TCS Daily


Does Welfare Reform Explain the Economy?

By Tim Worstall - July 7, 2004 12:00 AM

There are three facts being shouted round the political echo chamber at the moment: that jobs growth is poor, that corporate profits as a portion of the national income have risen to unprecedented levels and that low wage growth is leading to an increase in inequality. That these facts may be true or not is irrelevant to my concern which is that they are not actually three separate things. They are exactly the same thing.

The meme appears to have started at the Economic Policy Institute, moved in mysterious ways across the blogosphere via the likes of Kevin Drum and Brad Delong and this week arrived in the New York Times courtesy of Paul Krugman. This of course makes it all official, the three factoids simply proving that the VRWC is out to do the working man down. I really shouldn't argue economics with Professor Krugman, given his position on the list of likely Nobel winners in the future, yet I find myself leaping up and down wanting to shout out that these are not three separate things. They are simply different facets of exactly one thing, that the economy is not currently at full employment.

The connection between low jobs growth (which is exactly the same as saying excess unemployment of course) and low wage growth is obvious if you think about how a company works for a moment. Do we think that managers or shareholders say, "Gee, profits are up, better raise that pittance we pay the employees"? (I leave aside the truth that we right wingers are privy to, that rises in profits are meant for the third Ferrari which we each require.) Or do we think this is a little more representative of reality: "Dang, we just can't get good people at the wages we pay. Better raise them so their kids can eat, too"?

Now, run through the two alternatives again using the mindset, if you can deal with the horror, of a left winger. Obviously they will not believe the first for if they did they would never argue in favor of a minimum wage. I think we can all agree, both left wingers and the rational, that the second option is a fair description of what actually happens. Wages in general rise when firms are competing for labor and thus have to bid up the price to poach it. If there is a reservoir of the unemployed then an increase in the demand for labor can be met by hiring them, rather than raising wages. So two of our facts are just flip sides of the same coin, that the existence of unemployment leads to low wage growth.

What about the rise in the share of national income going to corporate profits? I'll have to abandon the numismatic metaphor here being rather short of three sided coins but it is simply inevitable that if the economy is growing and wages aren't rising then profits must be. There isn't anywhere else for the money to go.

All we have really done here is to take three symptoms of the fact that there are people unemployed and failed to connect the dots. I have no real objection to the EPI, a partisan think tank (please note that ours are not partisan, merely correct, while theirs of course obfuscate for political reasons) playing up such matters in an election year but I do have a vague feeling that we are owed something better by a person of the Professor's academic eminence.

It might even be possible for Paul Krugman to go on and explain exactly why this recovery seems to be working a little differently from previous ones. For several decades it was a given that by the time we got down to 5.6 % unemployment we would expect to be seeing wage inflation. That's where we are now and as is rightly pointed out we don't have that inflation. So what happened, has there been some structural change in the economy since the last recession, something that would change the relationship between unemployment rates and income gains? Well, yes, there has been: welfare reform.

My old Professor, Richard Layard, spent the 1980's banging on (I would say to the point of tedium but then one should not be bored with the truth) about how getting the long term unemployed back into the labor pool, if not the workforce, would permanently bring down NAIRU (don't worry, just think of it as the rate of unemployment at which you start to see worker's incomes rising). What was the main point of Bill Clinton's welfare reforms? Why, to get people off long term dependence upon handouts and back into the labor force. What are we seeing now? Having reformed welfare so that it is indeed a hand up not a handout we see that a level of unemployment which would previously have led to wage increases now does not. We might assume then that NAIRU has indeed been permanently changed in exactly the way that theory predicted it would.

Wouldn't that be an interesting story for an eminent economist to tell in his NY Times column? That the currently skewed growth in profits as against wages is simply proof that the structural changes to the welfare system last decade actually worked.

This still leaves of course the fact that after this structural change we appear to have excess unemployment. How to cure that is a subject for another day yet I am dubious about one of the prescriptions in the NYT, tax rebates for lower income families. As far as I can work out from the statistics the bottom quintile of the population pay no income taxes at all and the next one up hardly anything. Rebates to those who don't pay anything sounds rather like pushing on a wet noodle to me.

Tim Worstall is a frequent TCS contributor. Find more of his writing at www.timworstall.com


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