Defining Ideas

"Middle-Out" Economics?

Monday, August 4, 2014

This past week I appeared on the PBS News Hour on a segment hosted by Paul Solman. The segment was titled, “Top-down or middle-out? Debating the key to economic growth.” The show focused on the work of Nick Hanauer, an American entrepreneur and venture capitalist with a net worth of $1 billion, who appeared opposite me on television. Hanauer gave a talk on TED that went viral, receiving over a million views on YouTube, in which he advanced a middle-out thesis for economic growth: “The fundamental law of capitalism is, if workers don’t have any money, businesses . . . don’t have any customers.”

I was asked to comment on his thesis. The exchange was hard to get off the ground. His remarks were made without reference to anything that I said. I directed sharp criticism to his populist creed and argued that the middle class creates wealth through its demand—not the capitalist through his innovation.

Top, Middle, or Bottom?

When you appear on television, it’s hard to control how the central issues are framed. In this instance, the title chosen by PBS bought into Hanauer’s conception of the world with its middle-out perspective. But the phrase “top-down” does not reflect my views, as the segment’s title suggests. I take the classical liberal position on wealth creation.

The first source of difficulty is that a top-down approach frequently implies that wealth is created through central planning. That is, the government coordinates all forms of social investment. Following Friedrich Hayek, I cannot think of a worse way to plan the operation of any economy. The classical liberal view on this subject is that of bottom up wealth creation, which operates as follows.

The initial assumption is that the state is not regarded as the creator of rights, but as their protector. Individual rights in labor and intelligence belong to an individual as a matter of birth, not via a grant from the state. Claims to particular property are initially created by occupying land, capturing animals, or grabbing things that are otherwise unowned. Once individuals own property, the key office of the legal system is two-fold: First, to stop aggression, and second, to allow for coordinated activities, which includes the use of public funds to create the needed infrastructure over which private transactions take place.

At this point, the relationships between consumption, production, and growth are not determined by some magical law that favors a top-down, middle-out, or bottom-up position. What happens is that individual decisions to collaborate on various ventures drive all aspects of the wealth cycle from innovation to implementation. There is no privileged position for either middle class consumption or capitalist innovation. Hanauer is, of course, correct to say that unless consumers have income they cannot buy the services, both new and old, that capitalists produce. But the relationships are reciprocal, so that entrepreneurs must be there to provide goods and services that consumers want, and to pay wages to workers which they then spend in their roles as consumers. All sides of the relationship constantly feed each other.

At this point, any claim of priority no longer makes any sense. Indeed a claim to focus on aggregate consumption for the middle class makes no sense either. Let each individual decide how much of his income or wealth to consume or invest. Let each person also decide whether to direct his or her investments into new or old technologies. Each person makes his or her choices with some knowledge of the plans of others. Their decentralized choices will yield a more informed set of outcomes on both production and consumption than either a state-imposed top-down or middle-out version of the world.

The Problem With Middle-Out Economics

The decision by Hanauer to stress his so-called middle-out position carries with it dangerous policy implications, which are evident in how he treats both labor and taxation policy.

One supposed implication of Hanauer’s consumer-driven account is that efforts to pump out aggregate demand depend on boosting up income for the middle class by devices targeted to that end. This policy goes back as far as the 1930s when one of the rationales for mandatory collective bargaining under the National Labor Relations Act stemmed from the supposed belief, as its statutory findings announced that “the inequality of bargaining power” between employers and employees “depresses the purchasing power of wage earners,” for which the higher wages wrought by concerted union action was the appropriate policy response.

Yet the NLRB miscarried for multiple reasons. First, its pro-union policies only address the union members, not overall consumer demand. If unions get more through industrial action, other workers could easily get less, so that no confident claim can be made about the aggregate effects of unionization. In addition, the shift in market arrangements increases bargaining costs and results in monopoly dislocations, including strikes, lockouts, and other interruptions in production, that offset any supposed gains from more aggregate consumption. Rather than rig markets, the better approach is to secure open competition in all markets, so that wages are bid up as productivity increases, wholly without government intervention.

Hanauer does not grasp these fundamentals. He repeats a common mistake when he writes: “But there is this upper limit on what we can spend. I drive a very nice car, but it’s only one car. I don’t own 1,000, even though I earn 1,000 times the median wage.” True enough. But the point only shows that he has a diminishing marginal utility for one form of consumption, which means that his consumption expenditures will switch to fine wines and private jets, while his unspent wealth is used to fund investments in new businesses or charitable operations. Think of it this way: people who earn huge amounts, but take very little out by way of consumption are doing a public service. Others gain from the increased supply of capital.

Unfortunately, Hanauer does not see matters this way, and thus makes counterproductive recommendations for both labor policy and taxation. On the former, he is an active backer of the $15 minimum wage law in Seattle on the ground that it will put money in workers’ pockets so that they can buy more goods. But that assumes that the jobs will remain after the wages are increased—that the wage increase won’t unleash collateral damage.

Indeed, his defense of major wealth transfers is condemned by his own example: “Wal-Mart earned $27 billion in profit last year. They could afford to pay their bottom million workers $10,000 more a year, raise all of those people out of poverty—save taxpayers billions of dollars, and still earn $17 billion in profit, right?” Not so fast. He speaks as if the huge transfer of wealth is fully captured by subtracting $10 billion from $27 billion. But huge hits generate counterstrategies as management has to find a way to stop the decline in share prices when net earnings drop by close to 40 percent. The cost of capital increases; capital to fund internal investments diminish. The firm looks at ways to cut workers to save labor costs, so that we see more outsourcing and greater automation. By the same token, it may have to raise prices to boost revenues, but only at the risk of lost business, given that its core customer base includes a large percentage of price-sensitive lower-middle class people.

My approach was the opposite. Repeal the minimum wage and let people work for $.02 per hour. Let, not make, of course. This claim does not rest on some ludicrous assumption that anyone can “survive” on that nominal wage. Indeed, one reason that Solman was incredulous at my suggestion lay in his failure to understand why it sometimes makes sense for workers to take a low or nominal wage, namely, in order to improve their ability to earn more money a year later. Gary Becker called this investing in human capital, and clearly any individual who takes this strategy should have some other source of short term income, whether from savings, a second job, family support, or in kind payments of room and board. The constant talk of the living wage should not blind us to the importance of life-cycle earnings, which could be undercut by a high minimum wage that keeps people out of the labor market

A similar criticism can be lodged against Hanauer’s proposal to tax the rich to fund the middle class. It won’t work. The tax increases under the Obama administration have not stopped the slide in median income in the United States, because they do nothing to ease the ever-rising burden of labor regulation, a topic that Hanauer never mentions. Today, the combination of taxation and regulation eliminates job opportunities, especially for workers at the bottom of the market.

The same logic applies to taxation targeted to the rich, which creates political uncertainty, drains investment income, and leads to wasteful albeit legal strategies of tax avoidance, including the now-popular tax inversions that drive companies overseas. Adam Smith was right to insist that low, flat taxes increase stability and spur growth.

The conventional wisdom holds that classical liberals like myself are ideologues untouched by human emotion and uneducated by practical experience. Many believe that to oppose the minimum wage is to tolerate pollution and abandon a public highway system. But that is a false caricature of laissez-faire, which has never once licensed nuisances against strangers or prevented the state construction and maintenance of infrastructure.

Laissez-faire economics is in retreat. Today, the progressive mindset drives much of public policy. So the populist skeptics of laissez-faire have to ask themselves a simple question: How can the decline in median income and the slow growth rate over the past six years be attributable to policies that have not been in place for a long time? The source of our current malaise is the populism of people like Hanauer who fail to understand the negative, but quite real, unintended consequences of their policy prescriptions.