Promises, promises. It must be an election year.
With Idaho primaries coming up and a presidential election this fall, it’s time again for the promises of what government can do for you. No area of the globe is safe from these promises.
European leaders promise to keep spending, even if they must borrow it all. U.S. presidential and congressional candidates promise to spend more to help reduce unemployment. The Fed promises to purchase more long-term bonds to help home buyers. Local leaders promise to increase spending on schools or roads, or both.
Whenever policymakers say new government programs and expenditures are needed to grow the economy, they are following the theories of Keynesian economics. John Maynard Keynes’s 1936 treatise, The General Theory of Employment, Interest and Money, explained how the fiscal policies of the government could possibly help smooth out short-run fluctuations in the economy.
Part of Keynes’s overall theory of the business cycle included the idea that wages are "sticky." This theory says that when overall demand in an economy falls, firms are unable to cut their worker’s wages because of contracts or other negotiations and therefore reduce the workforce, cutting production and employment. Keynes said that the reason we get recessions is that firms’ employment costs become too high relative to what they can sell, leading to layoffs and unemployment.
The Keynesian policy implication for a weak economy is straightforward: The government should step in and increase overall demand. Government should buy what firms are selling.
Keynes wrote his theories in response to the deep economic problems of the early 1930s. Massive layoffs around the world at the time supported Keynes’ idea that wages were not adjusting to slowing demand. The recession of 2008–2009 at first bore out what Keynes predicted. Rather than lower wages, we saw a high number of layoffs and increasing levels of unemployment.
But this key tenet of the Keynesian theory just doesn’t fit today’s economy. Wages are no longer sticky.
Many employers are making new, short-term agreements with their employees for lower wages to avoid layoffs. For example, new employees at General Motors and other automakers receive on average about $14 an hour, half the rate paid previously paid workers in this industry.
Moreover, Keynes said that wages would not adjust at all in the short run, whether demand was rising or falling. Despite weak economic growth and high unemployment, overall U.S. wages are rising, not falling.
The U.S. Department of Labor reported at the end of April that wages and salaries for civilian workers increased 0.5 percent for the first quarter of 2012. Private sector wages and salaries increased 1.7 percent over the 12-month period ending in March, while government workers saw a 1.5 percent increase.
Even in the weak local labor market wages are rising. According to the most recent report from the Idaho Department of Labor, wages in the Treasure Valley are rising at 1.6 percent per year.
If the assumptions of Keynes’s models don’t fit the current situation, what then is likely to be the effect of all the candidates’ promises? New government spending is likely to crowd out private sector investment and employment.
The reason is known today as the Ricardo-Barro equivalence, named after 19th-century economist David Ricardo and current Harvard economics professor Robert Barro. What Professor Barro has shown using data not available to David Ricardo at the time is that when the government increases spending, whether by raising taxes or borrowing more from the public, there is no effect on overall consumer and business demand. In response to the new program, the public saves moves in expectation of higher taxes. Thus, the government spending gets in the way of public spending.
Even if Keynes was right for his times, the times have changed. Promises of more Keynesian economics today are just promises of more taxes tomorrow.
Peter Crabb is professor of finance and economics at Northwest Nazarene University in Nampa.