May 1, 2012

Beyond Austerity

We must liberalize labor markets, not rely on macroeconomic “fixes.”

Grim is the right word to describe the latest economic news from both the European Union and the United States. Throughout the European Union, austerity programs have failed both politically and economically. In Spain, unemployment rates have soared above 24 percent. The Dutch government is on the edge of collapse because of the popular and political unwillingness to accept the austerity program proposed by its conservative government. Romania is not far behind. Greece, Italy, and Portugal remain in perilous condition. France faces a presidential run-off election between President Nicholas Sarkozy, who is moving rightward on immigration issues, and the free-spending socialist candidate Franciose Hollande. On the American front, the decline of GDP growth to 2.2 percent rightly raises fears that our sputtering domestic recovery is just about over.

 Epstein  
 Illustration by Barbara Kelley

It is no surprise, therefore, that leading columnists like Paul Krugman have taken this opportunity to announce triumphantly that austerity is a “fairy tale” that shatters the social confidence that it is designed to shore up. It is futile to invoke fiscal austerity, he argues, when economically beleaguered countries really need to be “spending more to offset falling private demand.” The cure is supposed to be increased government spending, but that solution has its own serious problems. Krugman assumes that the declines in private demand and private investment are attributable to mysterious external forces that are beyond the power of government to control.

The rise in public expenditures has to be financed in one of three ways: higher taxes, increased inflation, or more borrowing. The question of which device is used is, in general, a secondary issue. But the primary insight is this: Any increase in public expenditures in either good or bad times will necessarily result in a larger fraction of the economy under government control.

The ostensible short-term benefit of increased spending comes with a high, but hidden, cost of substituting unwise government expenditures for more sensible private ones. The upshot is that these expenditures might give life-support in the short run, but in the long run they will surely delay the increase in private expenditures that make the stimulus gains unnecessary. And sooner or later, the long-term debt will come due, at which point the only alternative to austerity is wholesale default on key social obligations. 

Focusing, therefore, solely on monetary and fiscal policy has dire consequences that the macroeconomic establishment wants to ignore. It is right to say that austerity, taken alone, will fail. But it is wrong to think that increased public expenditures are the road to long-term salvation. The slowness of the American recovery offers solid evidence that priming the pump will fail as well. Even if it does not raise debt costs in the short run, it sops up resources better deployed by sustainable private investment.

Throughout the EU, austerity programs have failed both politically and economically.

How then to create desirable conditions for growth? The first key element is to focus on growth by calling off the acerbic attack on the top one percent. The good Keynesian concentrates on the fall in aggregate demand in the private sector, and should therefore not be concerned with whether that demand is flexed by the rich or the poor or any combination thereof.

All too often, macro-types engage in fancy footwork by claiming that skewing the tax breaks to those at the bottom of the income distribution will hasten the recovery because of their greater marginal propensity to consume. But that bet is exceedingly uncertain because people at all income levels may choose to save, rather than consume, their money depending on how they perceive future economic opportunities.

If low-income workers think that the downturn is permanent, then they will increase their savings to offset the anticipated decline in their future income. Or they will use some of their tax savings or public subsidies to pay off overdue debt, or to save for the college education for their children or, like Joe Nocera, to subsidize their own (underfunded) retirement. Trying to organize a revival of the economy by jiggering tax rates is doomed to fail. Individuals will choose to run their own lives as they see fit, and their financial decisions may negate any supposed advantages that the economic elites can impose through fiscal or monetary policy

So what next? The best first step is to free up labor markets world wide. Specifically, we need policies that take aim at the unbearable political forces that seek to tighten the regulatory noose on voluntary labor markets.

Unfortunately, the dominant attitude of macroeconomists is to assume that nothing that takes place within the labor market (of which Krugman never speaks) is large enough to influence the large macro trends to which they attribute today’s high employment rates.

The blunt truth is exactly the opposite. The calcification of labor markets is the primary impediment to economic recovery. The direct effects of government regulation of labor can matter far more than the indirect effects of macroeconomic policy, whether Keynesian or austerity-based. Neither austerity nor lavish public expenditures will improve the overall situation, which is why the massive increase in American public debt has not nudged unemployment rates down. The only workable solution has to stress job creation, not by misdirected subsidies, but by dismantling the government obstacles to market exchange.

The calcification of labor markets is the primary impediment to economic growth.

Start with the basic microeconomic theory of contract relationships. Private parties have objectives they wish to achieve by coordinated behavior. Voluntary agreements remain the only tool that they have to improve their joint position. There is nothing that the law can or should do to identify the gains through cooperation. That is for the parties to do. The simple combination of labor can allow two individuals to do more together than they could do separately. Two people can raise a barn wall at a small fraction of the cost of each person acting alone.

Specialization increases gains from trade. The function of the law is to reduce the transaction costs to permit the mutual gains to flow. Put another way, if the gains (G) exceed the transaction costs (T), then markets can operate. Where the gap narrows, the gains from trade shrink. When G is less than T, the market folds. Obviously, government should not work to shrink G or increase T. Today, however, it does both.

That said, some modest forms of regulation actually increase gains from trade. Think of a requirement that a real estate sales contract be put in writing. Simple formalities at the outset of a transaction can reduce the uncertainty about the deal and its terms. But virtually all government regulations on wages and terms increase that uncertainty. The high transaction costs reduce the possibilities of cooperation, and the explicit limitations on substantive terms kill off gains from trade. The common view that labor law protections are necessary to protect financially weaker workers from exploitation gets things exactly backwards by, again, raising T and lowering G.

Most voluntary employment contracts are entered into on an “at will” basis, which means that employers can fire their workers and employees can quit their jobs for any reason at any time. Parties that want more complicated deals can write them out. Usually they don’t because of the efficiency advantage of an “at will” arrangement.

European law at the EU and national level specializes in a set of “for cause” dismissal rules that make it virtually impossible for any employer to lay off any worker. Those rules cause massive amounts of labor market rigidity, which make it difficult for employers to lay off workers for general incompetence (which can never be proved) or in times of slack demand. The unfortunate consequence of that civil-service rigidity is that it reduces the likelihood that an employer will hire workers in the first place. The same is true of the disability regulations in the United States.

Faced with transactional obstacles, the parties will resort to inefficient substitute short-term contracts, where employers are less willing to invest in training workers for the long haul. The eager regulator can try to block this avenue of escape by imposing special taxes on independent contractors. But the likely response to that is simply to not hire new workers; instead, employers may choose to pay current workers overtime, to increase outsourcing, or to invest in capital equipment that reduces the overall demand for labor. Protection works, for a while, for the few in power, but in the long run, it leads to massive layoffs from struggling firms.

Labor markets operate best when gains from trade exceed transaction costs.

Just that outcome describes the fate of heavily unionized industries in the United States. The deeply protectionist National Labor Relations Act dictates that many employment contracts be governed by collective bargaining agreements, which never incorporate at-will principles. Dismissals are often subject to judicial challenges that leave the courts in the hapless position of having to decide whether the decision to dismiss the employee was for anti-union or legitimate employer motives.

In addition to this short-term difficulty, these agreements can never be economically efficient because no union can just bargain to get a bigger slice of a larger pie. Instead, the unions have to worry about maintaining political support from the rank and file. In response, they opt for inefficient labor contracts—think of the complex set of job rules found in standard union contracts—to achieve their dual objectives. These contracts are not easily amenable to mid-term corrections in response to changes in external conditions, all of which require time-consuming and tense renegotiation with unions.

The situation gets no better with the endless number of employer mandates and taxes that are routinely imposed on firms. A typical statute may say that an employer need not supply any health-care insurance for its employees at all, but if it chooses that route, it must meet the following mandates for health, disability insurance, and a host of other conditions. None of these conditions are bad in and of themselves. But legislators never ask the hard question of whether they are worth what they cost. If they are, such provisions would be included voluntarily in the agreement. If they are not, they should not be imposed at all. The constant uncertainty over the potential reach of the Health Care Act currently acts as a disincentive to hire workers.

Nor are bad output effects offset by favorable distributional consequences. The costs of these devices tend to constitute a larger fraction of total earnings for employees at the bottom end of the income distribution. The panoply of restrictions exerts its greatest pressure at the bottom end of the labor market. The upshot is that we see a rise in chronic unemployment, which has brought forth an endless set of laments—all warranted—by such notables as the New Yorker’s James Surowiecki about the socially corrosive consequences of the economic current policies.

But forget the laments. We need to reverse course now. Think simple: increase G and reduce T and labor markets will start to open up again. Regulatory costs will decline, unemployment costs will decline, and consumption will increase. If we fix what is broken, then the economy will start to recover. But if we fiddle at the macro level, then we will stretch the current malaise out for years and years.


Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).


Letters to the editor

Don't Forget About Business Regulations

Freeing labor markets is one part of the puzzle. The other parts are freeing business from the many statutory and regulatory threads that encumber business creation and expansion. Many of these regulations were created to protect a politically influential class and are not a public good. Like barnacles on a hull such requirements need removing not one by one but by sweeping reform that will allow the economy to plow ahead at greater speed, but there seems no political will to do this.

Jon Chambreau

The Dynamic, Unbounded Economic Pie

Your article Beyond Austerity notes that government regulation calcifies markets.

Implicit in your argument are two important truths. The first is that life and markets are dynamic while regulatory control is static. As you explain the imposition of a static system to over-control a dynamic economy results in tepid (or no) growth and, I add, fosters a concurrently thriving "black market."

The second implied truth is that some view the economic pie as a justification for regulatory control. Such control actually creates a finite economy as a self-fulfilling prophecy. This, in turn, is used as proof that re-distribution is necessary and should be achieved by the imposition of even more static regulation fostering an increasingly stagnating economy. It is a death-spiral which leads to an eventual implosion. As you point out, at some point the bill comes due.

In fact the economic pie is both unbounded and dynamic. Steve Jobs, as one example, did not become wealthy by taking wealth from someone else; he became wealthy by providing a product which enriched lives and contributed to our well-being. There is always room for innovation and growth in any economy, but those conditions can only thrive in a dynamic low-regulation environment as you outline.

---Anthony Benvin

Do We Understand the Problem?

“But forget the laments. We need to reverse course now. Think simple: increase G [gains from trade] and reduce T [transaction costs] and labor markets will start to open up again.”

Sadly, not a single person in the current administration believes this. I dare say not a single person in the Democrat party believes this. Amazingly, a great number of economists do not believe it. I cannot imagine how we can or ever will reverse course. As things get worse, we will strengthen our commitment to the current failed course. In turn things will continue to worsen. Europe will explode and crash first. We do not appear to understand what their problem is and are learning nothing from it.

---R. Willis Cook

Gore the Sacred Cows

Wonderful sounding words. No doubt, IF they could find their way to implementation the world economy would have an excellent chance to rebound.

But, the reality is that this is pie in the sky. Worse, Epstein is too smart not to know it. He's also smart enough to offer a reality based solution. I believe he won't because the cure would gore a couple of sacred cows.

I think there are two paths. The one we're on is to an outbreak of many civil wars, at worst. At best a radicalization of governments. The other path is to default on the repayment of the debts held by governments. That's where the sacred cows live.

Thanks for an interesting read.

Mike Mahoney


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