Exceptions to Keynesian Theory

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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.