Three Things That Don’t Exist: Ether, The Tooth Fairy, And Trickle-Down Economics

What the Little Red Hen could Teach Chuck Schumer about the GOP tax bill.

In the 19th century, physicists believed that an invisible substance called ether permeated space. It was later determined not to exist.

Young children believe in the tooth-fairy, who at night replaces a lost tooth with a coin. But we grow out of that by age seven or eight—OK ten in my case—and realize the tooth fairy is just mom.

A third example of something that doesn’t exist is the oft-mentioned “Trickle Down Theory” of economics.

Thomas Sowell has written extensively about the strange belief in this non-existent theory. Some excerpts:

“New York’s mayor, Bill de Blasio denounced people ‘on the far right’ who ‘continue to preach the virtue of trickle-down economics.’ According to Mayor de Blasio, ‘They believe that the way to move forward is to give more to the most fortunate, and that somehow the benefits will work their way down to everyone else.’

“If there is ever a contest for the biggest lie in politics, this one should be a top contender.

“While there have been all too many lies told in politics, most have some tiny fraction of truth in them. But the ‘trickle-down’ lie is 100 percent lie. It should win the contest both because of its purity—no contaminating speck of truth—and because of how many people have repeated it over the years. Years ago, this column challenged anybody to find an economist outside of an insane asylum who had ever advocated this ‘trickle-down’ theory. But they never could.

“Mayor de Blasio is not the first politician to denounce this non-existent theory. Back in 2008, candidate Barack Obama attacked what he called ‘an economic philosophy’ which ‘says we should give more and more to those with the most and hope that prosperity trickles down to everyone else.’

“Let’s stop and think. Why would anyone advocate that we ‘give’ something to A in hopes that it would trickle down to B? Why would any sane person not give it to B and cut out the middleman? But all this is moot, because there was no trickle-down theory in the first place.

“The ‘trickle-down’ theory cannot be found in even the most voluminous scholarly studies of economic theories — including J.A. Schumpeter’s monumental ‘History of Economic Analysis,’ more than a thousand pages long and printed in very small type.

“It is not just in politics that the non-existent ‘trickle-down’ theory is found. It has been attacked in the New York Times, in the Washington Post and by professors at prestigious American universities. Yet none of those who denounce a trickle-down theory can quote anybody who actually advocated it.”

Sowell is absolutely correct. The idea of lowering tax rates to spur economic growth, which opponents label as trickle-down economics, is if anything trickle-up economics.

Raise your hand if you’re ever heard of trickle-up economics. No hands? That’s because it’s more common name is supply-side economics, and it’s something they rarely teach in school. My son Erik (the bitcoin guy) majored in economics at University of Puget Sound and reports supply-side economics was never mentioned. They were primarily taught Keynesianism (aka demand-side economics) and also a lot about competing economic theories of the 20th century such as socialism and communism.

Supply-side economics, and it’s near identical twin Austrian economics (from Ludwig von Mises and Friedrich Hayek at the University of Vienna) has also been referred to as “Laissez-faire” economics, which is French for “Get government the *#&$^#!# out of the way.”

Enough about names. What is trickle-up economics? Here’s how it works, which is pretty much how all economic growth works.

Step 1: The Idea

An entrepreneur starts with a business idea, typically an idea for producing some useful good or service more efficiently, or inexpensively, or at a higher quality.

Let’s say it’s an idea for selling potato chips packaged in a cardboard tube, with the chips stacked efficiently one atop the other. I’m using this example because–growing up in Iowa–my next door neighbor, Dick Doerfer, was the engineer who created the Pringles stacking technology.

If you can organize potato chips like this, you deliver to the consumer an improved way to carry the product, store it, keep it safe from damage, etc.

Step 2: Raising Capital

The funds to launch the business may come from the inventor’s savings, or be borrowed from friends or family or even a bank, or invested by those hoping for a return. Or, very likely the idea occurred inside an existing corporation, and the corporation itself provides the funding.

Note that in Step 2, the people providing the money are doing so in hopes of one day, not immediately, earning it back with interest or a profit. They key phrase is “not immediately.” Some day. Maybe.

Step 3: Hiring Workers/Buying Equipment

Once armed with capital, the entrepreneur begins hiring the people, and acquiring the equipment and other items, necessary to create and market this new product.

Note that in Step 3, workers are immediately getting paid. This happens before the product exists. Workers must be found to design it, develop prototypes, conduct marketing, build a factory, buy equipment, etc. These workers benefit immediately (paychecks). The key word is “immediately.”

By the way, how much has the entrepreneur, or the entity providing the capital, received so far? None. They’ve sent some money out the door, and no one knows if they’ll ever see it again. Let alone when.

Step 4: Open For Business/Make Sales/Generate Revenue

Assuming there’s a demand for this new product or service, when it goes on the market people will buy it. But that doesn’t mean the owners are making money. Few companies generate profits immediately. Amazon didn’t generate a profit for nearly a decade and at the time no one knew if they ever would. Meanwhile the workers themselves are getting paid. The first money went to them, and it’s still going to them.

Tragically, 80% of startup businesses fail within the first two years. Like freshly-hatched turtles racing to the sea and trying not to be eaten, most new companies don’t make it.

And when they don’t, all that capital never gets paid back. Those investors, those risk takers, those “capitalists” typically lose every penny. But the workers, even the very lowest of them, were getting paid the whole time.

Step 5. Profits

If the managers of the company made good decisions and organized things successfully, the business finally brings in more than enough revenue to cover expenses. We call that profitability. The money paid to all those workers has now finally trickled up and the capitalists (those who provided the money) begin to get their cash back, and hopefully more.

In short, in trickle-up economics, aka supply-side economics, aka capitalism, the capitalist achieves a gain at the very end of the cycle. The value had to trickle-up from the idea, to the hiring of people, to the successful creation and marketing of the company, to the end game of reaching profitability—which most never do. Only then, if everything has gone right, does the capitalist experience a gain.

But the chance of loss is so great that most capital doesn’t go into new business startups or expansions. It goes into safer places like CD’s municipal bonds, t-bills, and the like. Capital for new business activity is hard to find.

What does this have to do with tax rates?

Too often, Democrats see tax rates as a way of redistributing wealth. Here’s Chuck Schumer, speaking on the Senate floor about the GOP tax bill:

“It concentrates more of our nation’s wealth at the very top.”

Think about that phraseology. “Our nation’s wealth.” What does that even mean? Does it mean the gold sitting in Ft. Knox? The total property owned by the federal government, including federal lands? The revenue that pours into Washington via our tax code?

No, Chuck Schumer is referring to wealth earned by individual citizens. He considers the wealth private citizens earned, through their own labors, to somehow be “our nation’s wealth.”

This is dangerous. The moment you describe the earnings of individual Americans as “our nation’s wealth,” (implying it somehow belongs to the nation as a whole) it doesn’t seem outlandish to suggest the nation (read: politicians) should decide how to divide it fairly.

This is the “Lifeboat fallacy of economics.” You’re in the ocean, your ship has sunk, and ten survivors are in a lifeboat. They find—in a storage locker—a small supply of food and water. We might say those provisions are the “lifeboat’s provisions,” and should be divided equally. Certainly it would be wrong for one person to grab, say, 50%.

But this is true only in a lifeboat, where none of the survivors was responsible for supplying the provisions, and where new supplies cannot be obtained. The quantity is finite. Distribution should be fair and equal. Chuck Schumer would be the right man for the job, if it came to dividing up lifeboat supplies.

Back in the real world, provisions don’t just appear out of a benign storage locker. Wealth has to be created. Also in the real world, there is no limit to how many additional provisions (wealth) can be created.

This concept is explained in the parable of the little red hen, which we all remember from childhood. Short version: while the other barnyard animals were slothful, the hen found some grain, planted it, grew crops, harvested them, made bread, and used it to feed her family.

Chuck Schumer would refer to the bread created by her efforts as the barnyard’s bread. His instinct would be to use the tax code to take it from her and divide it equally among all the animals.

But a Schumer-esque tax code that considers the wealth of individual Americans, earned by their efforts, as the nation’s wealth in need of being fairly distributed will destroy the pools of capital needed to start the trickle-up process, which is the only thing—ultimately—that can grow an economy. Such pools of capital will simply not get formed. Why?

(1) Bad Risk/Reward Ratio. The incentive to try to create profits is dampened in a world where such profits are so heavily taxed when/if achieved, that it makes no sense to take on the risky job of trying to achieve them. (The Hen would never have bothered, if she knew most of what she created would be confiscated.)

(2) Lack of Capital. The cash—the capital available to start new business activity—won’t exist in the first place because the government will have seized it for purposes of redistribution. (The single grain of wheat the Hen found to start her garden, would never have existed.)

So here’s the message to Chuck Schumer: Ether doesn’t exist. The tooth fairy is your mom. And trickle-down economics is a theory no one has ever espoused.

Meanwhile, trickle-up economics is how growth is actually achieved. The GOP tax bill will allow pools of capital to form in the first place, and incentivize the use of that capital to expand business activity. That means more jobs and higher wages. Some of that growth will eventually trickle-up to the capitalists, who will likely re-invest it, thus continuing the benign cycle.

Thanks to the anticipated GOP tax bill (aka “The Little Red Hen Encouragement Act”) the markets are already going nuts, and the economy has enjoyed two successive quarters of growth above 3%. Obama’s economy averaged 1.5%.

Wealth is trickling up, and it’s being created by an army of Little Red Hens.

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