Marketplace for Supply Side Economics No Longer Exists

You may remember that several issues ago (v18i29) I wrote about David Stockman, President Reagan’s budget director, who made the most honest comment about the Federal Budget anyone in Washington has ever uttered. When responding to a question from a Rolling Stone reporter, he said, “No one really knows what’s going on with all these numbers.”

In the same column, I also touched upon Supply Side economics, sometimes known as “trickle down” economics, and in this column I want to focus in on this economic theory.

Even though virtually every non-partisan economist in the world considers Supply Side economics to be a failed theory, it continues to be popularized and promoted, sometimes by direct reference and sometimes simply by iteration of the theory’s elements.

The website offers this concise definition of Supply Side economics: “An economic theory which holds that reducing the tax rates, especially for businesses and wealthy individuals, stimulates savings and investment for the benefit of everyone.” I would add to this that the theory believes that lost revenue from tax reductions will be offset and overcome through economic growth.

So let me give you a small example of supply side economics at work in the marketplace. My mother’s father (my grandfather), Robert C. Andersen, worked as a salesman for Fairbanks Morse and Company, and one day he had an idea. He presented his idea to the company and, suitably impressed, they sent him to the facility in Kansas City to work with an engineer. The end result of their work was the prototype for the gas powered, rotary lawn mower. Fairbanks Morse sold the patent and my grandfather was paid a $5,000 bonus for his work/idea.

My grandmother took this $5,000 and used it to purchase stock in AT&T. They put their resulting stock certificate in a safe deposit and re-invested their dividends while my grandfather continued to work. As time passed they bought stock in a few other companies and re-invested those dividends. So the number of shares they owned grew in these companies and the companies themselves grew. This is how Supply Side economics should work. And yet, not only has it not worked, it will never work because this type of marketplace no longer exists.

There are two main factors that changed the marketplace forever. The first reason is the rise of 401(k) plans. Named for a section of the Internal Revenue Code, the 401(k) plan was created in 1978 by a congressional provision intended to provide taxpayers a break on deferred income. But in 1980, benefits consultant Ted Benna, working on a client’s profit sharing plan, realized that the code could be used to create an easy, tax-friendly vehicle for employees to save for retirement. Best of all, the 401(k) was much more affordable for employers than traditional pension plans.

Before long, 401(k) plans were cropping up everywhere, across all industries. Today, it is estimated that 70 percent of all American companies with 100 or more employees offer 401(k) plans to their employees and, in 2008, investments in 401(k) plans were valued at over $3 trillion. Other investment funds came along, as well, and the result is that the vast majority of investors do not own shares of companies they own shares in some type of diversified funds.

The rise of 401(k) plan investing led to a huge boom in the financial industry. Job growth in this sector through the 1980s and ‘90s was staggering, and the amount of money invested in diversified funds grew just as rapidly. The result is that, today, there are over 100,000 401(k) plans in existence, each controlling an enormous amount of money and shares in publicly traded companies.

And each of these plans/funds is under the control of a small number of individuals, whose only responsibility – quite rightly – is to grow the value of the fund, thereby making money for those who are invested in the plans/funds.

And this leads to second factor that forever changed the marketplace: computerized trading. In the mid-1980s, when I was working with an advertising agency in Chicago, we had a client who had started a commodities trading service from his home. All he did was sit in front of his computer and track commodity trades and prices for clients. He was one of many who realized the potential for computers to track prices and execute trades quickly and efficiently.

Today, state-of-the-art computers and software are able to execute approximately 70,000 trades per second, and the people who control the vast resources of 401(k) plans and other investment funds are using these computers and software to trade shares of stock virtually instantly.

Stop to think about this for a moment, folks. If you controlled the resources of one of these investment funds and had the right algorithm in your software, you could theoretically execute trades that earned a penny per trade each second. If you did this your fund would grow by $700 each second, by $42,000 each minute, or $2,520,000 every hour. Of course, it’s not that simple, but this does give you an idea of what the computerization of the marketplace has made possible.

So where is the downside to this? One obvious downside is the extreme volatility this has led to in markets worldwide. Whether it is the stock markets or the commodities markets the huge swings between positive and negative results occur because of the ability to instantly buy and sell huge numbers of shares with a single keystroke on a keyboard.

On a smaller scale it has fundamentally changed the way in which corporations operate. Because investors – and I am referring here to the relatively small number of individuals who control the funds/plans we have been discussing – are continually focused on the bottom line (i.e. profit/loss), companies no longer allow themselves to weather natural business cycles. Board of directors for companies always want to show a profit (or at least minimize any losses) in order to retain the investment and/or attract new investment from these large plans/funds.

Take for example Oshkosh Corporation that recently announced they intend to layoff 450 workers (approximately 20 percent) of their workforce in mid-to-late January. Their reasoning for this pending reduction was the automatic Defense Department budget cut that will occur if Washington cannot agree to Federal Budget reductions by the end of the year. Whether or not this automatic reduction will occur remains to be seen, but Oshkosh Corporation wanted to make sure they were out in front of this potential problem by showing investors that they have a plan to remain profitable.

Does any of this sound like the small-scale Supply Side economics example I outlined earlier? The reality is that the marketplace that Supply Side economics will work in has vanished and the modus operandi of our current marketplace, which is driven almost exclusively by money being used to make money quickly and efficiently, has virtually no connection to growing business or stimulating economic growth.