's left? Entitlement programs!

Starve the beast, indeed. The majority of this is a calculated and long-running scam to eliminate entitlement programs and get rich quick while doing it: Promote your economic vision as "helping the job creators," by which you mean reducing taxes. This decreases revenue. Then you take money from those programs that you want to cut and refuse to pay it back, instead using it for your own ends. You engage in budget-busting policy decisions that creates a fiscal crisis when your reduced revenues can't match your current spending, and then you turn around and say "Hey, we can't raise taxes in a crisis like this! We've got to cut spending. And if you cut Defense spending, you're threatening the well-being of the nation. So, sorry, but we're really forced into this, we've got to cut Social Security and Medicare."

It's entirely manufactured, and it's paying off well for the conservatives right now.

The Relation to Supply-Side Economics

So how does this all relate to supply-side economics? Well, that's the fancied-up language they use to defend this move. You make the argument that you're spurring jobs growth by giving more money to the private sector, the people who produce things, instead of wasting government money on other programs. The people who get the tax cuts will produce more, and that will help everyone.

But this doesn't make sense.

Let's consider a few brief examples. Let's say that we have a group of 100 people. One of them is fabulously wealthy and can afford anything they want or need. The other 99 are getting by, some better than others, but can't satisfy their every desire. Now, if you're a Republican, you say that we need to put more money into the hands of that one person, and they'll spur some economic growth by investing more in their business, or by buying more and stimulating the economy directly. If they want another yacht, well, someone has to build the thing, right? It creates jobs.

If you dont' think about it too much, that makes a sort of sense. But when you really think about it, it all falls apart. See, they already have everything they want, and the economy is already supplying that for them. Given more money, their demand is not going to increase that much, and you're likely to see the tax-cut money disappear into their pocket or into investment banking, which, again, doesn't really create any jobs. The additional economic demand of one individual isn't going to be that great. Now, let's say instead you inact a policy which forgives the other 99 people's debt, or puts more money into their hands. Now, they have a lot of things they want and need - their demand is high, and given the ability to make additional purchases, they are likely to do so. The additional economic demand of ninety-nine people is much more likely to have an impact in our hypothetical scenario.

Now, you may say that's a little unfair. It's not just about direct purchases - these people will invest in the economy in general, and it will improve. Well, not really, again. Just because you increase productivity or increase supply, does not mean that demand will rise to meet it, or that consumers will have the purchasing power to satisfy their demand. Say I own a pizza company, and the government decides to cut the tax rate for pizza companies who make a certain number of pizzas per day. Or, alternatively, they decide to just subsidize pizza companies and give them money to make pizzas. "Great!" I think, as I hurry to make a lot more pizzas than I ever have before. Unfortunately, even though I have much more supply, the demand just isn't there. It's okay, though, because even though I waste money on the surplus pizzas, I get a huge tax break which more than makes up for it (or, alternatively, I'm being paid to waste money).

See, if you're already making a profit, there's little reason to hire additional workers - there's not much reason for job creation. Beyond that, we know that a lot of times, it's much more profitable for a company to lay off people. Shareholders see their stock prices jump massively after layoffs, because the company is supposedly becoming "more efficient." Just giving the heads of companies more money does not produce any real incentive for them to invest that money in hiring additional workers. And why would they? Demand is pretty low - companies aren't hiring because people aren't buying. It's ideal to match your supply to the demand so that you aren't wasting any production, and companies aren't going to artificially boost productivity if there's no demand.

This is the ultimate flaw of supply-side thinking - boosting supply does not automatically boost demand. Typically, it creates waste, and when you subsidize waste, you're just putting money into the pockets of people who have no intention of ever creating a job.

If you really want to spur economic growth, you have to increase demand, and that usually means increasing the purchasing power of consumers. For people who are massively in debt, or working very low paying jobs, it doesn't matter how much supply is out there - they can't afford it. So could tax cuts work for the middle-class and the poor? Well, potentially, but you'd have to wait a long time. People in that situation typically spend additional money paying down debt, which does not directly boost economic growth.

Henry Ford had a crazy idea when he hired people to work on his assembly line. He paid them $5 a day. That doesn't sound like much, but it was vastly higher than any other similar job would pay. Ford took a hit on his profits by paying his workers so much, but he also turned them into consumers. With that kind of money, they not only built Model T's, but they could afford to buy them too. This is part of the idea behind a minimum wage, and it's why "welfare" programs like Food Stamps have the largest economic multiplier of any government policy - these are people who have massive demand for food, shelter, basic necessities, and every so often, some luxury. When they receive food stamps or other such money, they spend it directly, and that demand fuels the economy. When you give more money to people whose demand is already low, i.e., those who already have everything they desire, you don't see it going back into the economy.


So don't believe the hype. When people say that they're for cutting taxes to the top brackets to spur economic growth, you know they're lying or are deluded. Ultimately, the proof is in the pudding. We've tried supply-side economics for basically the past 30 years, and look at where we are. We had some good growth times, but those turned out to be bubbles, and now we're basically on the edge of falling even further. The road to economic recovery is not through tax cuts and slashing spending on the programs that people need the most (and which also have the best economic multipiers). We need to boost demand, and we need to have a safer system in the markets and banking industries. I think the government can sometimes spend wisely, and it needs to invest in the country to stimulate job growth and consumer demand when the private sector refuses to step up.

But that's just my two-cents.


ClaytonLasSendas said...

Its AUSTRIAN economics, not AUSTRALIAN. And the real economists are not supply-side folks any longer, nor are they simple Keynesians, nor Austrians.
They focus on more complex models, are finding that all of the simplistic models of the past were bogus at the tipping points. Somebody should write a new Macroeconomics Text and teach it via U-Tube, like the Cato Institute tried to do with its "learn liberty" series based somewhat on the Austrian school ideas, with focus on Property Rights from which all else flows.

Ragoth said...

You are correct, it is Austrian economics, and I'm sorry for the typo. I have nothing to blame for that one aside from general fatigue and not carefully re-reading the post, so, I accept that one.

Working in an economics department at a university, I am likewise aware that real economists do not follow any of the simple models any more. However, this post was a bit more about politicians, most of whom are not real economists, and most of whom do over-simplify things to point of being either supply-side or simple Keynesian. It's frustrating, especially when you can knock holes in either side with relative ease, but, again, not real economists, but politicians.

That being said, an basic introduction to economics (or, even better, a much more in-depth study of economics) would be good for the general public so that they don't get swindled with promises of mergers creating jobs, or tax cuts bolstering the economy, or willy-nilly spending bolstering the economy.

Finally, I like the Cato Institute for a lot of things, but the economics of libertarianism simply do not work for me. Call me a big-government liberal if you want, but I do think the government has a role in providing services, and has the ability to provide services which are better and more inclusive than any private individual or company would.

At the end of the day, I don't trust a for-profit company to provide services which are in my best interest if it would cut into their margins. Certainly we see that with private insurance, and I have little doubt that many rural communities, which already have fairly bad roadways, would be even worse off if transportation was privatized. Why maintain a road that services only a few handfuls of people when you can maintain and charge a road that services thousands? Because they will complain? Who else will they enlist, or what other roadways will they take?