Introduction

In my last post, I discussed the unfortunate state of affairs in the United States today. From a pre-industrial agrarian economy controlled by wealthy landowners, to an era of industrialization marked by the creation of a middle class and a period of prosperity, and ultimately a post-industrial phase where the middle is systematically being hollowed out and the extremes once again dominate the landscape, the United States finds itself at a crossroads. The country can ignore the state of affairs or rationalize it as a byproduct of modernization, continue along its current path, where increasing income stratification creates an oligarchy controlled by wealthy elites from a few key sectors – financial services and petrochemicals, to name a few. Or, it can collectively come to terms with the fact that the country has fundamentally changed over the last four decades in ways that demand significant political and culture reform.

Identifying the problems is not sufficient. With that in mind, I want to propose solutions that address what I consider to be the root causes. The criteria is that they be practical, yet attainable. They are ambitious reforms that include a mix of proposals embraced by Democrats, Republicans, or both (or neither). While they are achievable legislatively, I am ignoring the political horsetrading and gamesmanship that would be required to have them pass.

What’s Next

The thirty years leading up to 2008 are generally considered to be a period of prosperity in the U.S. A few cyclical recessions aside, the 80’s, 90’s, and 00’s were marked by solid GDP growth and a strong increase in the overall wealth of the country. Yet, with the outsourcing of labor-intensive jobs (and the weakening of labor unions in the manufacturing sectors that remained) and the overall movement toward a service-based economy, dominated by a fast-growing financial sector, income gains largely went to the top 10% of earners, with a disproportionate share going to the top 1%. Simultaneously, short-sighted economic policies designed to control government spending steadily dismantled much of the social welfare system – a trend that continues today at an accelerating pace, with family planning and food stamps as the most recent victims of the guillotine.

Some of this was inevitable. The depletion of the middle class is a byproduct of globalization. On a global scale, it is actually a good thing, as developing countries reap the benefits of burgeoning manufacturing sectors. The result will be the greatest migration out of poverty the world has ever seen. But there is no denying that the U.S. itself will be worse off. More specifically, the low-wage workers, the urban minorities, the recent immigrants, the rural whites, the high school-educated, and all of the other would-be chasers of the elusive American dream will find fewer opportunities in this new world, and their struggles will only get worse.

So the question remains: what can we do about it? If we are undergoing a systemic change at a global level, is the situation hopeless? The answer to the second question is no. The answer to the first question is the subject of this post.

Why Tax Reform Makes Sense

On the most basic level, an economy – whether a nation or a household – is a self-contained entity in which goods and services are exchanged. In a modern economy, the medium of exchange is money – a fiat currency issued by a central bank that regulates its volume and the cost of borrowing it. When economies trade with one another, money either comes in or goes out. Rather than trying to do everything, economies specialize in whatever they are best at doing, relative to their peers. On the most basic level, you pay a plumber to fix your pipes or a carpenter to build your cabinets because it doesn’t make sense for you to do those things yourself. Instead, you earn money by specializing in what you do, and use the money generated from your expertise to pay others who specialize in something else. On a much higher level, nations specialize in broad industries. Manufacturing in Germany, financial services in Switzerland, carmaking in Japan, and electronics in South Korea are all examples of what is known as competitive advantage – where countries excel in particular sectors and trade with one another.

Within larger economies, there are smaller economies – the household, the community, the city, the state, etc. – that also trade with one another. The doctor provides care for patients and decides to re-do his kitchen. He hires a general contractor, who subcontracts to an electrician, a painter, a plumber, and a carpenter, all of whom purchase materials at Home Depot, which employes hourly workers and buys products wholesale from equipment manufacturers, which hire truck drivers and warehouse workers to move pallets. All of these people buy food from the grocery store and clothing from retailers. They buy cars and houses and school supplies. And all of those products – known as “durable goods” – that used to be manufactured here in the U.S., are now made overseas. And the people who used to make them have find new jobs, which are now in shorter supply.

So why does any of this matter? Because money moves around an economy is when people spend it. After the financial crisis, the Bush administration send every American a check for $600 so that they would get out and spend it. The much-maligned stimulus package and the tactic called “quantitative easing” – otherwise known as printing money – are both massive efforts to get people to spend money. There is a term in economics called velocity, which is the number of times a dollar changes hands during a year. The velocity of money describes the speed with which people are spending money, and, in general, faster is better.

Chart showing the log of US M2 money velocity (green), calculated by dividing nominal GDP by M2 stock, M1 plus time deposits 1959–2010. Employment-to-population ratio is displayed in blue, and periods of recession are represented with gray bars).

So when the economy is moribund and fewer people are reaping the benefits of broader economic prosperity, the solution is to spend money. And the people who spend the most money, as a percentage of their income, are the ones who have very little. As I mentioned in my last post, the bottom 20% of earners spend more than 60% of their income on clothing and housing. After food, schooling, car payments, and other incidental expenses, they have very little left to save, much less invest in the future. To make ends meet, these individuals take on debt, which traps them in an escalating spiral of interest payments that culminate in eviction and bankruptcy. Not many people are aware of debt agreement plans, the awareness of which might have solved the issues with bankruptcy.

In short, the best way to increase the velocity of money in an economy is to put it in the hands of people who have very little, because they will spend every last penny. And the people they buy goods and services from will, in turn, spend that money at the same pace. In contrast, the best way to slow the velocity of money is to give it to people with nothing to spend it on.

It is this insight that leads liberal economists to the conclusion that taxing the rich is the solution to the problem. I don’t fully agree with this point. There is a legitimate case to be made that excessive taxes on the rich create a perverse incentive toward investment. I am not advocating raising taxes on ordinary income for the top quintile of earners. But there is another road.

In my next post, I will explain what that I believe that road looks like, from a financial and economic policy perspective.

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