During the last economic boom, families on median income found that their discretionary disposable income hardly went up at all. Sure, the UK boomed. The UK enjoyed its longest ever run of uninterrupted economic growth, but the wealth created did not trickle down, at least not in any significant way.

Does it matter? If you have a social conscience, it may seem to matter. But how does this lack of trickle down affect the economy? Well, actually, we would argue this was disastrous for the economy. Maybe the single biggest cause of the 2008 financial crisis was the way the gap between the super rich and the rest grew. So it has got nothing to do with what is right or wrong. Rather, if you look at this from the point of view of wanting an efficient and growing economy, then the rich should pay more tax; tax on dividends should go up; inheritance tax should rise; we should see a property tax; and actually, corporate tax should go up, too.

Demand matters

Economic theory says that GDP is made up of consumption, investment, exports and government spending.

That might be true for an individual economy, and it might be true at a single point in time. But for the global economy, and over an extended timeframe, that is not true. For one thing, across the global economy, exports and imports cancel each other out. But, for another thing, in the long term, demand drives investment. Take as an example Moore’s Law. Computers double in speed every 18 months. This has happened because as computers fall in price, and their applications grow, demand goes up, and this in turn justifies higher investment and allows new economies of scale, so that computer chips either fall in price or become more powerful.

So, actually, for the global economy, demand really is vital.

Keynes once came up with the idea of the paradox of thrift. In an economic depression, such as the 1930s, argued Keynes, consumers tend to save more, because they are worried about the future. But as the rate of saving rises, aggregate demand across the economy falls, and the depression gets even worse. Keynes advocated channelling wealth into the poorer households, because poorer families tend to save less. So, Keynes argued that in times of a depression, money should be taken from the rich and given to the poor. He said this not because he was a socialist, in fact he was no such thing, but because, under certain circumstances, he saw this as the best thing for the economy.

Paradox of toil and paradox of flexibility

Post-credit crunch and two new theories have emerged, building on the Keynes idea of the paradox of thrift.

The paradox of toil was suggested by Gauti Eggertsson, an economist who works at the Fed in New York. He argued that under certain circumstances, if workers start to work harder, then the result can be a rise in unemployment and falls in wages. The theory is based on certain conditions: that the economy is suffering from deflation, there’s declining output, and interest rates are zero.
See: The Economist, Double, double, toil and trouble

Of course, such circumstances would be especially worrisome if consumers, or indeed the government, are highly indebted, because falling wages would be rather bad news for individuals in debt.

You don’t need to be a genius to see the parallels between the conditions that apply to this theory, and conditions today.

Another theory is the paradox of flexibility. This one, from Lynne Gouliquer, a sociologist, draws similar conclusions, but from a scenario in which labour market flexibility leads to falling wages. See: Pandora’s Box: The Paradox of Flexibility in Today’s Workplace

The point about these theories is that they hinge on the idea that demand drives corporate profits, and demand is determined by wages. So if the cost of labour falls, companies may make more money in the short run, but in the long run aggregate demand falls, and profits then decline.

The globalisation of labour

But then there’s globalisation. This column is pro-globalisation, but just because you are in favour of something, it doesn’t mean you can’t recognise its disadvantages.

This is what Ernst & Young had to say on the matter earlier this year: “The household sector’s share of national income is counter-cyclical and last year this shot up from 70.3 to 73 per cent. However, comparing this with the two previous low cycle values of 77 per cent in 1991 and 76 per cent in 2001 reveals a clear deterioration. Similar downward trends in the labour force’s share of national income are evident in all western countries. This seems to reflect what IMF economists have dubbed the ‘globalisation of labour’. Immigration, import competition and off-shoring affect the provision of services as well as goods and the demand for skilled as well as unskilled labour, and these effects have clearly been at work in the UK. These adverse trends help to explain why the recent ‘consumer boom’ was so modest compared to the Lawson boom and other historical episodes – and why households had to borrow so much to sustain this.” See: Did globalisation cause the economic crisis?

The paradox of innovation

Here is a theory, made up here. Maybe, paradoxically, innovation can also create problems for the economy. Innovation can lead to a fall in prices, and innovation may lead to a requirement for less labour, driving down wages. Innovation can lead to higher profits, without necessarily leading to higher wages. Meaning, innovation can create a scenario in which demand lags behind capacity.

Or to put it another way, under certain circumstances the Luddites were right.

This does not mean innovation is bad, of course not. But it must be recognised that sometimes even good things can carry a sting in their tail.

This column has argued before that a possible underlying cause of the Great Depression was that all the innovation that had occurred during the previous fifty years (a period, by the way, that may have seen more innovation than in any other period in history), may have created an environment in which potential capacity was greater than aggregate demand. Then the economic boom of the 25-year period after the Second World occurred, as we finally found a way of turning that innovation into wealth and distributing the proceeds efficiently .

Economists under-estimate the importance of the Internet. Why the Internet is so important has also been covered here before. See: What is the Internet really worth to UK economy?

On more than on occasion it has been said here that for feeding innovation, there have been four great advances: the evolution of language, the development of writing, the invention of the printing press, and now the emergence of the Internet. Interestingly, Chris Anderson, author of ‘Free’ and ‘The Long Tail’, and former editor of Wired, has said something similar. He has coined the phrase ‘Crowd-accelerated innovation’, and has argued that the development of online video has done for face-to-face communication what Guttenberg’s printing press did for the written word. See this excellent video: Chris Anderson: How web video powers global innovation

Steven Johnson, author of ‘Emergence’, one of the most interesting books published in the last few years, has penned a new book entitled ‘Where Do Good Ideas Come From?’ His hypothesis overlaps with Anderson’s idea in that, actually, the great breakthroughs don’t come when inventors sit on their own, beavering away at an idea, but, rather, they come via communicating with others. And since there has been no greater medium in history than the Internet for enabling communication with others, you can see why an awful lot of good ideas are likely to emerge over the next few years.

But, with innovation comes greater capacity, and unless demand grows in tandem with greater capacity, the result could be mass unemployment.

When doctors become too expensive

When equal pay for women was advanced, education may have deteriorated. The argument here is not, repeat not, saying women should not have equal pay. Rather, that there can always be unpleasant side effects of good developments. Before equal pay, one of the best careers a women could pursue was teaching, and so the teaching profession attracted the crème de la crème of women graduates. Today, instead, the women who may have become teachers head for that place where the roads are seemingly paved with gold, the City.

When you have a sector of the UK economy in which financial rewards are simply huge, it becomes harder, or perhaps more expensive, to attract top people to other professions. And so, doctors and dentists become more expensive. And since the rich and poor alike need doctors and dentists, and since these health professionals are increasingly demanding salaries that are competitive with City salaries, it means that unless the super rich pay more tax, quite a bit more, it will be simply impossible to fund decent provision of medical support for the majority of people.

Increase inheritance tax

If you believe in capitalism, and believe pay should reflect ability and effort, then you should believe in 100 per cent inheritance tax. This point was covered here almost three years ago: see: Inheritance tax – there’s votes in changing it, but is there prosperity?

The paradox of success

It seems there are times when we can become victims of our own success.

This column is in favour of encouraging innovation, so how can the problems above be fixed?

It is tempting to suggest charging more tax on the income enjoyed by the super rich, and less on the rest of the income scale. Although, unfortunately, it seems that higher income tax is not likely to achieve much. Even if the super rich paid 90 per cent income tax, the money raised would not be significant enough to make a huge difference.

Besides, such a tax would be counter-productive, and a 50 per cent income tax rate for the super rich is probably about as high as is desirable.

The income distribution problem could possibly be solved by encouraging more people to take part in the innovation process, perhaps by encouraging more entrepreneurs.

But maybe a tax on property, especially at the point of inheritance, may be the key. And if you believe that booms in property prices lie behind most economic bubbles, such a move would have the added bonus of restricting future bubbles. See: Property tax: dynamite fuse is lit by Bank of England man

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