Why capitalism has nothing to do with supply and demand

Editor’s Note: Nick Hanauer is a billionaire venture capitalist, who made his fortune first as one of the original investors in Amazon, and later in a web ad firm. He’s also been a strong supporter of the increased minimum wage in Seattle, which is where Making Sen$e met up with him this year reporting on his city’s fight to adopt a $15 an hour minimum wage.

But as Hanauer has argued in a popular 2012 TED Talk, and most recently in a Politico Magazine essay, addressing income inequality, through measures like a higher minimum wage, is not simply a moral issue; it’s an economic issue because prosperity originates from having a strong middle class.

His brand of “middle-out economics” is the subject of Paul Solman’s broadcast report on Monday’s NewsHour, which you can watch below.

In the transcript of Hanauer’s extended conversation with Paul below, the billionaire explains how we’ve misunderstood prosperity and capitalism and why the rich are reluctant to see that change.

— Simone Pathe, Making Sen$e Editor

So what is ‘middle-out’ economics?

So middle out economics is essentially a 21st century way of understanding how an economy works – not as this linear mechanistic system — but as an ecosystem, with the same kinds of feedback loops. The fundamental law of capitalism is if workers don’t have any money, businesses don’t have any customers; that prosperity in a capitalist economy is a consequence of a circle of feedback loops between customers and businesses, which means that a thriving middle class isn’t a consequence of prosperity. A thriving middle class is the source of prosperity in capitalist economies, which is why a policy focused on the middle class is and has always been the thing that drives prosperity and growth — not pouring money into rich people, which simply makes rich people richer.

And so middle-out economics is the idea that if you make a policy focused on the middle class and generate demand from the middle class, you’ll both create more entrepreneurs to drive innovation, and essentially, a sale cycle and a hiring cycle for business that generates a virtuous cycle of increasing returns that benefits everybody.

But trickledown economics is true, to some extent, right? I mean, rich people get money and then they’ve got to either spend it or, ultimately like Warren Buffett or Bill Gates here in Seattle, give it away.

Yeah. So it is true that rich people can spend more money than middle class people, but there’s this upper limit on what we can spend. I drive a very nice car, but it’s only one car. I don’t own a thousand, even though I earn a thousand times the median wage. I have a few jackets, not a few thousand. My family can afford to go out to eat more than most American families, but not more than three times a day. We can’t go out 3,000 times a day.

So if you concentrate wealth in the hands of a very few people, you break down this feedback loop between customers and businesses. My family, among other businesses, owns a pillow company, and the pillow business is tough because fewer and fewer people can afford to buy pillows. Again, I may earn a thousand times the median wage, but I don’t sleep on a thousand pillows.

You need everyone to be able to afford a pillow every year in order to have a successful pillow business, and concentrating wealth at the top essentially creates a death spiral of falling demand.

The thing about a real economy is that it actually is like the game of Monopoly in the sense that when one person has all the money, the game is over. And in a game of Monopoly, of course, that’s quite charming, but in a real economy it’s much more problematic.

What Separates Wealthy Societies from Poor Ones?

But why can’t it be that the top 1 percent, 10 percent, 20 percent, who’ve done well in the last 20, 30 years simply trade with one another?

Well, of course you could have an economy like that, and indeed around the world, there are many examples of economies like that. There are many countries in Africa and South America where essentially that’s what you have, but they’re horrible places to live and dangerous places to live.

If you want to have a sustainable democracy which is prosperous, secure and enjoyable to live in, impoverishing the many to benefit the few is hardly the path to go on. If history is any lesson, at the end of the day, an economy that doesn’t work for everyone eventually will work for no-one.

But is that necessarily true? Think of the Roman Empire — “bread and circuses.” The emperors would give bread to the people, entertain them, and they kept that game going for a very long time.

So I allow for the possibility that the other 99 percent of American people would prefer to live in a society where 1 percent of us do very well and most people don’t, but my instinct is that that’s not really what they prefer, and I can tell you for a fact, an economic fact, that if you want prosperity and growth, the more people you include, the more prosperity and growth you have.

It’s not by accident, for instance, that the south, which employed a slave economy, was then and continues to be much poorer than the north, which included as many people as possible, and that’s because an economy that’s inclusive is dynamic and fast growing, and an economy that is exclusive is always destined for poverty.

And in fact, in 1776, Adam Smith wrote that the more people who participate in an economy worldwide, the more people will specialize, the more people will come up with new technology, better ways of doing things and we’ll all be better off.

And indeed that’s the case. Most people believe, mistakenly, that wealth in a human society has something to do with money, but that’s not true. Money is simply a medium of exchange. Prosperity in a human society is the accumulation of solutions to human problems that we create for ourselves.

The difference between a poor society and a wealthy one is largely the difference in the number of solutions to human problems we have available to us. And it is simply a fact that the more people you have trying to solve human problems, the more problems you are likely to solve. That’s why an inclusive economy is always more prosperous than an exclusive economy.

Capitalism really has nothing to do with supply and demand. That’s just a mistaken idea. Capitalism works by being essentially an evolutionary solution-finding algorithm. The genius of capitalism is that it both permits and rewards people for solving other people’s problems.

But the problem is we have structured our economy in this sort of death spirally way, where huge profitable organizations like Wal-Mart pay poverty wages to a million workers, and then taxpayers make up the difference in social services programs like food stamps and Medicaid and rent assistance, and so on and so forth. It’s as morally repugnant as it is economically inefficient.

It’s a fact that 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 tax payers billions of dollars, and still earn $17 billion in profit, right.

It’s simply nuts that we have allowed this to happen. And the only way you can change things is to raise the minimum wage. Certainly the people that run Wal-Mart will not do this on their own.

The idea that businesses will go out of business if they pay workers more is just not true, even though I understand the sort of visceral fear that some of them feel about this change.

But you’re talking as if it’s self-evident that this is a stupid system. But these rich people, these are not stupid people, they are your friends. Why don’t they see it the same way you do?

That’s a terrific question. Some of them do, to be clear. And my sense is that more and more wealthy people are beginning to see the economy in this different way, and they recognize that we have taken a bunch of these terrible ideas way too far, and that eventually it’s going to be bad for everybody. Of course, in a group of 100 people, there will be some people who do not care about other people, and simply are aimed at maximizing their near-term self-interest at the expense of others.

But the truth is, and I think this is a very important point, you can’t change a society with the kindness of strangers. It takes more than a few do-gooders to create a society that systemically benefits everybody.

Highway signs, speed limit signs are not suggestions – they are rules. If they were suggestions, it would be much more dangerous to drive, and we need to have essentially the same kind of thing in our labor markets to make sure that the most sociopathic employers are not allowed to lead a race to the bottom, that we push up the bottom in a way that benefits everybody.

Why Rich People Balk at Changing the System

But if it’s so clear to you that this is dysfunctional, and will hurt everybody in the end, why don’t more rich smart people agree with you?

The facts are that this change threatens both the pocket books, but more particularly, the status of rich people. One of the most interesting things I’ve learned about litigating these issues is how emotional people can get around seeing themselves, for instance, as job creators.

If you are a job creator, you’re very much at the center of the economic universe and everything orbits around you. And if you’re a job creator, a 15 percent tax rate on capital gains, a 15 percent tax rate on carried interest – all these things are the righteous instantiations of sensible economics. But if the middle class is the true job creator in the capitalist economy, all of those advantages and all of that status are essentially a con job.

And a 15 percent tax on carried interest is a tax break for money managers on money that’s supposedly at risk.

Right, yes. This is just one of the somewhat obscure elements of our tax code that massively advantages people like me. Working people pay 39 percent, investors pay 15 percent. And that differential is essentially explained away and justified by this idea that the more money people like me have, the better off you will be.

Of course, if it’s the other way round, that tax break makes no sense whatsoever. But these arguments don’t just threaten pocket books – they threaten status. And you have to remember people like me care a lot about status. That’s why we are where we are. And so when you mess with status, when you mess with the status of people who care about almost nothing but status…

Because you have enough money already…

Right, well, what’s money, other than status? And so it’s not by accident that the people with the most money and power want status and power more than other people, and so when you mess with that, people get very angry and emotional.

You’ve used the term “sociopath” talking about, essentially, people you know or who are in your economic class. What do you mean? You don’t really mean “sociopath,” do you?

No, well, a sociopath is a person who doesn’t care about other people. In any normal distribution of people, there will be people who don’t care about other people. And those people will often adopt a politics that justifies that behavior.

But this idea that the more greedy we are as individuals, the better off the society is, in general, is a lie.

If you live in a society where most people are cooperating and taking care of one another, but you don’t and no one punishes you for that, that is very advantageous, and indeed there are people in our society that do take advantage of that.

I don’t mean to say or imply that I am somehow morally superior and that if everybody was like me we’d be better off. I reject that idea. People like me need to be forced to do the right thing.

When you talk about a non-virtuous circle, you’re talking about people who do disproportionately well economically as a result of economic growth, and therefore start feeling that there’s a justification to what they do, and it’s self-reinforcing, and they become more sociopathic, or less cooperative?

There’s a lot of research emerging that shows people who are wealthier have less empathy, and that’s not surprising, when you don’t experience what other people experience, the difficulties in other people’s lives. It gets harder and harder to relate to them.

The thing I’ve learned most about poverty is how expensive it is to be poor. It’s super easy to pay rent every month if you earn enough to pay rent and have a decent job. It’s super hard to pay rent if you need a coupon from the state and then need to go find an apartment that will accept that coupon, and only that coupon. There’s a much smaller group of apartments available, and it’s just hard to do, and if you don’t have a good car to get you to and from work, then you inevitably won’t get to work, which means you’ll get fired, and then you need another job, but you won’t be able to get the new job because you got fired from the last job, and so on and so forth.

This is a terrible, terrible problem in our society, where people like me live increasingly isolated lives; we fly in our own airplanes; we go to our own schools; we live in neighborhoods that are gated and guarded; we have our own police forces. And we live lives which are detached from the lived experience of ordinary people and we forget what the challenges are.