The idea that policies favourable to the wealthy, such as financial deregulation and favourable tax treatment of capital income, will ultimately benefit everybody has been described, pejoratively, as “trickle down” economics.
The same idea has been summed up, more positively, in the aphorism “a rising tide lifts all boats” attributed to John F Kennedy, and a favourite of Clinton advisers such as Gene Sperling and Robert Rubin. (It should be noted that this phrase is also used in the context of debates over free trade and over the effects of macroeconomic expansion. While it generally implies that we should focus on expanding aggregate income without too much concern over distribution, it is less sharply focused than the “trickle down” pejorative.
Whatever you call it, trickle down economics is one of the casualties of the financial crisis. I’m not the first to point this out, and I’m sure I won’t be the last, but here’s a piece summing up my thoughts.
US experience during the decades of neoliberalism gives little support for this view. In the period since the economic crisis of the early 1970s, US GDP has grown strongly, and the incomes and wealth of the richest Americans has grown spectacularly.
By contrast, the gains to households in the middle of the income distribution have been much more modest. Between 1973 (the last year of the long postwar expansion) and 2007, median household income rose from $44,000 to just over $50,000, an annual rate of increase of 0.4 per cent. (More on this here and here)
Household size has decreased, mainly due to declining birth rates. The most appropriate measure of household size for the purpose of assessing living standards is the number of “equivalent adults” derived from a formula that takes account of the fact that children cost less to feed and clothe than adults and that two or more adults living together can do so more cheaply than adults in separate households. The average household contained 1.86 equivalent adults in 1974 and 1.68 equivalent adults in 2007 (my calculations on US census data). Income per equivalent adult rose at an annual rate of 0.7 per cent over this period.
For those at the bottom of the income distribution, there have been no gains at all. Unlike the situation in Australia and other countries where a poverty line is defined in relative terms, as a proportion of average income, the US has a poverty line fixed in real terms, and based on an assessment of a poverty-line standard of living undertaken in 1963.
The proportion of Americans below this fixed poverty line fell from 25 per cent in the late 1950s to 11 per cent in 1974. Since then it has fluctuated, reaching 12.5 per cent in 2007, a level that is certain to rise as a result of the financial crisis and recession now taking place. Since the poverty line has remained unchanged, this means that the incomes accruing to the poorest 10 per cent of Americans have actually fallen over the last 30 years.
Other measures yield similar conclusions. Median earnings for full-time year-round male workers have not grown since 1974. Women have done a little better, with median earnings for full-time year-round workers rising by about 0.9 per year over this period.
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Overall, the main factors sustaining growth in living standards for American households outside the top 20 per cent have been an increase in the labour force participation of women and a decline in household savings. Over the period since 1999, consumption financed by borrowing against home equity has been the main factor offsetting stagnant or declining median household incomes.
Thus, in statistical terms the US offers little support to the trickle down theory. It is equally important, however, to look at how the theory is supposed to work. The general idea is that, the more highly owners of capital and highly-skilled managers are rewarded, the more productive they will be. This will lead both to the provision of goods and services at lower cost and to higher demand for the services of less-skilled workers who will therefore earn higher wages.
The financial sector is the obvious test case for this theory. Incomes in the financial sector have risen more rapidly than in any other part of the economy, and have played a major role in bidding up the incomes of senior managers and professionals in related fields such as law and accounting. According to the trickle-down theory, the growth in income accruing to the financial sector benefitted the US population as a whole in three main ways.
First, the facilitation of takeovers, mergers and buyouts by private equity firms offered the opportunity to increase the efficiency with which capital was used, and the productivity of the economy as a whole.
Second, expanded provision of credit to households allowed higher standards of living to be enjoyed, as households could ride out fluctuations in income, bring forward the benefits of future income growth, and draw on the capital gains associated with rising prices for stocks, real estate and other assets.
Finally, there is the classic “trickle-down” effect in which the wealth of the financial sector generates demands for luxury goods and services of all kinds, thereby benefitting workers in general, or at least those in cities with high concentrations of financial centre activity such as London and New York.
The bubble years from the early 1990s to 2007 gave some support to all of these claims. Measured US productivity grew strongly in the 1990s, and moderately in the years after 2000. Household consumption also grew strongly, and inequality in consumption was much less than inequality in income or wealth. And, although income growth was weak for most households, rates of unemployment were low, at least by post-1970 standards for most of this period.
Very little of this is likely to survive the financial crisis. At its peak, the financial sector (finance, insurance and real estate) accounted for around 18 per cent of GDP and a much larger share of GDP growth. With professional and business services included, the total share was over 30 per cent.*
The finance and business services sector is now contracting, and it is clear that a significant part of the output measured in the bubble years was illusory. Many investments and financial transactions made during this period have already proved disastrous, and many more seem likely to do so in coming years. In the process, the apparent productivity gains generated through the expansion of the financial sector will be lost.
The failure of the trickle-down approach has been even more severe in relation to consumer finance. The idea that increasing income inequality was unimportant when households could borrow to finance growing consumption was never defensible. The gap between income and consumption had to be filled by a massive increase in debt. With sufficiently optimistic assumptions about social mobility (that low-income households were in that state only temporarily) and asset appreciation (that the stagnation of median incomes would be offset by capital gains on houses and other investments) these increases in debt could be made to appear manageable, but once asset prices stopped rising they were shown to be unsustainable.
In the US context, these contradictions have been resolved for individual households by a massive increase in financial breakdowns. Until 2005, this mainly took the form of a steady increase in bankruptcy, to the point where Americans were more likely to go bankrupt than to get divorced. Restrictive reforms introduced at the behest of the credit card industry produced a dramatic drop in bankruptcy (in part, the lagged counterpart a massive upsurge in 2003 and 2004 as people rushed to get in under the old rules). From 2006, onwards, bankruptcy rates resumed their upward trend, reaching 1.1 million per year in 2008
This trend attracted little attention as bankruptcies were rapidly overshadowed by foreclosures on home mortgages. During the boom, when overstretched householders could normally sell at a profit and repay their debts, foreclosures were rare. From 2007 onwards, however, they increased dramatically, initially among low-income “subprime” borrowers but spreading ever more broadly. 2.3 million houses were affected by foreclosure action in 2008. In hard-hit areas of California, more than 5 per cent of houses went into foreclosure in a single year
As in other respects, the longer-run implications of the crisis have yet to be fully comprehended. Even when economic activity recovers, consumer credit will be far more restricted than in past decades. As a result, there will be no escape from the implications of decades of stagnant wages for workers at the median and below.
Politically, the failure of the trickle-down theory seems likely to produce a resurgence of the class-based politics pronounced dead in the era of economic liberalism. The contrast between the enforced austerity of any recovery period, and the massive, and massively unjustified, excesses of the financial elite during the boom period, will produce a political environment where phrases like “malefactors of great wealth” no longer seem quaint and old fashioned. (Just after writing this, I Googled it, and found it as the title of a piece in Time Magazine’s Swampland by Joe Klein, among the most reliable indicators of the political zeitgeist).
* Here I’m measuring the ratio of gross FBS output to gross domestic product, which is the figure most relevant to the argument. The value-added in FRB (which nets out inputs purchased by the FRB sector) is smaller, around 20 per cent, but still indicates a highly financialised economy.
The article first appeared on John Quiggin’s blog.