Has “Trickle-down” Been Shot Down?

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John Maynard Keynes

No, not yet, much to the chagrin of the small cadre of Keynesians still holding forth in the United States and around the world.  But it has taken some major ground fire recently, from an unlikely source and, ironically,  in an extremely unexpected way. 

Back in the 1930s, John Maynard Keynes, a “classical” economist by training, broke ranks. The “classical theory,” he pointed out, hadn’t predicted the Great Depression, and had no explanation for it.  According to the classical theory, an economy should always rapidly adjust to full employment “equilibrium” following any temporary setback: Any decline in consumption implies increased saving, so investment takes up the slack because saving, by definition, equals investment!

Keynes said no: All that we have done so far, my friends, is describe an economy at full employment.  Investment does not automatically equal saving. Instead of automatically creating more investment, a decline in consumption creates unemployment.   Following a “temporary” glitch, therefore, government will have to step in and stimulate demand to increase consumption.  Keynes developed a modern dynamic approach to economics called “macroeconomics” and a model that explained (predicted) the level of employment called The General Theory of Employment.  This became  the basis for modern economic theory.

Then along came Milton Friedman.  His distaste for government led him to reject the underlying premise of Keynesian theory, and through the “Chicago school of economics” to generate ideas that would promote unfettered capitalism and minimize government regulation or interference with business.  “Chicago school economics argues that markets are presumptively competitive and efficient,” reports Nobel laureate Joseph Stiglitz in his new book The Price of Inequality (p. 45), adding that: “While [Friedman’s] pioneering work on the determinants of consumption rightly earned him a Nobel Prize, his free-market beliefs were based more on ideological conviction than on economic analysis,” and further that:

Friedman’s monetary theory and policy reflected his commitment to making sure that government was small and its discretion limited. * * * That monetary policy could not be used to stabilize the real economy— that is, to ensure full employment— was not of much concern. Friedman believed that on its own the economy would remain at or near full employment. Any deviation would be quickly corrected as long as the government didn’t muck things up (p. 257).

Friedman’s free market emphasis overwhelmed Keynesian macroeconomics in the 1970s, and never looked back.  The key idea that gave the Chicago school’s theory legs was the belief that “on its own the economy would remain at or near full employment.” But wait –wasn’t that the same aspect of the classical theory that Keynes had so carefully refuted? Hadn’t that very idea been disproved by the Great Depression?  Not to worry. The Chicago school painstakingly rationalized the depression as a failure of monetary policy.

So the wealthy free-marketeers had the argument they needed for free rein.  The supply-side theory then developed a strain of the classical theory on steroids: If an economy doesn’t automatically adjust to full employment, just cut taxes on the owners of capital and their corporations and they will have a greater incentive to invest and create jobs; the proper response to any temporary glitch is to cut taxes at the top, and everyone will be better off.  This “trickle-down” argument has dominated federal taxation policy ever since it was officially adopted during “the Reagan Revolution.”

A leading protagonist of this theory is Steve Forbes, editor-in-chief of Forbes Magazine, the magazine that has been keeping track of the rich and powerful and advocating for their interests since 1917.  In 2010, Steve Forbes and Elizabeth Ames published an updated edition of their book How Capitalism Will Save Us: Why Free People and Free Markets Are the Best Answer in Today’s Economy, a book that attributes economic growth almost entirely to the glories of unfettered private initiative, ingenuity, and productivity.

They argued that “taxes intended to protect the economy almost always do just the opposite — they kill jobs,” and: “When tax rates are cut, however, the opposite takes place: the economy booms. Tax revenues grow. This has happened after every major tax cut in the last eighty-five years (KL 3143, 3153).  For this  “continuum effect” they cite Arthur Laffer, whose book with Stephen Moore and Peter Tanous, The End of Prosperity: How Higher Taxes Will Doom the Economy – If We Let It Happen, was published in 2008, during the early years of the Bush tax cuts and, ironically, just before the stock market Crash of 2008 and the onset of the Great Recession.  (Those events were subsequently overlooked in the Forbes/Ames 2010 assessment.)

What everyone has been failing to account for is the growth of inequality, and not just the supply-siders. Mainstream economics until recently has had little interest in income inequality, in particular, because it was hard to pin down a macroeconomic connection between inequality and growth.  In his book released in May of 2012, End This Depression Now!, Paul Krugman tentatively concluded that income inequality is a “political” problem.

But along came Joseph Stiglitz two months later, further spreading the message about the stunning growth of income inequality between 1979 and 2007: Over those three decades the top 1% of American households doubled its share of total income while the bottom 80% saw its share fall.  Over those thirty years the average real income of the top1% tripled, while the bottom 80% saw only just a 20% increase, on average.  By 2007, the top 1% share of total income had reached the peak it had previously reached just before the Great Depression.

Reporting on the Stiglitz book in an article entitled “Inequality and its Perils” recently appearing in The National Journal (September 28, 2012, here), Jonathan Rauch remarked that “it wasn’t just that the top was doing better than the rest, but that the very top was absorbing most of the economy’s growth.”   And he cited from Stiglitz “a good two-sentence summary of the emerging macroeconomic indictment of inequality:”

“Widely unequal societies do not function efficiently, and their economies are neither stable nor sustainable in the long term,” and

“Taken to its extreme—and this is where we are now—this trend distorts a country and its economy as much as the quick and easy revenues of the extractive industry distort oil- or mineral-rich countries.”

The Stiglitz analysis, says Rauch, has “reopened the debate” about the significance of inequality.

What comes as a major surprise, however, is that Frederick Allen, the Leadership Editor of Forbes, made this statement in October of 2012 (“How Income Inequality Is Damaging the U.S.,” Forbes, October 2, 2012, here) :

New research indicates that growing income inequality isn’t just unpleasant; it is seriously hurting the U.S. economy. And economists are figuring out just how the damage is done, according to a fascinating new article by the journalist Jonathan Rauch in National Journal.

This recognition at Forbes that income inequality has macroeconomic significance is  not only historically significant, it is stunning.  Consider that economists are still asking themselves whether the Crash of 2008 and the Great Recession coming when they did is merely coincidental to the enormous rise in income inequality, and that even the Keynesian community remains split between considering income inequality to be a macroeconomic problem with significant economic impacts, or merely a “political” problem.

It comes at a time when Allen’s editor-in-chief is arguing that all those tax cuts have created great prosperity and everything is just fine in the land of milk and honey.  It comes at a time when the Romney/Ryan ticket argues that “the path to prosperity” is to cut the taxes of the wealthy by another $700 billion over eight years, and pay for the tax cuts by slashing programs for the bottom 99% by $700 billion (CBO, here.)  At a time when one could reasonably argue that supply-siders are unconcerned about the welfare of the bottom 99% and the effects of widening inequality, the possibility emerges that until now they simply didn’t think the rapidly expanding wealth at the top was hurting anyone.

But wait, just because, as the leaders of free market advocacy have now acknowledged, all those tax cuts for the rich (the top rate came down from 70% in 1979 to 35% today, and the Ryan plan calls for reducing it further to 25%) did not produce the increased growth the trickle-down ideology promised, that doesn’t mean that they caused the decreased growth that resulted in the Great Recession, does it?  Does it??

To be sure, Rauch is correct that the economics community has only recently found “good reason” to believe that inequality is a real macroeconomic phenomenon, and much work remains to be done.   But it’s interesting to note that Rauch’s initial reaction to Stiglitz’s Keynesian macroeconomic analysis is try to focus on it through a supply-side lens:

The rich save – that is invest – 15 to 25 percent of their income, Stiglitz writes, whereas those on the lower rungs consume most or all of their income and save little or nothing. As the country’s earnings migrate toward the highest reaches of the income distribution, therefore, you would expect to see the economy’s mix of activity tip away from spending (demand) and toward investment.  That is fine up to a point, but beyond that … [a]s Christopher Brown, an economist at Arkansas State University, put it in a pioneering 2004 paper (here), “Income inequality can exert a significant drag on effective demand.” 

True, saving and spending should eventually re-equilibrate. But ‘eventually’ can be a long time. Meanwhile, extreme and growing inequality might depress demand enough to deepen and prolong a downturn, perhaps even turning it into a lost decade—or two.

With respect to the first sentence, to which I have added emphasis, it is important that Stiglitz did not say that the rich invest 15 to 25 percent of their income; Rauch added that. Stiglitz was pointing out that as the rich get a greater portion of total income, aggregate demand drops due to their lower “marginal propensity to consume.” This is what happens when you cut their taxes.  Remember, Keynes’s point was that investment depends not on the amount of saving but on “the marginal efficiency of capital,” that is, the prospect an investment will earn a return commensurate with its perceived risk.  If investment automatically equaled saving, then the economy would automatically return to full employment equilibrium as the classical theory required, and Milton Friedman believed, and we wouldn’t be in this mess in the first place.

So we would not “expect to see the economy’s mix of activity tip away from spending (demand) and toward investment” up to some undetermined point at which Keynesian macroeconomics suddenly kicks in.  Stiglitz and Keynesians understand the economy to be unstable, and since there are no identified forces naturally countering the growth of inequality, income growth must begin to decline immediately as inequality begins to grow. And there’s no reason to expect that the prolonged downturn would be limited to a decade or two.

It is incredibly important that the supply-side community is starting to recognize the macroeconomic significance of inequality, and Messrs. Allen and Rauch are to be commended.  They seem not yet ready to return to Keynesian economics, but the door is open.  I suspect that before this reopened investigation of the significance of income and wealth distribution is over, we will have learned that maintaining a consistently higher level of taxes on top incomes, perhaps in the range of the effective rate associated with the 70% top rate that was abandoned thirty years ago, will be required once again for economic health.

JMH – 10/19/2012

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2 Responses to Has “Trickle-down” Been Shot Down?

  1. vorfahrt says:

    I think that in the 1970s the economic policy was too Keynesian and demand-sided. We had record lows in the corporate earnings as %age of GDP and demand outstripped supply in general resulting in an inflationary crisis. As a reaction to these problems, the free-market and supply-sided economics worked well initially. However, we became victims of our own success by following the “slash taxes on the rich and put all burdens on the middle-class and poor” mantra every time there was a recession. We took away from demand and gave to the supply side until the economy, resting equally on these two pillars, became completely dislodged (1929, 2008). I guess it is the human experience to always overshoot on both sides.

    • I agree, Vorfarht, there was too much money chasing available consumer supply after Vietnam, bidding up prices, so there was a demand problem; but that did not invalidate “demand-side” theory, or make any sense out of trickle-down theory. There needs to be a middle ground, for sure. I believe that consists of an optimal level of inequality, and it is government that must find that middle ground. Thanks for your comment! – JMH

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