On the demand side
Political analysts and reporters keep talking about “trickle-up” and “trickle-down” economics. What do these terms mean? Personally, I’m interested only in “trickle to my pocket.” But as far as taxes are concerned, I pay what the government says to pay. They decide how to apply the money.
President-elect Barack Obama has spoken in multiple election speeches about trickle-down economics and how it has often had the opposite of its intended result, stating: ” … instead of prosperity trickling down, the pain has trickled up – from the struggles of hardworking Americans on Main Street to the largest firms of Wall Street.”
The trickle-down economics viewpoint cherished by the Republican Party sees tax breaks that benefit mostly the wealthy, who will invest it in companies that will expand operations, increase employment, and produce cheaper goods resulting in a higher standard of living for all.
This economic model relies on each step acting according to plan. The tax break-generated extra income must be large enough that the wealthy individuals invest it instead of saving it or spending it on personal consumption.
The public company receiving the investment must use it to expand existing operations, instead of buying back stock or buying competitors. The expansion must result in increased domestic employment, rather than outsourcing. Finally, the business expansion must result in profits on cheaper goods purchased by the public.
But does it work?
The Richard Nixon administration did not cut taxes. He thought the incentive for the wealthy to invest in the market was zero. Instead, the government controlled wage and price increases, but not interest rates. The economy ground to a halt with high inflation, a condition known as stagflation.
The Ronald Reagan administration Federal Reserve chairman Paul Volcker, squeezed inflation from the economic system by raising the federal funds rate to 20%, deliberately causing a recession. As interest rates were gradually lowered, the administration cut taxes by $479 billion over five years, and pulled the economy out of the recession, recouping $476 billion over the five years from increased tax revenues.
The George W. Bush administration avoided an impending recession in 2001, lowering taxes as an economic preemptive strike. In spite of the bursting of the dot-com bubble just before he took office, the 2001 9/11 attacks, and wars in Iraq and Afghanistan, President Bush managed to keep the country out of recession, until the bursting of the U.S. housing bubble at the end of his second term.
It has been 17 years of growth.
The $1.35 trillion in tax cuts over ten years was expected to be mostly repaid by the time they ran out in 2011. The recouping of the ten-year tax breaks is now a new ball game, depending on when the current recession will end, and how close to pre-bubble levels we return.
Does supply-side economics work?
Tax cuts are the key.
In the three cases cited, Nixonomics failed due to no tax breaks, Reaganomics and Bushonomics succeeded because of tax breaks, even though Reagan had to pull the country out of deep recession first.
Keynesian economics, also known as the trickle-up effect and favored by the Democrats, is a different type of macroeconomic philosophy that holds that:
1. Tax cuts can be used as an economic stimulus if spread across the entire economy, not just toward one specific group (like the wealthy).
2. Tax cuts should be used to increase demand, not supply, and should be targeted at cash-strapped, lower-income earners, who are more likely to spend the additional income.
3. Spending on goods demanded by the public will result in business expansion, increased employment, raising of standards of living followed by more demand.
Keynesian or demand-side economics proposes that consumption or demand is the key to economic prosperity and that production or supply follows.
Percentage-wise, it is obvious the wealthy spend less of their disposable income in the economic market. Dollar for dollar, the working class will release more into the economic system than the wealthy, simply because there are more of us.
The trickle-up effect states that directly benefiting the working class will cause them to spend their disposable income, buy more goods, encouraging more product output. As the supply of goods and services increases in response to increased demand, the wealth of the society as a whole improves and benefits will “trickle up” to the wealthy.
John Maynard Keynes was a British economist who still remains the world’s foremost expert on recessions and depressions. Although he died halfway through the 20th century, his findings are still accurate today. He knew how we got into recession, and he knew how to get out.
People are conventional.
Keynes developed the theory that increasing government deficits stimulates an economy. He also developed the theory that rational people in times of uncertainty fall back to conventions that give them comfort and assure them they are doing the right thing.
Conventional behavior turns into group behavior reinforcing their assurance. As an example, people think housing prices will return to their original values, and once we are out of this recession, the economy will grow again from the point it left off.
That is uncertain.
Keynes approach was based on his conception of money as a “store of value” rather than a method of payment. The desire to hold money with its perceived fixed value is a gauge of our distrust of our own calculations of the future. We think the more we have, the more we are protected against future uncertainty.
Keynes said that this uncertainty theory extends to banks (and credit card companies), that will raise interest rates to borrowing consumers to increase their own “store of value” heedless of the guiding interest rate charged by the Central bank.
Private banks will eventually follow the Central bank’s leadership and slowly reduce their lending rates, but their reluctance to spend will initially clamp down on credit and liquidity. This will leave the ball in the government’s hands to spend and stimulate the economy.
Government spending to “prime the (economic) pump” include infrastructure improvement programs (roads, bridges, dams, schools), tax cuts to workers, and the direct application of spendable cash.
John Maynard Keynes was one of the first economists to advocate government deficit spending as part of a fiscal policy to cure a recession. His theory is that increased government spending in areas that give discretionary income to the worker class will raise demand and increase consumption.
He argued that the solution to recession or depression was to stimulate the economy with a combination of two approaches :
· Reduction(s) in interest rates led by the Central bank, to stimulate cash flow
· government investment in repairing, upgrading and improving the nation’s infrastructure employing many thousands, and providing discretionary income for their families. This results in more spending in the general economy stimulating more demand for goods, resulting in a upward cascading cycle of recovery.
The upward recovery cycle can be short-circuited with excessive saving throughout the population, reversing the upward cycle.
Excessive saving decreases investment and demand, causing companies to cut back, increasing unemployment and completing the circle by cutting back on saving.
Advocates of Keynesian economics hold that economic stimulus should be directed towards the lower-income worker class, as they are more likely to spend the money than to save it.
The purpose of the stimulation is to get the economy moving again.
Economics against the tide
Keynes promoted countercyclical economic policies that act against the tide of the business cycle of economic expansion and contraction. This means embracing deficit spending when a nation’s economy is in recession and unemployment is relentlessly high.
We have already seen that fiscal stimulus increases the market for business output, raises cash flow and profitability, sparks employment and business optimism, and encourages investment, increasing gross domestic product (GDP). This accelerator effect means that government and business can be complements of each other rather than substitutes.
Government spending and investment in public goods not provided by profit-seekers, such as public healthcare, education, and infrastructure upgrade and repair will also encourage the private sector’s growth in suppliers and employment.
On the reverse side of the business cycle, in boom times with excessive demand-side growth, reducing government spending for public goods, raising taxes and interest rates to suppress inflation will cool the economy.
Herbert Hoover’s 1932 tax increase making the Depression deeper, and Franklin D. Roosevelt’s fiscal policies of public projects are examples pointing to the potential success of the trickle-up approach as a way out of our dismal economic situation.
Let’s hope a policy that works to dig us out comes soon.