Formalising ‘Trickle Down’ Economics

Note I am not an advocate of trickle down, I just want to make the definition meaningful. I apologise for the slap dash structure.

Looking at the Wikipedia definition of trickle down economics one can get a broad sense of the kind of policies that it might imply. My contention is that the term is just a euphemism used by left-wing audiences, with little actual substance in its current popular usage. I propose an alternative interpretation here which is more in line with the original conception.

When people normally think of trickle down they think of things like tax cuts on the rich, financial deregulation and union busting. Tracing back to 1896 the term was popularised by a Presidential candidate as being “you just legislate to make the well-to-do prosperous, that their prosperity will leak through on those below.”

This is a purely rhetorical point, but it is possible to think about how this framework can work from a technical economic perspective. There are a few ways. From a supply-side point of view we might just think of deregulation. But this is not really ‘trickle down’. It already has a term- deregulation.

The notion of ‘trickle down’ that I would understand from the 1896 definition is one where we conceptualise that by funding the business and wealthy interests we can boost economic growth for all. Deregulation may or may not be in the interests of businesses, so it’s not a useful way of thinking of it.

So let’s think about this formally. Why would helping rich people boost economic growth? Milton Friedman in a famous video described the argument as being “When you give money to a rich entrepreneur, they’ll put it back into the business and create investment and jobs for all. By contrast if you give it to a poor person, they will tend to consume rather than invest”.
This idea can be made more rigorous as follows. Rich people and businesses have a lower marginal propensity to consume. Therefore they have a higher propensity to save. Under standard macro assumptions, these savings in turn go through the financial sector to create investment. Thus by allowing the rich to retain more income you can grow the economy faster for long term benefit to everyone, at the cost of short term consumption. The point is that you try and take from agents that spend, and give to agents that save to boost the pool of savings. In turn you boost the pool of investment.

The precise mechanisms which lead to this can be found in an intro macroeconomics textbook if the reader is interested.

I contend that this is the most meaningful way to approach the definition of trickle down. Don’t think of it as a bunch of policies with uncertain impacts on the rich. That is just pure political rhetoric with no meaning. Think of it as a framework to grow the economy by affording businesses and the rich more opportunities.
Now that we are thinking of trickle down in a more formal and precise framework, what are some examples.

Let’s look at Reaganism. Is that trickle down? I contend that it is NOT. Reagan’s economic reforms involved large scale financial deregulation. One impact of this was to allow the US economy to borrow more from international capital markets. This in turn via some technical trade theory forced a current account deficit on the US economy. This borrowing surge overall probably lowered the total pool of investment in the US and dramatically lowered savings rates. (Interest rates would have stayed roughly the same though.). Hence yes while in some ways the rich benefited from these policies, the impact on US business profits is uncertain. We can look at this some more, but I think I have illustrated my point.

Now let’s look at China and Germany. In a certain sense these two economies have similar structure, but China would be the one to focus on here. Both via a large swathe of economic policies give huge implicit subsidies to business. Things like energy subsidies, infrastructure spending and currency devaluation take money from consumers and give money to businesses. The result is a strong pool of savings that have created highly industrial economies. Consequently we get faster (though distorted) growth, and a widening of income inequality. Note that both these economies are very different from Reagan’s conceptualisation of the ideal US economy. They both have high regulation. But it is this regulation that captures the ‘trickle down’ effect at its most potent.

If we look at trickle down this way, then in a sense it definitely does lead to fast growth. Japan, China, Germany, the UK, Taiwan, South Korea all used a form of high regulation trickle down to reach record levels of growth, though with large negative consequences. This is not to say that ‘trickle down’ is good in any normative sense. I don’t really have a view on that, as the morality is extremely complex. But it certainly seems like it works from a ‘boosting growth’ perspective if we have a formal definition.

The point of this rant is to give a shitty rhetorical tactic some substance, and address a pet peeve of mine. Helping business interests actually does boost growth in developing nations, and the left cannot simply ignore this inconvenience.

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