Wednesday, August 17, 2011

Exceptions to Keynesian Theory

Copyright, The New York Times Company

While taxpayers have been wondering if all of the extra government spending of the past couple of years has actually served to impede the recovery, Keynesian economists have been asking them to keep faith in the promise that government demand is the secret to economic recovery. Now Paul Krugman, an outspoken Keynesian stimulus advocate, admits that Keynesian theory has many exceptions.

It’s pretty easy to see how various types of government spending might reduce employment, rather than increase it: a number of government programs have been reducing the incentives for people to work, and reducing the incentives for business to hire.

Unemployment insurance is an example (among many) of how the work incentives of so-called stimulus programs operate. Unemployment insurance payments to individuals cease as soon as the individual starts to work again. I agree that such payments are compassionate, and may well be the right thing to do, but economists have long recognized that such compassion is not free: unemployment insurance reduces employment, rather than increasing it, because it penalizes beneficiaries for starting a new job.

Without offering any proof that incentives suddenly ceased mattering, stimulus advocates, and even the Congressional Budget Office, have recently ignored this effect. Many of them aim to prove the potency of unemployment insurance and other components of the stimulus law by insisting that the recession was caused by a lack of demand, and that any public policy that raises aggregate demand must be a big help.

Even if they’re right that the recession was a result of low demand, it does not follow that the way to recovery is to destroy supply, too. Before we turn away from one of the basic lessons of economics, we ought to have some evidence of the fundamental Keynesian proposition that “incentives to seek work are, for now, irrelevant.”

(Another tendency of Keynesians is to “prove” their supply claim by pointing to the existence of unemployment. Of course, unemployment exists in large numbers, but that does not tell us whether, and how much, incentives affect employment rates.)

Part of my research has been to examine episodes, from the current downturn, of changes in the willingness and availability of people to work. If, as Keynesians have been insisting, the incentives to work are in fact irrelevant in a recession, then none of these episodes would be associated with employment changes. (In their view, an increase in the number of people willing to work would just increase, one for one, the number of people who are unemployed.)

I looked at seasonal changes in labor supply. I looked at the increase in supply of workers to the nonresidential construction industry (workers who were leaving home building after the crash). I looked at the increase in the supply of elderly workers. I looked at the increase in supply of workers in Texas. In all of these recession-era episodes, more supply meant more jobs, and less supply meant fewer jobs.

(I also looked at some recession-era demand changes to see if they were at all constrained by supply, and they were — very much as they were before the recession.)

There is still no evidence to confirm the fundamental Keynesian proposition that supply doesn’t matter.

Rather than completely discard that proposition, Professor Krugman has recently formulated a theory of exceptions to the Keynesian theory, which he believes can help explain some of my findings:

Here’s the question: why do patterns of employment over time that are, in fact, normally supply-driven continue to be visible even during a demand-side slump? And here’s the answer: businesses make long-term decisions that influence hiring patterns over time, and those decisions continue to shape their behavior even when there is a surplus of labor.

In other words, Keynesian theory has exceptions that have to do with business’s long-term hiring decisions. For example, businesses have lived through enough seasonal cycles to know that they can normally make more money when their hiring patterns are responsive to the seasonal availability of people to work, so businesses continue to be responsive to the seasonal pattern of labor supply even during a deep recession when there are plenty of workers available throughout the year.

I don’t understand how Professor Krugman explains that the nonresidential construction industry took advantage of the plentiful supply of home builders after housing crashed (he also has no explanation for my minimum wage findings, Christmas seasonal findings or elderly employment findings). He also fails to explains why some business hiring patterns survive the recession intact, while other practices are completely different (e.g., businesses used to think they needed 138 million payroll employees, but by 2009 they got by with fewer than 130 million).

But even if Professor Krugman were correct that the ghost of labor supplies past haunts the recession through business’s long-term decisions, how can he be so sure that the labor-supply effects of government spending programs would not also have the same effects they did in the past?

For example, employers found that people were more difficult to hire and retain when a generous safety net was available. In this way, unemployment insurance would continue to reduce employment even after the recession began because employers have learned that the more generous the safety net, the more they must get by with fewer workers.

Would Keynesian stimulus spending work only when it came as a surprise? Or only when the spending was outside the range of prior business experience? Keynesian economists have not even begun to answer these questions. For now, Keynesian theory has so many exceptions that we might as well discard it.


Milton Recht said...

Interdependent of incentive concerns, there is often failure to look at the marginal effects of stimulus funding.

When someone loses a job, there consumption does not drop to zero. The unemployed use their own savings, or rely on friends or relatives for some free meals, temporary living quarters or free services such as a washing machine, etc. Part of this consumption is supplied and purchased by others and increases their demand.

Keynesian stimulus, including unemployment insurance, substitutes for other consumption spending funds.

The same is true on state and municipal levels where part, probably most, of local projected spending will substitute federal stimulus funds for local funds.

To the extent that federal stimulus funds acts as substitute funding, there is no demand increase and economic boost from it.

The part of stimulus funds that replaces other spending has a zero multiplier effect on the economy.

When the extra US government stimulus inefficiencies and delays, as compared to the private sector, are considered, parts of stimulus funding can even have a negative economic multiplier.

The failure to look at marginal spending effects, the failure to consider government inefficiency and the negative incentives mentioned in the blog post are the reasons payments such as food stamps, unemployment insurance and other stimulus spending do not create jobs or provide strong economic stimulus. Stimulus spending, inefficiently and often with negative incentives, substitutes one funding source for another, but does not increase the spending above the baseline amount that would occur without stimulus funding.

RationalThought said...

Prof. Mulligan, I hope you read the comments on the Economix site. To state that unemployment insurance is the be-all-end-all of stimulus spending is ludicrous. And to insist that someone who gets a job is 'penalized' by losing their unemployment check is crazy. What about the benefit they receive from the paycheck they get?
As for Milton's argument that federal stimulus 'replaces' other spending for a zero multiplier effect...please! Maybe if the stimulus spending occurred at the same time as the decrease in private sector spending. Unfortunately that never happens in the real world. First, private sector spending declines (a negative multiplier effect). GDP falls. After Congress acts, then stimulus spending begins. Starting at a lower level of GDP and a lower 'total spending' figure, it will result in a POSITIVE multiplier effect. (Note: Please consider stimulus spending to include infrastructure spending in addition to unemployment insurance).
How does the UofC allow this type of economic instruction??

Prof J said...

Prof. Mulligan,

Your findings are consistent with Say's Law. That's good to know.

I do not think businesses are quite as stubborn as Krugman seems to think they are. A business will not keep hiring people if the marginal benefit of the hire does not at least equal the marginal cost, no matter their previous plans. Businesses understand the principle of 'sunk cost.'

To "RationalThought:" Perhaps you should read John Taylor's recent working paper on the topic:

Misaki said...

Might be useful

"The essence of macroeconomics is understanding why such things are a fallacy, why what happens if one group does something is not at all what happens when everyone does it. And it’s a sad commentary on the state of economics when tenured professors at famous schools don’t get that distinction."

Saying that the US should not be China is not the same as proving that the US would not increase employment by being China. It's a sad commentary when....

Once again, US companies do not have to lower wages to increase employment or depend on the weakness of the USD; they would only have to decrease costs of their products in other currencies (and wage decreases would follow naturally).

But I'm sure everyone upset about the recent report on the percentage of GDP as imports from China and other countries is fully convinced by you saying "fallacy of composition" as an explanation for why the government must spend more of "their" tax money.

Both sides of a debate simplify. It is poor form to say that no simplification by the 'other' side is justified while simultaneously including similar simplifications in your own arguments.

Misaki said...

2nd comment: the explanation of "progressive" motives.

"The general argument that the President should try to do something effective has merit. However, just as important is understanding what, exactly, is likely to be effective given the existing goals of people and the resistance that will result from policies that contradict their goals. People do not want the government to spend money to create jobs, so while it is "brave and foolish" to continue advocating such, a more flexible approach both by the President and by other concerned parties is more likely to achieve a reduction of unemployment.

The largest battleship ever constructed, the Japanese battleship Yamato, was given as much fuel as the local port commanders could provide instead of just enough for a one-way voyage as ordered, but this did not prevent it from being destroyed in combat or heavy criticism about better uses for that precious fuel under the blockade."

Mr Jared Bernstein said,
"House Rs will likely block most of the above ... let’s make sure everyone in this country knows exactly who’s standing between the 20+ million un- and underemployed Americans, and their jobs, paychecks, and living standards."

Think this through to the logical conclusion. On one hand you have an unemployed worker, who has lost their self-esteem. On the other hand you have an employed worker angry that the government is spending "their" tax money in ways that seem to benefit only Wall Street and fin. inst.

Do you really expect the unemployed worker to want the government to spend more, so their neighbor who is employed has to pay higher taxes (or suffer inflation on their savings/fixed income)? How exactly does this cause people to feel any less like a "manipulative leech" as someone I know put it?

The alternative, once again, is for the employed worker to be 'taxed' (where the taxes go to their employer, not the government) only if they refuse to reduce their working hours to allow the unemployed worker a job and an income.

[following omitted due to space]

There is already a strong undercurrent of opinion among the general public that people need to consume less, not more:

So "aggregate demand", and the economy are only likely to get worse if people do not agree to conserve work.

Misaki said...

In general, however, it is true that many things, such as unemployment insurance, increase the incidence of unemployment in a population.

However, society is not balanced solely on supply and demand and labour; the third component, "avoiding riots and the destruction of property and owned capital that form the basis for the distribution of resources", provides a floor to the optimum wage level and quality of life (including taxes) even if this is above the point where supply and demand would balance. It's a three-variable system, not a two-variable one.

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