Trickle Down Economics

In my last blog, I mentioned the book “Aftershock - The Next Economy and America’s Future” by Robert Reich [Reviewed in NYT], in which he quoted some statistics revealing how income distribution was becoming more heavily weighted in favour of the top 1% of earners. The consequences are significant – as manifested by the widespread anger over the multi-million dollar salaries and bonuses bestowed on many people who are perceived to be the perpetrators of the economic meltdown.  Despite my comments in a previous blog advocating talking about books one hasn’t read, I have read most of Aftershock (it is short).

The Causes of the Meltdown

According to Reich, the root cause of the 2007-9 economic meltdown is simply stated: the majority of the consumers do not earn sufficient money to consume what the economy is capable of producing. Producers cannot sell their goods and therefore must lay off employees who become even less able to consume. This creates a downward spiral in the economy.

The majority of consumers in number and buying power are lower to middle income earners. Their real income has deteriorated over the past 30 years and far too much income has been appropriated by the top few % of earners.

This is a serious problem which has already dramatically affected most if not all of us and can only be solved by major political and economic changes. The effects include the erosion of savings, lack of opportunities for our children professionally and otherwise, unemployment, education costs, downward pressure on spending for infrastructure, education and medical care, etc.

In US (similar to Canada), the average lower-middle earners’ income has not increased for approximately 30 years (adjusted for inflation). People have used 3 means to “improve” their material living standards – more women have joined the workforce, people work more hours and families have borrowed to provide for their spending. In the long run, none of these are permanent solutions, at best they are temporary stop-gaps. By the end of 2007, many people had maximized their lines of credit and exceeded their ability even to pay interest on their credit cards and mortgages, let along paying off debt or saving for the future. This triggered the sub-prime mortgage mess.

Don’t Blame the Banks

According to Reich, blaming the banks for granting easy credit and the monetization of sub-prime mortgages as the problem (as egregious as such behaviour may be) ignores the real issue - that the wealthy have appropriated the discretionary income and simply don’t have the time or inclination to spend the money.

Having already acquired much of their material desires including their second homes and recreational properties, their yachts and sports cars and other toys, etc., they still have a lot of money and want to invest it. Because the investment opportunities are limited, this gives rise to speculation; investors accept higher risks for lower returns. That creates the second problem – the resulting speculative bubble which also in time must burst.

The Wealthy Must Pay Attention

Reich’s concludes that the wealthy and powerful had better start paying attention. It is in their best interests to level the playing field to some degree. In the golden years from 1946 –75, the top 1% of the income earners got about 9% of the income; in 2007, the top 1% got 23% of the income. If the top income earners continue to bleed off such a large percentage of the income (without needing it for current expenses or savings for future needs), therefore depriving the middle and lower earners of income they actually do need for current expenses, this may well lead to social unrest, even revolt. This would certainly not be good for the rich. Just look at what happened to Marie Antoinette (of - Let them eat cake fame).

Fix It With More Progressive Taxes?

There are those, primarily the upper income group, who will argue that taxing upper income earners reduces incentive [there is little evidence in support of this] and that they are few in number that even if you were to reduce taxes on the lower-middle income earners, this will produce very little benefits. Reich. always a pragmatist, argues that because the amount of wealth now diverted to the upper income earners is so vast, re-allocating it to those who will use it for consumption will have a major beneficial effect. Additionally, the re-allocation will diminish the demoralizing deprivation of hope and opportunity experienced by the middle class.

The Great Prosperity – 1947-1975 – and the Bargain

Reich also discusses why the income distribution was much fairer from the end of WWII until about 1975. He calls that period of time the “Great Prosperity”. It followed in the footsteps of the sacrifices of WWII at which time there was a general feeling that everyone was pulling together. Despite the McCarthy Era anti-communist craze, during the Great Prosperity the government in the US was very active in enforcing “the basis societal bargain – using Keynesian policy to achieve nearly full employment, giving ordinary workers more bargaining power, providing social insurance, and expanding public investment.” (page 49)

Why was the bargain abandoned? Reich attributes the first “cause” as the loss of high paying jobs to low paying jobs due to globalization and automation. He then points out that not only did the government fail to enforce the bargain but actually did the opposite from about 1975 onwards. It “deregulated and privatized. It increased the cost of public higher education, reduced job training, cut public transportation, allowed bridges, ports, and highways to corrode. It shredded safety nets – reducing aid to jobless families with children, and restricting those eligible for unemployment insurance…”. (Page 55) Yet at the same time it reduced taxes on the topmost 1.5% of earners and capital gains taxes and boosted sales and payroll taxes.

There are many reasons suggested for this movement to deregulation and lower taxes on the rich. We have heard them all. from the libertarians to the trickle down economists. However, Reich identifies the real reason as the concentration of income, wealth and power in fewer and fewer hands – an echo from Mariner Eccles,  head of the Federal Reserve Board in the mid-1930’s. This elite group protects their wealth and power, both as insiders in government (elected politicians and trusted advisors), and as lobbyists.

Coping with Real Income Decline

As the plight of the middle and lower income earners deteriorated, Reich points out that they coped using the 3 mechanisms mentioned above. They coped rather than revolting because they still held sacred their confidence and belief in the American Dream - the “rags to riches” myth - and a further belief that if you did not succeed, you were at fault rather than the cards being stacked against you. As people become disenfranchised and lose faith, and find their lives have changed for the worse despite their hard work and efforts and their kids have no opportunities because the public school system has been destroyed by under-funding and university has become unaffordable, they will begin looking for scapegoats.

Fundamental Values

Unfortunately, Reich does not question the fundamental values of a society which permits such gross distortions. For example, what are the values of a society that condones paying a school teacher $75,000 per year while bestowing $700,000,000 on the head of a failing merchant bank, or $100,000,000 on a hedge fund manager; or a company which pays a line worker $50,000 per year and the CEO $300,000,000.

Secondly what mechanisms are available to remedy this inequity? If the values held by those who have the political and economic power support the inequities, there will be no impetus to remedy them - except self-interest. Reich has no alternative but to make his pragmatic pitch because the wealthy and powerful are unlikely to give up their money and power voluntarily on the basis of compassion.

The Roadblocks to Reform

If we accept that the concentration of power and income will hinder any reasonable progress towards the required fair distribution of income which in turn will slowly end the recessionary cycle, that concentration must be diminished. This was done by government action during the trust busting era of Theordore Roosevelt circa 1900 and by the Franklin Roosevelt administration during the Great Depression circa 1936. The historical background to these government actions should be studied to determine if there is any possibility today’s governments in US or Canada are capable of passing legislation to curb or reverse the trends from 1980 to 2010. I am sceptical that government has the will or even the power to do so. If government cannot or will not act, is there some other work-around, perhaps as suggested by Reich voluntary action by those have power and economic clout in order to protect their interests?

Suggestions for Action

Reich does propose some actions which are worth considering, however unlikely they are to occur: reverse income taxes by supplementing the wages of the middle class (see proposal for giving money to low income earners in the Saturday Focus section of the Globe); higher marginal tax rates on the wealthy, wage insurance; revising funding for higher education, infrastructure projects which benefit all such as public transportation and getting money out of politics. Most of us would agree that these proposals would face very strong opposition politically and from vested interests. However, given the deficit situation in the US and Canada, it seems that higher taxes are inevitable – whether they will be achieved by higher marginal rates on the wealthy or other means has yet to be seen.

As the economic situation deteriorated in the fall of 2008 and the stock market declined precipitously, I assumed that the establishment, government and big business would do whatever was necessary to protect their interests. This meant avoiding a full economic meltdown, no matter what the cost. The bail out focussed more on Wall Street using its many avenues of influence resulting in the injection of massive funds into banks, investment banks and AIG, with the politicians rationalizing that saving them would in effect save the economy as a whole. These institutions ultimately survived with the injection of massive amounts of government aid and went on, in some cases, notably Goldman Sachs, to make more money and pay more bonuses (after paying their fines which were no more than the cost of doing business), than before. But the plight of the borrowers under the subprime mortgages in default, the middle and lower income earners who were unemployed, the drastic decrease in house values, and general stagnation of the economy has not improved, certainly not by the widely touted trickle down effect.

I have no more insight into solutions than Reich does. The experience with the Obama administration does not lend much comfort that there are any easy answers.  Navel gazing about a misguided value system is not going to be a fix.

Future Blogs

For those who found “Pay More Taxes – Session 101” interesting, I did receive comments back from my friend Larry Wasserman, a mathematician at Carnegie Mellon and a devout libertarian. Needless to say, his Taxes 101 does not look anything like mine. I responded back to him with “scathing criticism” and then asked him if I was still welcome in his home in Italy. He replied: “I have lots of tax-loving liberals visit. The problem with being a libertarian is that it's lonely. The conservatives and the liberals both hate us.” More on this lively dialogue in the future.