January 27, 2014

The Fragile State of the Union

Should the President champion populist policies in times of economic stagnation?

In the run-up to Tuesday evening’s State of the Union Address, President Obama faces a tricky situation. Jarring uncertainty in the financial markets threatens to bring about a serious retreat of all the major stock indices, which in turn presages more sluggish economic performance in the months ahead.

It is never easy for a President to rebuild his base in the second year of his second term. Indeed, the President has special vulnerabilities, especially with the deeply hostile public response to Obamacare, which has revealed one unhappy surprise after another. The President could talk about the fixes that tantalizingly lie around the corner, but that strategy will backfire so long as administrative glitches remain, coverage is uncertain, and premium increases are the order of the day. There is not much traction here.

Krugman, Jobs and Inequality

Another possibility is for the President to play the populist card yet again. So advises Paul Krugman, for whom income inequality and unemployment are the dominant issues of our time.

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Illustration by Barbara Kelley

In a recent column, he begins per usual with an appeal to the Keynesian notion that the same problems that dogged the world in 1936 are the ones that plague us today: high rates of unemployment coupled with an “arbitrary and inequitable distribution of wealth and incomes.” What was true of Keynes in 1936 is all too true of Keynes today. Trained as a macroeconomist, he paid no attention to the labor market policies that fall outside his cosmic vision. I have never been a modern-day Keynesian and here is why.

The single largest problem that faced Great Britain in 1936 was the breakdown of its labor markets; a problem that, apart from during the Second World War, did not receive sufficient attention until Margaret Thatcher took the reins of power. It is hard to overstate the damage that was done to the British economy by the ill-advised Trade Disputes Act of 1906, with its three-pronged agenda that rendered labor contracts unenforceable, allowed unions to induce other individuals to breach their contracts with targeted employers, and allowed workers collectively to act in any way that individual workers could act on their own.

This last point may sound abstruse but the 1906 Act effectively allowed unions to become a law unto themselves. More specifically, the Act gave legal support to their orchestrated collective refusals to deal—activity which, when practiced by commercial firms, is a per se violation of the antitrust laws. To the incredulity of many British and American writers such as A. V. Dicey, the English Constitutional theorist, and Joseph Schumpeter, the American political economist, the statute gave unions the ability to prop up their monopoly power. This led to the General Strike of 1926, with its consequent disruption of the entire economy in both the short and long term.

To overlook the harm wrought by such protective policies is economic blindness. Nonetheless, the Keynesians insist that the key to overcoming structural unemployment is to adopt policies that transfer wealth to low income consumers who are on average somewhat more likely to spend. But choices between investment and consumption must be made during both good and bad times, and no one knows in the abstract whether the marginal dollar is better allocated to consumption or investment. The constant Keynesian effort to use macro policies to deal with the difficulties in labor markets ignores the market rigidities that hamper the gradual movement of wages and jobs in response to market pressures.

Krugman falls headlong into this wholesale blunder, for his entire approach looks exclusively at macroeconomic policies of taxation, monetary supply, and deficit spending to deal with an issue that would be best solved with a massive dose of deregulation. The regulation of labor markets never enters into his equation. Instead, we hear the tired refrain that a combination of more aggressive transfer policies, higher minimum wages, and stronger unions are the cure to all that ails us.

Krugman supports his view by noting that high unemployment rates are “destroying work bargaining power.” But the more accurate explanation is that workers and employers alike are increasingly constrained by the rise in the minimum wage law, the Obamacare tax on full-time employers, and the beefed up enforcement of antidiscrimination and overtime laws. These factors have the undesirable effect of making it impossible for workers to accept lower rates that would at least get them back into the workforce before their overall skills erode.

There is in fact no a priori way to determine the effect of any form of labor market regulation. If the minimum wage is set below or at the market wage, it will in the short run have little effect, which is why during the boom Clinton years (in which welfare reform, technological innovation, and free trade initiatives more than offset tax increases) the minimum wage barely moved overall employment rates. But the situation is different when demand for labor falls, as was the case after the passage (with bipartisan support) of the Fair Minimum Wage Act of 2007, which increased the minimum wage from $5.15 to $7.25 per hour.

Krugman compounds his errors by claiming that the recent economic crisis is somehow driven by the supposed increase in economic inequality. But again, this ignores the mistakes, both public and private, with respect to the overheated mortgage market. Current policies drag out the foreclosure process.

The correct policy with respect underwater properties is quick foreclosure, which has multiple benefits. First, it avoids the serious risk that the owners of these properties will let them go to seed if they are allowed to remain on the premises. Second, it forces all the losses on the books promptly, and allows the foreclosed properties to reenter the real estate market at more realistic valuations, while encouraging the displaced owners to lease, not buy, if they cannot cover their payments. But cheap money policies and imprudent implied guarantees encouraged the housing bubble that resulted in unsustainable home loans and generated messy legal disputes lasting years.

Nor is it possible to rail at the Republicans for their heartless cuts in the safety net, in light of the pattern of transfer payments and unemployment benefits. The OECD account on this point concludes tersely: “In the United States too, the increase in social spending generally outpaced GDP-growth in recent years and by 2013 public social spending has been estimated to have increased to 20% of GDP, up from 17% in 2008,” which amounts to about a 17.6% increase.

At the same time, the attacks on the cuts to food stamps must come to grips with the major expansion in that program over the past five years, during which nominal unemployment rates went down. “According to the U.S. Department of Agriculture about 23,052,388 Americans were on food stamps in 2013. There were 15,232,115 Americans on food stamps in 2009.” The definition of a cut always depends on the choice of baselines. But a 50% increase over the past five years raises the hard question of whether wise social policy would continue with transfer payments that tend to keep unemployed workers out of the workforce instead of policies of market liberalization that let them back in.

The Middle Class and Economic Opportunity

The blunt truth is that the President should steer clear of Krugman’s seductive populist message because it will only reinforce the view that a floundering administration is unable to mend its ways. Indeed, key Democratic operatives are on to the risk of populist rhetoric, because they realize that it is risky business to push hard, for example, on the minimum wage, which is not an issue that resonates most strongly with their core constituency: "A thriving middle class is the backbone of the economy."

Opportunity, not equality, is the new buzzword. Sadly, a change in rhetoric isn’t the same as a change in policy. Once again, the key issue is how “opportunity” is defined. For those like myself in the Classical Liberal tradition, equality of opportunity allows all individuals, regardless of their race, creed, color, religion, national origin, or any other characteristic, to offer their goods and services to others at the highest price that they can obtain in a competitive market. This principle means that we do not have to go through the artless process of deciding, in the name of equal opportunity, which characteristics are those on which employers cannot discriminate in labor markets. The logic of this position is to minimize transaction costs and administrative overhead in order to increase the velocity of win/win transactions free of government oversight.

Unfortunately, the President always equates equal opportunity with the expanded and misguided agenda of the Equal Opportunity Employment Commission, which hopes to “enhance efficiency and enforcement of federal sector equal employment opportunity laws,” without stopping to ask whether costly “enhancement” will kill off job creation for both workers and employers.

These counterproductive activities, moreover, will do nothing to aid the elusive middle class. The middle class consists of employers, employees, independent contractors, and retired individuals. It is not defined by its occupational role, but by its basic income characteristics.

It is a common error of union supporters to write, as in the 2007 Congressional Report, for example, that any increase of unionization will improve the fortunes of the middle class, which translates into a support of the Employer Free Choice Act with its card check and compulsory arbitration provisions—a dual recipe for economic disaster. The simple point here is that many employers hurt by such legislation are also members of the middle class; so too are countless employees, many of whom are shareholders of large public corporations whose bottom line will be adversely affected by any shrinkage in the overall economic pie.

Dwindling Presidential Options

So what should the President cover in his State of the Union address, beyond offering more bromides to respond to the current situation?

The President, alas, is as stubborn as he is uninformed. He does not grasp that the only way to save his misbegotten administration on the domestic front is to relent on his uncompromising view that higher taxes, greater transfer payments, and more regulation of the labor and real estate markets will jump-start an economy whose long-term prospects remain in the doldrums. But instead of recalibrating the substance of his message, the President will likely keep to his old agenda, by stressing those activities that he can undertake unilaterally, that is, without Congressional help, chiefly in the areas of jobs, education, infrastructure, and environment. In these areas, it is likely that his approach will only compound policy weaknesses with probable abuses of executive power.

The overall lesson is this. Think hard about substance. Cut back on redistribution. Remember that efforts to narrow the income inequality are likely to make the rich poorer, not the poor richer, and to result in the decline of investment capital that could spur the creation of new jobs. The President needs to recognize that the first order of business is growth, not transfer payments. 


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).


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