Defining Ideas

The Road to Economic Perdition

Wednesday, September 7, 2011

The recent onslaught of disappointing economic and political news continued to bring gloom and doom to the United States this past Labor Day weekend. With unemployment rates still hovering over 9 percent, all eyes anxiously cast about for a solution—a solution made more urgent when all the forward-looking indicators point in the negative direction.

What then should be done?

In Monday’s Labor Day speech, President Obama did not tip his hand. The short answer is to reject the most common suggestions, such as those for grandiose government initiatives put forward on a weekly basis by the New York Times. Congress should not rush to pass dumb legislation. The Federal Reserve should avoid unsound macroeconomic forays. Congress and the president should work hard to undo counterproductive labor market regulations.

Illustration by Barbara Kelley

Let’s start with dumb legislation. It is always tempting to promote bold legislative reforms as short-term economic relief. Congress is now posed to pass the America Invents Act, a patent reform bill that favors large firms at the expense of small-startups in the technology sector. The patent protection of these startups will be systematically eroded under the new legislation. President Obama has urged Congress to pass this act so that jobs can be created. For a powerful demonstration of the multiple errors in this legislation, readers should take a close look at four articlesthat Hoover fellow and patent scholar Scott Kieff wrote on the legislation several months ago.

Putting the details of that legislation aside for now, what is critical to understand is this: if jobs are the issue, Congress has gotten into the business of throwing Hail Mary passes. Why should we have any confidence that our grotesque legislative process can turn out any statute that could actually improve economic matters by creating jobs? The general rule is the more complex the statute, the worse the result. The massive complexities of the America Invents Act, which is ironically uniformly despised by inventors, bodes ill for job creation.

The 1952 Patent Act, an admirable piece of reform legislation from a bygone era, has worked well for close to 60 years by strengthening patent protection from the low position to which it sank in the 1940s. Yet the best features of that 1952 law are likely to be upended by this new legislation that will, in my view, hobble those firms that create new inventions, while allowing large, established firms to free-ride on the technology of others. The worst provisions of the America Invents Act create new and redundant procedures that allow patents that have been sustained in the courts to be reexamined and, perhaps, set aside by the Patent and Trade Office. Far from creating jobs, this legislation will introduce just another layer of administrative expense and economic uncertainty into the economy. Stifling small-business technology has no positive long-term effects.

Congress should not rush to pass dumb legislation.

But assume, for the sake of argument, that my view of the substance of this bill is wrong, and that this statute might, against all odds, improve the operation of the patent system. It is nonetheless completely bizarre to think that any new statute could jump-start an economy today when its full impact will be felt years from now. It is a sad commentary on the quality of our public debate that this flawed statute has elicited much bipartisan support for its supposed positive effects on job creation.

The public’s attention, however, is not focused on these legislative diversions. Rather, it is rightly focused on what the government can do for us now. But again, too many policymakers are marching off in the wrong direction. There are the incessant calls, especially from the left-wing of the Democratic party, for yet another stimulus program. If you believe that the first two rounds of massive stimulus kept the 9.1 percent jobless rate from reaching 10 percent, you might declare victory when the next round of stimulus keeps unemployment rates below 11 percent.

It has, alas, become too easy to praise bad legislation so long as someone can claim it forestalls some worse hypothetical economic outcome. By that standard, all government failures count as successes. But whatever the received wisdom, the Keynesian foundation for a third stimulus program leads us down the road to perdition—one more time. It is pointless to talk about the gains from these programs in the public sector without taking into account the loss of jobs in the private sector when capital is transferred to less productive uses by government fiat.

Who cares if jobs are gained the public sector when so many will be lost in the private sector.

The difficulty with the entire idea of "stimulus" can be explained by looking at the relationship between public and private expenditures. Ideally, a sound social program is one that tries to insure that the last dollar of revenue spent in the public sector has the same value as the last dollar spent in the private sector.

Clearly, the ideal raises obvious difficulties of implementation. But those measurement problems should not lead people to throw their hands up in despair in trying to determine how to fund public projects. Public projects dedicated to classic public goods such as defense and infrastructure at least have a chance of working out. But even desirable ends can spawn foolish projects, be they worthless weapons systems or poorly designed roads to nowhere.

Who cares if jobs are gained the public sector when so many will be lost in the private sector.

Stimulus programs have an even smaller chance of working out. Quite simply, they are systematically unable generate that extra dollop of consumer demand needed to jump-start the economy. Let us suppose that we had a community of 100 people. Each person could spend $1,000 today to hire two laborers to dig holes and then to fill them up again. That useless maneuver would create some 200 jobs for people tomorrow. Nonetheless those privately owned resources could easily be put to better use by paying workers to build something that has value. No sane person would spend his or her own money in this fashion.

Consider the same situation, if those expenditures were instead made in the public sphere. The only difference between the two scenarios is that the state must now raise either through taxation of borrowing the same $100,000. Those steps would add an extra layer of administrative cost and confusion. I know of no magic alchemy that converts admittedly wasteful private expenditures into smart public ones.

The stimulus is also defended on the ground that it puts more money into the right hands—the hands of people located on the lower rungs of the income ladder who desperately need to buy things now. Doing this, the argument goes, will spark the economy. Yet this dubious chain of inference consists of missing links. First, if this were a good idea, why not use it in good times as well as bad? Second, no one agrees on what fraction of resources should ideally be devoted to consumption and what fraction to investment. And there is no reason for the government to arrive at a conclusion on that point. Decentralized decisions by separate actors, each reflecting on his or her own position, are far more likely to produce better "aggregate" decisions on investment and consumption than any séance inside the Federal Reserve.

Most people have a good sense of how much to save and how much to consume. Indeed, their convictions on this topic, right or wrong, will prove powerful enough to completely counteract any stimulus gimmick. Go back to Milton Friedman’s permanent income hypothesis, which starts from the simple observation that people rarely want to earn and consume wealth in lockstep fashion. In the early years of their careers, they will borrow to cover living expenses and invest in education. Then, in their middle years of peak production, they will first pay back their earlier loans, and then, increasingly, put money aside for retirement. The private smoothing of consumption over time lets each person wring the maximum value out of his or her lifetime income.

This centralizing tendency will undercut any government effort to prod ordinary people into spending more—as if that were the social goal—by showering them with cash today. Quite simply, those people will not do what the government wants them to do with the money. Instead, they will take that one-time contribution and divide it into three bundles—one to pay off past debt, one to increase current expenditures, and one to save for future needs. It is not necessary to know how much wealth each individual puts into each bundle. It is sufficient to know that not all, not even most, transfer payments are likely to go into consumption.

If the stimulus won’t work, neither will cheap money in the short run. There is lots of liquidity in the system right now, as private parties tend to hoard cash, gold, or treasury bills in uncertain times. People will not risk making long-term commitments knowing that they are vulnerable to short term shifts in current economic policy.

By the Obama administration’s standard, all government failures count as successes.

A basic principle of sound banking is that it is dangerous to lend long while borrowing short. An upward move in interest rates will raise borrowing costs without generating any offset in lending revenue. Matching maturities reduces that risk.

That same matching principle applies to all business investments. The Congress and the president will surely propose some short-term reduction in payroll taxes in order to induce businesses to hire. But any investment in permanent employees can only recover front-end costs over a period of years. It is foolish to invest heavily in new workers when the overall tax burden is sure to increase down the road. The better strategy is to hire short-term workers in whom the firm makes few, if any, long-term investments, which translates into lower growth in human capital. Systematically, that rational employer strategy also leads to higher instability for workers, which corresponds precisely to the rise in short- term hiring today.

So, returning to our original question, what should be done to improve our economic situation? There are only two approaches that will work. The first is to lower marginal tax rates at the top, which might induce investments from those who have money. Second, and more importantly for the short run, is to put fiscal and monetary policy on the backburner while proactively removing the senseless blockages in the labor markets.

For both goods and labor, free markets work better than regulated ones. In order for any voluntary exchange to take place, the gains from trade have to exceed the transaction costs needed to put any trade together. A successful system therefore has to increase the prospects for gain, while reducing the transaction costs needed to get that gain. Here is how it should be done.

Get rid of all mandates on the labor markets. The legal rules intended to "protect" workers in fact protects them from getting jobs by reducing labor market flexibility. This, in turn, shrinks the expected gains from voluntary trade. The rise in temporary employment is in large measure due to legal rules that ladle mandatory benefits on top of full-time employment contracts. Imposing minimum wage and maximum hours on large numbers of jobs then compounds the damage. So do anti-discrimination laws.

Clearly some of these laws will raise the wages of protected workers. But those gains come at a high cost, because, systematically, labor laws produce far greater social costs by wreaking havoc on the lives of those who can’t get into the labor markets at all. The Obama administration takes a schizophrenic approach to labor markets. While clamoring for job-creating programs that won’t work, it simultaneously takes steps in the labor market to throttle new jobs (think Boeing) or to impose costly mandates on job markets (think health care).

It is a testimony to the resourcefulness of the American economy that the unemployment figures are not more dismal than they are. That said, this nation will not be able to get off the road to economic perdition unless it junks both parts of the Obama administration’s economic policy—its futile macroeconomic programs and its mindless labor market restrictions. Let us hope that President Obama takes these harsh realities into account when he makes his own job proposals later this week. But after reviewing his uninspired Labor Day remarks, we shouldn’t count on it.