Wednesday, December 16, 2009

A 'Paradox of Toil'?

Copyright, The New York Times Company

Some economists have been recently discussing a “paradox of toil,” meaning that an increased willingness to work actually depresses the economy. But evidence from this recession clearly shows that the paradox of toil is of little practical importance.

Paul Krugman explained Monday on his blog:

when you’re in a liquidity trap … If you cut taxes on labor income, this expands labor supply — which puts downward pressure on wages and leads to expectations of deflation, which increases the real interest rate, which leads to lower output and employment. [emphasis added]

This paradox of toil is of interest because it turns standard economics on its head, and helps rationalize the view that active fiscal policy can boost the economy even while it reduces incentives to work. Professor Krugman and other fiscal stimulus advocates tell us that the paradox of toil describes our economy during this recession.

Fortunately, the relevance of the paradox does not have to be taken on faith, but can be examined with data from 2008 and 2009.

For example, if the paradox described this recession, then the expansion of labor supply that occurs at the beginning of every summer as students become available to work would lead to lower employment. Or on the other hand, an increase in the minimum wage would increase employment as it raises prices and costs and leads to inflation.

In fact, the 2009 labor market reacted to these events in the conventional way, with no paradox.

When school let out for the summer of 2009, teenage employment increased by over a million, and total employment increased by about 700,000 (these May-July comparisons are necessarily seasonally unadjusted, because the school year is part of the seasonal cycle). The expansion in labor supply did not reduce total employment, as Professor Krugman would have us believe would have happened in a “paradoxical” year like 2009. Total employment expanded seasonally as it did in previous years.

The federal minimum hourly wage was increased from $6.55 to $7.25 at the end of July 2009. It did not have the stimulating effect that Professor Krugman assumes.

Teenage employment fell 1.5 million after that increase, as compared to the 1 million that teenage employment typically falls at the end of summers that do not have minimum-wage increases. Total employment also fell more than the usual seasonal patterns would suggest.

The evidence shows that the laws of economics remain in full force, despite the present “liquidity trap.”


Chris said...

Exactly how does reducing taxes on labor affect it's supply?

Doesn't reducing cost increase demand putting upward pressure on wages?

Unknown said...

When you decrease income taxes, the cost of an additional unit of work (say work-hour, for example) in terms of leisure increases. Because an additional hour of work yields more money, presumably that would give workers a greater preference for additional work over additional leisure. Therefore, the labor supply would increase.

Of course, none of this changes the fact that the Krugman/Eggertsson analysis hinges on convoluted logic. It is highly unlikely that these effects could be demonstrated in any time-frame that could be considered the "short-run". You'd think that such esteemed economists would understand the concept of "impact lag". These proposed causal relationships are not strong enough to overcome traditional economic incentives. This is another example of academics torturing theory to make it say what they want.