Common Sense Economics

By Klaus Klix, 10/2/04

Derailleur Economics - What is that?

Any modern free market economy consists of two basic and fundamental
components, a revenue generating component and a revenue consuming
component. In virtually all such economies the revenue generating component
consists of private sector business and the revenue consuming sector consists
governmental entities. Since government creates many laws and regulations
which influence how the private sector can operate it is also the controlling body
as its actions or inactions influence private sector activity. Another way to define
the revenue generating component is that it consists of all individuals that don’t
receive a paycheck from a governmental agency, and the revenue consuming
component consists of all individuals that do get their paychecks from a
governmental agency.

At this point in the discussion it is imperative to note that both of these essential
components of the economy, combined, are made up of a finite number of
individuals which remains for all practical purposes relatively constant. In other
words each component makes up a certain percentage of the whole but the two
combined will always be 100%. So if one is 20% the other is 80% of if one is
60% the other is 40%. This brings us to what I call the 1st and 2nd laws of
Derailleur Economics.

1st law Derailleur Economics:

For all practical purposes government employees don’t pay taxes

By this I mean that government employees don’t contribute to the revenue

stream from which government operates. Although government employees
have taxes withheld from their paychecks, that tax money is just a pass through
which was really generated and paid by the taxpayers within the private
(revenue generating) sector. Consider for a moment this very simple example:
Suppose I pay as my tax obligation to the government $100.00. The
government takes my $100.00 and pays their employee $10.00. The
government employee has a tax obligation of $2.00 which he pays back to the
government. The government at the end of the day ends up with $92.00 and
the employee ends up with $8.00 in his pocket. The total is still $100.00, 100%
of which came out of my pocket. In essence what I am saying here is that the
private sector is not only paying their own taxes but also the taxes of all
government employees. The same net effect would occur if government
employees paid no taxes at all and their paychecks were just reduced by the

1
amount of taxes withheld from their checks. Either way the government and the
government employee get the same amount of money. The difference is that by
passing it through the employee’s paycheck, it makes the government look less
greedy and makes government employees feel like they are contributing in
taxes.

2nd law of Derailleur Economics:

For any economy at any given point in time there is an optimum ratio
for the size of the revenue consuming component to the size of the
revenue generating component

Since an economy is dynamic in nature due to the many variables that affect it, it
must be able to readily compensate for these changing conditions by maintaining
an appropriate ratio between revenue generating and revenue consuming
components in order that that optimum ratio is closely maintained. The
problem we encounter is that, given current economic philosophies and
governmental policies, there is currently no mechanism by which we can
maintain this optimum ratio. Since government structure is relatively inflexible
the burden falls squarely upon the private sector to compensate in any way it
can to keep the economy from stalling out.

It is clear that a mechanism must be provided by which both sides may

compensate for ever changing market forces and conditions. Consider for a
moment the analogy of our economy to a person riding a mountain bike on an
unknown trail. (Hence the term Derailleur Economics) This rider guides the bike
along a path he can not see and has only some visual clues which might hint at
the potential terrain he may encounter. He knows that his ability to traverse the
terrain before him successfully depends entirely on his ability to adjust and
compensate his gear ratios and riding style to the type of terrain he encounters.
As he encounters a hill he has to push harder on the pedals and as the hill gets
steeper the force required gets harder and harder until he either gears down or
stalls out. If he gears down he can continue to climb and if it gets steeper he
gears down even more. As he crests the hill and starts down he can either coast
or gear up and if he gets going too fast he might even have to apply some
brakes. Imagine for a moment that the bike and rider represent our economy
and the terrain represents the forces which influence our economy and that it
can vary greatly in its ups and downs, smoothness, and roughness. Further
imagine that the front sprockets of our bike (the drivers) represents government
and government programs and the rear sprockets of our bike (the driven)
represents the private sector and business. The chain connects the two and
represents the tax revenue stream. It is easy now to visualize that the man on
the mountain bike, as he encounters a hill, finds it advantageous to gear down,
reduce the size of the front sprocket and increase the size of the rear sprocket,
in order to maintain optimum forward momentum without producing undue
strain on himself or his bicycle components. As the terrain flattens out or

2
becomes smoother it is possible to upsize the front sprocket and downsize the
rear to gain speed without creating additional strain. This is in fact the way a
good economy should work. (Derailleur Economics) When times are good and
the way is smooth, government can be allowed to gradually “gear up” gradual
increased spending and taxation to a point where the optimum ratio isn’t
exceeded. In times of economic difficulty, government must “gear down” by
quickly reducing spending and taxation in order to keep from overburdening the
revenue generating sector. The tension on the chain is analogous to the burden
placed on business (revenue generators). During an up hill climb, if you don’t
gear down the front sprocket, gear up the rear sprocket, or both, then one of
three things is likely to happen. The rider could stall out, the rider would
become unduly strained and weary, or the chain could be overstressed to the
point that it breaks. The same thing can happen with our economy. During
difficult economic times when we are on a long or steep uphill, if we can’t gear
down government and gear up business then one of three things is also likely to
happen. (1) The economy could completely stall out as business is over
burdened (read taxed). (2) The economy would become sluggish due to ever
increasing pressure and strain put on businesses to the point where they could
not sustain indefinitely or recover quickly, or (3) Businesses and taxpayers would
be so severely strained that they would go bankrupt and drop out of the revenue
generating side thus breaking the chain completely.

The Derailleur Model makes it easy to see why during tough economic times it is
imperative to scale back government spending and increase incentives to
stimulate the private revenue generating sector in order to keep the economy
moving forward and to reduce the stress and burden imposed on businesses.
What this effectively does is spread out the load over more individuals
(increasing the teeth on the drive sprocket) so no one is asked to bear more
than they should reasonably have to bear. It is not the time to increase this
burden (asking fewer to carry a larger load) just as you would not gear up your
mountain bike while climbing a hill. It is also easy to see that if you increase the
revenue generating side you can maintain tax revenue or even have a net gain in
tax revenue while at the same time relieving the burden on each individual
taxpayer. The key here is that the tax generating side has to grow in
relationship to the tax consuming side and since the two together have a finite
quantity of individuals that make them up, as one increases the other must
necessarily decrease. Conversely when times are relatively smooth and stable, it
is the time to gear up gradually knowing that eventually another hill will be
encountered and the appropriate adjustment must again be made. It is
important to note that we must be able to shift down relatively quickly to keep
from stalling but can shift up more leisurely as the terrain flattens and as the
danger of stalling diminishes. In other words, we must be prepared to shift
down quickly as hills are encountered but can take our time shifting up as we
crest the high points.

The important thing to remember in all of this is that, just as in the mountain
bike analogy where there are a finite number of teeth on the combined

3
sprockets, there are also a finite number of individuals which make up any
economy. When one side, for instance government, (revenue consuming side)
increases in size it also removes someone from the other (revenue generating)
side and vise versa. On the mountain bike where the combined number of teeth
of front and rear sprockets is always nearly the same, the ratio between the two
have a dramatic affect on the ability of the rider to traverse varying terrain.
The problem I see in our current political economic condition is that the front
sprocket (government) keeps growing (more and more programs) while the rear
sprocket is decreasing or remaining nearly the same. This condition inherently
puts undue strain on business and taxpayers on the tax generating side and
makes it difficult if not impossible to sustain a long uphill grind without suffering
dangerous negative consequences. We must remember that for each person
hired by government, one person is also lost in the private sector. There seems
to be no mechanism for readily reducing government when it is required. There
are few instances where government voluntarily reduces its programs, spending,
or expansionist tendencies. The challenge therefore becomes to find and
implement such a mechanism and to educate the public, politicians and
educators so they can see these relationships and the implications various
policies have on the overall economy. I believe it would be relatively easy to
come up with an optimum ratio, private sector vs. government sector, size
relationship curve. The mechanism for flexibility would simply be to keep
government relatively small and then regulate spending through the contracting
out of services, to the private sector, as much as possible. In this way the tax
money would go more directly for essential services (including social services)
and less would be spent on the maintenance of inefficient bureaucracies. It
would also be quite easy to develop a mechanism which would monitor the size
of each component and give an alert when the ratio gets out of kilter. In any
case it is vital that government be able to regulate spending more efficiently and
to provide real business incentives in times when the economy is suffering.

There is only one instance where a short term divergence from these principals
may be taken and that would be in times of national emergencies and for
defense purposes. Even in this case all efforts should be made to funnel funds
away from non-essential programs and toward the prime obligation of
government which is of course our national defense. This would fulfill the
government’s prime obligation and not increase the burden on the tax
generating sector unduly. It is in fact a time when even more emphasis should
be placed on privatization and growing the revenue generating sector.

Social Obligations:

Over the years government has usurped the ability of individuals to give from
their hearts. This has been done in large part for political reasons. A party that
has many and large social programs is viewed as being caring and concerned.
In reality the tax revenue collected to administer social programs is in large part

4
consumed in the bureaucracy itself and only a small, and many times,
insignificant portion of the collected revenue ever really reaches those it purports
to want to assist. The tax money collected, if left in the hands of the individuals
who earned it, could and would in all likelihood be given more freely to efficient
real charities where the money goes directly to those it is intended to help.
Individuals could choose their own charities and participate in them and get the
great satisfaction of really doing something meaningful and worthwhile to help
their fellow man. When government takes citizen’s hard earned money and
accepts all the credit for the so called social programs, it is robbing individuals of
a charitable heart and it is robbing the less fortunate who never receive the real
help they desperately need. Many of these social programs exist only to garner
political power. The increased tax collected under the guise of helping the poor
out of their poverty and affliction only serves to drive more into that same state.
I believe a real litmus test for the health of an economy is the individual
charitability of the people within an economy. As tax burdens increase the
charitability of people diminishes. And conversely, as government becomes less
imposing, people become more charitable. As people become more charitable
they also tend to be more optimistic, feel better about themselves, and are
willing to take more risks in investing and in creating new businesses and job
opportunities. At the same time, their charitability promotes unity instead of
division among people. As people become more charitable they also become
more personally responsible and involved which leads to even greater giving and
social rewards, a thing no government can accomplish through taxation.

Over the years we have lost sight of the true purpose of the function of
government and many policies and regulations are now simply political levers to
leverage votes, money, and power with no real concern for the long term
implications on the viability and strength of our economy or nation.

The term “Sustainable Economy” is an ambiguous and meaningless term. The

application of the principles of Derailleur Economics can bring us back onto the
path leading to a sustained healthy and thriving economy which would serve as
the vehicle of opportunity in order to allow people to elevate themselves out of
poverty and to pursue their own dreams and ambitions.

Klaus Klix

President, Ferrotek Corporation

(one strained tooth on the rear sprocket)