Trickle Down Economics

Trickle down economics is the theory that the best way to help the poor is to give money to the rich (eg through tax breaks).  The idea is that these rich people will then be motivated to create a thriving economy which will benefit everybody.  I am immediately reminded of Galbraith’s brilliant observation that “Capitalism is the theory that the rich don’t work hard enough because they are paid too little, and the poor don’t work hard enough because they are paid too much”

The image that comes to mind is that of pouring water over a pile of rocks. The water trickles downwards, spreading out, until it comes to rest at the lowest level.  But this comforting metaphor is deceptive. Money, the “water” of the economy does not sink and come to rest – it is in constant circulation. The real metaphor is that of an elaborate fountain.  At the top are a few enormous gushers, through which flow fantastic amounts of watery wealth. The water runs down and down, though progressively smaller spouts, until it is sucked up by a tremendous pump, which collects all these small streams and pumps them back up to the top again.  Much of the water never reaches the lowest levels at all.  The real nature of the economy is “Pump Up” rather than “Trickle Down”.

The reality of course is that in order to get money you have to work for people who are in a position to give it to you. And it is a common observation that the people who work the hardest get paid at the lowest hourly rate. But, putting my moral outrage at grotesque inequality to one side for a moment, and moving to a different watery metaphor– is there any truth in the idea that giving more money to the rich, concentrating wealth,  actually  creates a tide that lifts all boats? Do low labour costs lead to a more active economy?

Let us suppose that a certain thneed factory decides to undercut its rivals by reducing the price of its product from £10 to £5. We will suppose there is no new technology available, so in order to do this, it cuts the hourly rate of the workforce. Because thneeds are now cheaper, everyone else now has more money left over after buying all their thneeds, and this surplus money is available to provide demand for other goods and services, which could not otherwise be afforded. This will lead to an increase in employment to fill the new demand.  Great! But wait. Other thneed factories will be forced to follow suit in order to remain competitive; the same drivers apply to the rest of the economy too, and so wages in general are reduced. Although  general prices go down this is offset by a general drop in wages.  Which effect is greater?

Presumably the company owners and management will not cut their own wages; on the contrary they will probably give themselves a cost-cutting bonus.  It follows that the company will have to reduce its wages by 60% to achieve a 50% drop in price. In other words, the general drop in wages will be greater than the drop in price; and so people will have less spare money; demand will be reduced, and the economy will go into a downward spiral.  The only people to be better off will be the owners and managers, and these wealthy people form their own micro economy, buying assets from each other and inflating the price of art and vintage wine, which does not serve the general population. Remember none of this applies if the reduction in price is due to new technology; that is quite different, as was discussed in the previous post.

The corollary is also true; if wages are generally increased, this will create a general increase in demand.  This is not a controversial idea; it is well known that the United States became great by following Henry Ford’s policy of paying his workers enough money to buy his cars.  Such altruistic behaviour is out of fashion; but it should be clear that far from being a drag, a minimum wage can be a boost to the economy.  More in the next post.