For the last 150 years, “neoclassical” economics, now the dominant and nearly exclusive paradigm in American academic economics, has taken a “supply-side” path that avoids the truth about income and wealth distribution, and a complete understanding of the workings of the monetary system. Ironically, honoring ideology instead of verifiable truth, mainstream economics has consistently supported the interests of wealth. The supply-side approach has been profoundly misleading, obscuring the dynamics of the system, the mechanics of economic growth, and the process and impacts of inequality growth. Sufficient information is now available to conclusively demonstrate the controlling, and devastating, effects inequality has on income growth and wealth concentration, but mainstream economics has yet to comprehend and acknowledge the truth.
The recent narrow defeat, in the face of massive public opposition, of the initial GOP attempt to repeal Obamacare, provides an important teaching moment. Under Paul Ryan’s proposal, an estimated 24 million people would have lost their health care coverage, and many would likely have suffered health deterioration, or even lost their lives. Ironically, it appears this draconian bill would have passed but for opposition by the “Freedom Caucus” in Congress, which felt the bill did not go far enough. The only conceivable basis for such a proposal was economic: the idea that the tax cuts financed by the cut in benefits would somehow “trickle down,” benefiting everyone.
There may also be a broad pathology of wealth at work here, a tendency of the wealthy elite to deny and oppose anything that might threaten their accumulation of profits and wealth, such as the overwhelming scientific evidence that fossil fuel emissions cause global warming. But there is something else going on here that no one is talking about, and that is the long-time perversity of mainstream economic thinking that has led to the false trickle-down argument.
In the entire body of supposedly “scientific” mainstream economic knowledge there is no evidence to support the perverse neoclassical claims that everyone benefits when the tax responsibility of the wealthy is reduced, and that doing so will magically stimulate economic activity. Nor is there any evidence that attempting to correct inequality leads to “inefficiency,” or that wealthy people can get richer without hurting others, an idea attributable to a former chairman of Ronald Reagan’s Council of Economic Advisers, Martin Feldstein. Neoclassical economics simply ignores the constraints of the monetary system. Thus, conventional wisdom confronts adverse denial-ism in the case of global warming, but supports false mythology in the case of economics.
The time has come for the economics profession, after 150 years of denial and neglect, to recognize that the distribution of wealth and income is the overriding factor determining the pace of economic growth and the degree of prosperity. This post will explain how distributional theory disproves the trickle-down fantasy, and sets forth a distributional macroeconomics that shows how a properly managed market economy can prosper and survive.
The Basics of Distributional Macroeconomics
Cutting taxes for the rich and corporations has been the heart and soul of the GOP agenda for decades. Recently, Bernie Sanders wrote on his Facebook page that “Trickle-down theory is a fraudulent theory designed by the rich and their think tanks in order to protect the billionaires and large corporations” (February 12, 2017, here). Trickle-down theory, however, actually has a much longer history: It grew out of the core philosophy of the “neoclassical” economics, which began to develop in the mid-19th Century with the advent of the Industrial Revolution and modern capitalism.
Historical Background
The neoclassical mindset was a new perspective on what economics is about: The classical economists for the most part were “socialists” – concerned about improving the lot of the impoverished in their societies – while neoclassical economists adopted the “supply and demand” orientation, focusing on income maximization. Both provided static conceptions. The classical approach was to assign “value” among the factors of production, namely, landlord, capital, and labor.
The early classicism of Adam Smith, David Ricardo, T.R. Malthus, J-B Say, etc. reached its peak with John Stuart Mill, a renowned philosopher, who emphasized that allocating work product is society’s choice, and Karl Marx and Fredrick Engels, who theorized (circa 1860) that great inequality would develop in industrial societies with the growing returns to capital, and that the system would become top-heavy and ultimately collapse. Marx and Engels were joined by several other European socialists, and by Henry George in the U.S., who argued that “progress” generates “poverty” through inequality. Classical economists generally detested “greed” and its social consequences, but they used a scientific approach to describing economic systems.
In America, from John Bates Clark beginning in the 1880s to Paul Samuelson, from 1948-2006, neoclassicism replaced the classical value of work system with emphasis on social values of economic success. This led to the “supply-side” perspective which ascended to academic dominance in the 1950s and early 1960s. Earlier, in the 1930s, John Maynard Keynes had mounted a fierce attack on the static nature of such theorizing, arguing that economies expand and contract cyclically (the business cycle), as the proportion of income saved for investment in future productive capacity expands and contracts. He also emphasized the crucial importance of “effective demand” in stimulating investment, an understanding dating back to early classicism.
American neoclassicism, however, rejected the Keynesian “demand-side” perspective, with the result that further progress in understanding growth was halted. In 1955, Simon Kuznets warned that the process of income growth would not be properly explained until the effect of income distribution was understood. Progress in that regard did not take place until the French economists Thomas Piketty and Emmanuel Saez compiled a database of distributed incomes from the entire history of 20th Century U.S. income taxation. Today, sufficient data is available to answer Kuznets’s question.
The Distributional Perspective
Inequality is by nature a monetary phenomenon, and money is debt (See The Web of Debt, Ellen H. Brown, 2007). Money is created when banks extend credit, and is destroyed when that credit is written off. In the early years of capitalism, money was recorded as bookkeeping entries and stored in coins and precious metals, represented by paper currency. Today most money is stored on computer chips, greatly increasing the ease and scope of transfers. The Federal Reserve Banks (the Fed) keep track of the money supply. Although the money supply is subject to substantial fluctuation, there is always a finite amount of money in the system. GDP is a record of aggregate income over a year: Understanding the relationship of money to aggregate income is the key to understanding how the system works.
Income, wealth, and monetary statistics are ill-suited to evaluating and quantifying actual output. By assuming that income is the equivalent of actual output, the supply-side perspective produces misleading results. Indeed, it can (and does) suggest that the economy is growing even when actual production is declining. The distributional perspective is essential, because it focuses on the money supply.
Inequality and Growth
Computers can rank incomes from the highest to the lowest (the Lorenz curve), and it is easy to understand that whenever one segment continues to grow faster than other segments, that segment’s share of total income grows. Since 1980, the top 1% share of income has grown much faster on average than lower percentile shares, and so long as its growth rate remains the highest, the concentration of income in the top 1% continues to grow. Income inequality naturally grows, in fact, even when higher incomes grow at the same rate as lower incomes.
It is not quite as obvious, but as I explained in my March 14 post (“Inequality Depresses Growth,” here), as income concentration increases, the rate of growth of aggregate income declines. Thus, inequality acts like a giant python, patiently squeezing the life out of a victimized economy. This fact is necessarily confirmed in the factual record, both conceptually and mathematically. The factual record reveals the substantial reduction in average annual income growth from the 30 -year period of declining inequality before 1980 to the 30 years of growing inequality that commenced with the Reagan Revolution. The conceptual logic is straightforward: Because lower-income people tend to spend a higher percentage of their incomes on consumption than do high-income people on consumption (per J.M. Keynes, they have a higher “marginal propensity to consume”), when the top 1% share of total income grows and the bottom 99% share declines, the overall average propensity to consume necessarily declines.
This point is absent from mainstream discussions, because once Keynesian economics became unpopular (circa 1970) work on “consumption function” issues flagged. However, the point has always been fairly obvious. Think of Adam Smith’s observation that the landowner cannot possibly consume all the crops produced in his fields:
“It is to no purpose, that the proud and unfeeling landlord views his extensive fields, and without a thought for the wants of his brethren, in imagination consumes himself the whole harvest that grows upon them. *** The rich ... consume little more than the poor.” (The Theory of Moral Sentiments, 1790, p. 165, here).
Although the richest people spend the most per capita, the total consumer spending of the top 1% does not come close to matching the total spending of the bottom 99%: Therefore, when the top 1% share of aggregate income grows, total spending declines. Because decreased spending constitutes a reduction in aggregate income, rising inequality provides a logical explanation for the observed decline in the growth rate of aggregate income.
The Quantity Theory of Money (QTM)
In addition to the facts of experience and this compelling logic, the Quantity Theory of Money (Irving Fisher,1911) provides mathematical proof. The QTM’s equation of exchange (PY = MV) reveals, unequivocally, that the average level of prices in an economy, all else equal, is determined by the amount of money in circulation. If the money supply grows with no change in the level of economic activity, prices adjust upward.
Importantly, the velocity of money, or the speed of its transactional flow, determines the level of economic activity, that is, the income produced by transactions (Y). Because the distribution of money determines the marginal propensity to spend, and the propensity to spend determines the its velocity, the distribution of money directly determines the amount of income.
In the discussion of the QTM in my March 14 post, I related the QTM as a counterpoint to the rigid “Say’s Law,” providing another valuable approach to visualizing this reality. Say’s Law maintains that “supply creates its own demand,” because every sale is an exchange of money. But the model is static, effectively presuming instantaneous performance; and because none of the perfections presumed to validate the supply-and-demand model exist, real-world activity always lags substantially behind the perfect performance presumed by the model. In fact, Say’s Law does not provide for any flow of money, so it effectively removes the velocity of money from the equation of exchange, leaving us with an incomplete model (Y = M/P) which cannot account for variation over time.
This is a major theoretical lapse which has led to an incredible amount of political and social damage. For example, in support of the free-market philosophy, Milton Friedman asserted that the Great Depression could have been avoided with more effective monetary policy, a thesis hailed as gospel by conservative economists such as the former Fed Chairman Ben Bernanke. Friedman simply assumed a constant velocity of money, removing the effects of distribution from consideration, and preserving the neoclassical presumption that inequality is a political, not an economic, problem. Researchers are only recently becoming comfortable with the idea that inequality is related to growth (IMF Staff Discussion notes, A. G. Berg and J.D. Ostry, April, 2011, here, and February 2014, here).
It is well understood today that the velocity of money is not constant. Economists at the Federal Reserve Bank of St. Louis have noticed velocity beginning to decline during the Reagan years (G. J. Santoni, March 1987, here) , and the persistent decline since, punctuated by plummeting velocity after the Crash of 2008 (Yi Wen and M. Arias, September 2014, here). I have found no indication, however, that today’s Fed or anyone else associates income or wealth distribution with the velocity of money; I may be the first to do so.
The static models of supply-side thinking are inherently incapable of explaining growth: By leaving the time variable indeterminate, neoclassical modeling removes consideration of the element of time and, in effect, presumes instantaneous growth of investment and productive activity, effectively removing the velocity of money from consideration.
Wealth Concentration
That mind frame also obscures recognition of the crucial fact that profits and rents continuously concentrate at the top, accumulating as wealth, gradually and inevitably increasing inequality, and reducing aggregate income growth. The latest edition of “Striking It Richer” by Emmanuel Saez (Table 1, here) reports that in the 2009-2015 period (most of the Obama administration) 52% of income growth was captured by the top 1%. It was 45% during the Clinton Expansion and 65% during the Bush expansion. In short: When income grows, most of it goes to the top 1%, and this has been going on for decades.
This fact makes a mockery of the trickle-down fantasy. In the American economy, income is being sucked to the top at a phenomenal rate. Because money is concentrating at the top, not circulating back down, the lower (bottom 99%) economy, as explained above, is contracting. The signs of a decaying lower economy are everywhere now, in declining state and local governments, flagging infrastructure, shrinking colleges and universities, and declining consumer markets. Apparent recent revivals of the flagging consumer and housing markets are not “real” – they reflect growing debt, not rising incomes. What appears to be growth is just a mirage.
Median real income has been flat since the 1980s, and most people have about 10% less real income than before the Crash of 2009. Income growth at the very top, however, though volatile, has mushroomed. Over the last two years, the stock markets have grown far faster than the population, routinely setting new records. This feeds the popular myth that our entire economy is growing robustly.
Growing income at the top contributes to the growing inequality of wealth, and as I reported in my fourth post on this blog (“How Wealth Concentration Destroys Everything,” March 15, 2017, here) the growth of top 1% wealth since 1980 has been shocking: Including a rough estimate of U.S. off-shore wealth of $6 trillion, a rough estimate of the top 1% total wealth gain in the 1980-2014 period, in 2010 dollars, is about $27 trillion. Income is growing more slowly now than before 1980, but with the top 1% taking in more than one-half of all new income, total top 1% wealth gain is necessarily growing, and it will continue to grow until the next crash.
To put these numbers in perspective, consider that if all the increased money supply from the federal debt (more than $18 trillion in 2014) is reflected in the $27 trillion, $9 trillion must have been provided by the bottom 99%. Per capita, for the $317 million people in the bottom 99% that year, the wealth gain each person contributed on average to the top 1% over the 35 years is more than $28,000. That’s more than $800 per person per year; more than $112,000, almost $3,500 per person per year, for a family of four.
Meanwhile, the additional $18 trillion gained by the top 1% from the growth of the money supply has caused inflation, offset only by the depressing effect of inequality growth. So, we have a rogue economy, out of control, with no real idea of how badly the lower economy has been harmed to date.
Taxation
The growth of income and wealth inequality is exponential, because interest – the foundation of returns – compounds. The mainstream perception that inequality lacks significant economic effect is no longer credible. As the very rich get richer, everyone else gets poorer. Still, the tyrannical grip of mainstream economic ideology is strong: To stimulate growth, the argument goes, taxes for the rich and corporations must be reduced. That is the opposite of the truth. Taxation must be increased at the top, and substantially, to reverse the steady inequality-driven decline. Otherwise, the economy will continue to march steadily down the road to the disaster that looms ever closer.
Congress will shortly pass legislation to implement the centerpiece of Trump’s agenda, substantial additional tax reductions for the wealthy and their corporations. The Trump administration is turning its attention now to broad tax “reform” proposals to reduce taxation of the wealthy elite and their corporations. Meanwhile, his administration blames “job-killing regulation,” which limits profit levels, for restraining economic growth, and is eliminating regulation.
These are exactly the wrong thing to do. It is easy to see why the holders of wealth would endorse an elaborate academic paradigm (neoclassicism) designed to support their interests. However, regardless of anyone’s interests or ideas, real-world economies are monetary systems that work in specific ways, and the concentration of wealth necessarily shrinks economic activity. That overriding fact means that the continuous accumulation of profits by the wealthy, unless restrained by taxation and regulation, will lead to economic collapse and depression.
As I explained in the second of my posts on this site (“The Great Tax Scam,” March 5, 2017, here), halting this pernicious decline will require, at a minimum, a return at least to the 70% top marginal income tax rate in effect until “Reaganomics “ took over. Real tax “reform” also must include less reliance on sales and use taxes, which are disproportionately paid by the lower economy, and more progressive estate and property taxation.
Conclusion
A distributional perspective on economic theory is essential for facing the major challenges ahead. The endless pursuit of profits and wealth accumulation is ultimately self-defeating, and leads to economic depression and social disintegration. This can be prevented, but there is only one way back from the disaster which is rapidly approaching: We desperately need a return to progressive taxation.