Occam's Razor

We have more than thirty years of evidence that giving more tax cuts to those that don’t need it has hurt the economy, not to mention hollowed out the middle class. Why do so many of us still believe that doing more of what hasn’t worked will make us richer? Are we that impressed by talking suits on Fox News or CNBC?

Let me see if I can clear your head on this. This way the next time you hear this bullshit you can call the person on it. Let’s go through a thought experiment. What would you do with an extra $100, $1000, $10,000, $100,000 and $1,000,000? My assumption is that you are likely of modest means, which is a good assumption because most of us are not in the top 1%. I certainly qualify although since I am nearing retirement and the end of my professional career, unsurprisingly, I am in my peak earning years. According to the New York Times, I am in the top 7%, except when I retire I’ll be demoted to the top 23%.

So if I had an extra $100, I probably would not even notice it. Most likely you would not either. But, if you are of very modest means, you live paycheck to paycheck, and you found yourself $100 richer you would probably spend it. Maybe you would go to Target and buy a few gizmos from their electronics department. If this happens to a lot of people of relatively modest income at the same time over a significant period of time, not only do you get stuff that you want, but more money flows into the economy. Target and Wal-Mart would likely to report higher sales. The extra money might give them confidence to build new stores, or expand existing ones, and perhaps some people will have jobs they might not have. This is one reason raising the minimum wage makes a lot of economic sense. Almost all this extra money by the lowly paid will get spent, which is good for the economy.

With an extra $1000 most people with modest means would probably spend it, or perhaps use it to pay off debt. If you are rich, you won’t notice $1000. It won’t have any more of an effect on your spending patterns than an extra dime would have to someone on food stamps. It goes into an account somewhere and gets forgotten about.

With an extra $10,000 you might do some serious purchasing. Perhaps it would be a substantial down payment on new car. The smart thing to do for those of modest means would be to save it. But most likely it would be spent. A rich person won’t notice it and thus won’t spend it.

With an extra $100,000 you might be able to pay off your mortgage, or all your credit cards plus take a couple of nice vacations. If you are wealthy, $100,000 won’t buy you a new house except maybe in a bad neighborhood of Detroit. In any event you don’t have a mortgage. The money could buy you a super fancy car, perhaps a Tesla. If you are that rich though, then you probably have a Tesla already. You’d likely have a hard time finding the motivation to buy another car, probably because you would drive it sporadically at best, as you have as many as you want already anyhow.

With an extra $1,000,000 most of us would think we would be living grand, but it doesn’t buy as much as you think. You can buy a nice house in a nice neighborhood for cash and maybe afford to pay the taxes and maintenance on it with what’s leftover if you invest the money carefully. You might even have a house built to your exact specifications. That would keep a lot of people gainfully employed for a while. They would take the extra money and spend it elsewhere and where they spent it, those merchants or service providers would see a modest bump in income perhaps. By itself, $1,000,000 won’t have a huge wealth effect on the larger community because it’s just you spending it, and it’s unlikely a hundred people in your area will be similarly fortunate.

That’s what you might do with the money. If you are rich, say Mitt Romney, $1,000,000 goes into your portfolio. Maybe his son Tagg gets a bit larger inheritance than he expected when Mitt passes on. You already have a bunch of houses across the United States. You probably won’t use it to buy another one. It’s not enough to buy a private jet, assuming you don’t have one already. Mostly though Mitt has everything he needs. So whether it’s $1,000,000 or $10,000,000 or even $100,000,000, about a third of his net worth, he’s much more likely to save the money rather than spend it. A lot of it might go into stocks and bonds, which hopefully will generate more wealth, and is essentially another form of saving.

Perhaps with so much money, a rich person would put it into venture capital funds. Venture capital funds exist to fund the next Facebook, because most of the money put into them will be bad bets. It’s that one in 100 that beats the odds that you are hoping to have invested in, so you can snag part of its meteoric growth. Venture capital money is useful to these start ups, and does stimulate some growth, although much of it is ultimately unproductive because most of these start ups fail. Rest assured though that while the really rich people may be investing in some venture capital, mostly their money is not being spent this way. Mostly it is sitting in vaults, often in offshore banks and in stocks and bonds. It’s unlikely to go to a venture capitalist in your neighborhood. It is money that will not trickle down to you or your neighbors.

The basic issue is that there are a relatively small number of very rich people. Mostly they already have everything they need. It’s not that they won’t spend money, but they don’t need to spend a whole lot more of it. They already have estate managers, the freedom to fly to Paris on a dime and stay at first class hotels. Their lavish spending will make life better for those providing these services, but only marginally so, because there are only so many rich people. It’s a safe bet though that Bill and Melinda Gates, for all their billions in net worth, have a hard time spending more than $100M a year for their own personal needs. Most of that will be to maintain the lifestyle they already have, not to make it a bigger lifestyle. After all, there are only twenty four hours in the day, so they can only enlarge their lives so much.

Money sitting in vaults of course just sits there. It doesn’t pay anyone’s salaries or stimulate the economy. It’s all about churning money to buy goods and services. That sort of stimulation is what drives growth. If it’s not spent, i.e. if someone doesn’t use their money over a finite period of time, it has no effect on the economy as a whole. (If a whole lot of people stop spending money, then we get recessions and depressions.) Whereas if you and people of modest means like you have some modest increase in income, you will most likely spend that money. It would drive a lot of growth.

So the “trickle-down” economic theory is actually well named. Just a trickle of the money the relatively few wealthy people have will get spent, which means lots of people competing for those relatively meager dollars. When the rest of us have to compete harder for a smaller slice of the economic pie, our incomes tend to decline. Our labor is cheaper to acquire. Which is exactly what has happened to most of us over the last thirty years if you look at median household income. Our standard of living has eroded because money that used to churn more frequently churns less frequently, often because it got acquired and held by the rich, who mostly don’t need to spend it.

The trickle-down theory was sold as prosperity flowing down to the masses from the rich because they acquire more money and know how to spend it more intelligently. But of course it really does trickle down, and worse most of their new wealth used to be our wealth. The bad news for the rich is that when our economic and social systems fail, they too are swept up in the change. Even the very rich only remain rich while there are systems in place that allow them to spend their money. In truth, the rich are utterly dependent on the system that made them rich, just like us. Just as we all need roads to get from place to place, we need our economic system to enable broad prosperity. And it works as long as prosperity is possible, i.e. all social classes have a realistic expectation that they can acquire more wealth.

Economies actually grow from stability, predictability and generally from the middle class out. Innovation does not come principally from the rich, but from the middle where talent, attention and drive are in abundance. Wise rich people don’t mind paying more taxes to help out the middle class because they realize that the prosperity of the middle will trickle up to them in time. Unfortunately, too many rich people are so caught up in their own puffed up egos that they cannot see this. They think that because a formula worked in their particular case, it will work for everyone.