Fiscal Restraint and Casimir Pulaski Day

There has been considerable discussion this election year about the economic consequences of fiscal restraint.  Some economists believe that the economic recovery has been hampered by government cutbacks in particular spending programs.  A recent article in the Wall Street Journal noted that as state and local governments “get a handle on their finances” its “good news for tomorrow’s economy” but “straining today’s recovery.”

Downsizing institutions, public or private, is costly because it takes time for resources to be reallocated to other sectors of the economy.  However, wasteful government spending diverts resources from other more valuable uses and does not stimulate the economy.  There is no sensible economic argument, even in a weak economy, for delaying cuts in duplicative, ineffective or wasteful government programs.

President Obama’s jobs bill includes $35 billion of Federal aid for state and local governments to be used for teachers, police and firefighters.  Voters seem more likely to support this policy because they see the tangible benefits from this focused spending.  However, the President’s  support will dwindle if the pay and benefits of government workers seem excessive for the typical voter.  For example, a recent story in the Chicago Sun Times indicated that the average pay for a unionized Chicago firefighter is about $104,000 per year while the average full-time worker in Chicago earns $49,000 per year (according to the Bureau of Labor Statistics).

Chicago firefighters receive costly collectively bargained perks and retirement and health care benefits.  For example, firefighters in Chicago are awarded thirteen paid holidays and receive double time if they work on any holiday including Flag Day, both Lincoln’s and Washington’s birthdays, and Casimir Pulaski Day (March 4).  Democratic mayor Rahm Emmanuel is currently negotiating for limits on non-wage benefits in a new contract with the firefighters’ union (whose current five-year agreement ends in a few days).  Emmanuel is at the bargaining table with the same union leaders who helped elect him.  He knows that support for President Obama’s $35 billion spending package for teachers, police and firefighters will evaporate if voters believe that this money is not being spent wisely.

There are a number of areas where there is some bi-partisan support for government spending reductions.  The GAO recently released a report detailing $100 billion in possible savings by eliminating duplicative programs.  Senators Tom Coburn (R-OK) and Mark Udall (D-Co) and Representatives from both parties introduced legislation to eliminate duplicative government programs.  These cuts in spending will help the economy, even in the short run, and free up resources for more valuable projects.

Even wasteful government spending is difficult to eliminate because of vested interest in the status quo and the political power of government unions and contractors.  Al Gore, Jr. tried to reinvent government and Bill Clinton said the era of big government is over.  But, Ronald Reagan knew how difficult it is to achieve fiscal restraint.  He said: “No government ever voluntarily reduces itself in size.  Government programs, once launched, never disappear.  Actually, a government bureau is the nearest thing to eternal life we’ll ever see on this earth!”

Dyed-in-the-wool Keynesians believe all government spending stimulates the economy, even a holiday honoring Casimir Pulaski or an expensive junket to Las Vegas for GSA employees.  Keynesian economists who advocate government spending for its own sake are their own worst enemies.  Taxpayers will lose confidence in government solutions to economic problems if fiscal restraint is dismissed even as journalists report on government spending excesses.

The Long Road Back to Full Employment

It will take years of vigorous sustained economic growth to restore the U.S. labor market to anything close to “full employment”.  Consider the case of young adults age 20-24.  The unemployment rate for this age group has fallen from 15% to 12.9% over the past three years.  Nonetheless, the labor market for young adults is anything but healthy.  The labor force participation rate for adults age 20-24 has fallen from 73.4% to 70.8% since May 2009 because of the weak recovery.  Although there are 264,000 fewer unemployed workers age 20-24 than there were three years ago, there are also 566,000 fewer labor force participants than if the participation rate had remained steady.

As I have written in a previous post to this blog, there is an even more dramatic decline in the rate at which young adults are finding full-time work.  In May, 2000 54.3% of adults age 20-24 were employed in full-time jobs, but last month only 37.1% of adults age 20-24 were employed full-time.  If today’s labor market was comparable to 2000 full-time employment of adults age 20-24 would be higher by 3.75 million.  Some of these 3.75 million workers are currently working part-time while others are unemployed, and still more have left the labor force.

Young adults aren’t the only workers dropping out of the labor force or settling for a part-time job.  When a vigorous economic recovery finally arrives there will be millions of underemployed and unemployed workers and labor force drop-outs looking for full-time jobs.  Given the slack in the labor market and the rate of population growth, two years of employment growth of at least 500,000 full-time jobs per month would be required to restore the participation rate, the employment to population ratio, and the fraction of workers in full-time jobs to pre-recession levels.  In other words 24 straight months of growth about five times faster than what we have seen of late is needed to restore full employment.

With Friends Like These …

Fewer than one in six African-American teenagers are employed.  Only 28 percent of African-Americans who have not completed high school are employed.  Faced with these historically low employment rates for young and minority workers, it would be cruel to require employers to pay 38% more per hour for unskilled labor.  Such a mandate would certainly drive teen and minority employment down even further.  Yet this is exactly the policy that Representative Jesse Jackson Jr. (D-IL) is advocating.

The demand curve for unskilled labor slopes down.  Mandating that workers are more expensive to hire does not make them more valuable or productive to employers.  In other words companies faced with a 38% increase in the cost per hour of unskilled labor will reduce their use of unskilled labor.  An increase in the minimum wage would harm the most vulnerable participants in the labor force.  The fact that the majority of Americans support an increase in the minimum wage reflects their economic illiteracy.  The fact that most liberal political commentators and journalists support a minimum wage increase is disturbing.   

An example of progressive pundits’ flawed reasoning is last Saturday’s edition of Up With Chris, when Amy Goodman, host of Democracy Now!, and host Chris Hayes had the following exchange:

GOODMAN: it would have been a wonderful truth for President Obama to offer yesterday … when he was speaking about the economy, let`s increase the minimum wage.  Very little coverage has been done of Jesse Jackson Jr.`s introduction of the bill for the minimum wage, that would mean it would go up to something like $10, which would bring it back to 1968…. He would have massive support.  I think something like, polls show, 70 percent of people would support it.

HAYES: I agree with you. I think we should raise the minimum wage. That would be a good net positive good for people.

President Obama is very unlikely to endorse a 38% increase in the minimum wage because he knows it will kill jobs and further weaken an already fragile economic recovery.  If prosperity was that easy to achieve through legislation Congress should mandate a minimum wage much higher than $10 per hour.

It is ironic that Alan Krueger, the head of the Council of Economic Advisors, is one of the academic economists who contributed most to the misinformation about the minimum wage.  His controversial and flawed academic research with David Card on the minimum wage has been misinterpreted.  A higher minimum wage doesn’t harm all workers or all firms. Workers who compete with unskilled labor may benefit by a large increase in the minimum wage.  Unskilled labor intensive firms are harmed but their more capital-intensive competitors may benefit from a higher minimum wage.  But Chris Hayes is 180 degrees from the truth; a minimum wage increase is a net negative bad for the economy.   More importantly the primary losers are the unskilled workers directly impacted by a minimum wage increase as their employment opportunities disappear.

A higher price mandate is not the kind of “help” that firms want from government.  Companies would lobby against legislation that would raise the price of their products and services by 38%.  The same logic applies to workers; a 38% increase in the cost of hiring unskilled workers will make it much harder for young and minority workers to find employment in an already weak job market.

Waiting for the Next Tom Watson

At the U.S. Open in San Francisco, Tiger Woods appears to be regaining the form that made him one of the best golfers in history.  Comparing great golfers across generations is complicated by improvements in equipment, an increase in the number of professional tournaments per season, and differences in the strength and depth of competition on the PGA Tour.  My comparison uses the World Golf Rankings methodology applied to the four major golf championships.  Tiger Woods may never be as dominant as he was a decade ago, but he is capable of winning several major championships over the next decade.  At this point in Jack Nicklaus’ career he was challenged by a young Tom Watson, who eventually won eight major championships.  Watson was Nicklaus’ primary rival after the careers of Arnold Palmer and Gary Player faded.  Tiger’s game, and his quest for the major championship record, could benefit from the emergence of a young rival who will win multiple major championships.

Jack Nicklaus won his first major at the 1962 U.S. Open.  The following chart compares Nicklaus’ performance in majors over the next 24 years to his main rivals: Arnold Palmer, Gary Player, and Tom Watson.  Palmer was dominant in the early 1960s.  Watson was the world’s best player in the late 1970s and early 1980s.  Player was Nicklaus’ primary rival in between.

Tiger Woods won his first major at the 1997 Masters.  The following chart compares Woods’ performance in majors over the next 15 years to his major rivals: Phil Mickelson, Ernie Els, and Vijay Singh.  Mickelson will celebrate his 42^nd birthday tomorrow, Els is already 42 and Singh is 49.  These golfers’ best years of championship play are behind them.  Tiger dominated his competition between 2000 and 2003, and again between 2006 and 2009.  In between, Mickelson, Els, and Singh, a late bloomer, were playing at about the same level.  Woods, at age 36, needs a younger rival to continue to push him to reclaim the title of the world’s top player.

There are probably more young golfers, from around the world, capable of winning major tournaments than at any time in golf history.  There have been 14 different winners of the past 14 major tournaments.  The only other time, in professional golf history, with similarity parity among the world’s best golfers was when 15 different golfers won 15 major tournaments between 1994 and 1998.  What Tiger may need to break Jack Nicklaus’ record is the emergence of a single great rival, such as Rory McIlroy or Charl Schwartzel, who can play the role of Tom Watson and be near the top of the leaderboard at the next 20 major championships.  It’s unclear whether such a rival will emerge from the pack.  Until then it’s Tiger vs. “the field.”

Technical Note: The World Golf Rankings award 100 points to a golfer who wins a major tournament, 60 points for second place, 40 for third, 30 for fourth and 24 and 20 points for fifth and sixth place finishes.  The points drop steeply with rank order finish with 1.5 points awarded to any golfer who made the cut and finished 60^th or lower in the tournament.

The High Take-Up Rate for Unemployment Insurance Signals that Hiring is Weak

The U.S. Department of Labor released the 23^rd weekly report of new unemployment insurance claims for 2012.  About 374,000 workers per week, on average, applied for first-time unemployment insurance in 2012.  Bureau of Labor Statistics data also indicate that about 392,000 workers lost their jobs each week due to layoffs in the first quarter of 2012.  These are the workers for whom the unemployment insurance system can provide some relief.  Unfortunately the economy continues to plod along so that 95% of job losers file for unemployment benefits.  This is a clear indication that even experienced workers are struggling to find work.

Five years ago, when the labor market was relatively healthy, about 404,000 workers were laid off each week, but only 314,000 applied for unemployment benefits.  Many of the remaining 90,000 job losers either found a job immediately or expected to find one soon.  In a healthy labor market, as we had in 2007, over 20% of job losers didn’t bother to apply for jobless benefits because they did not expect to be out of work for long.

If today’s labor market was as healthy as in 2007, new jobless claims would be 305,000 per week – almost 70,000 less than the average for 2012.  The high “take-up” rate (95%) for the unemployment insurance system is just one indication of the problem that jobless workers face.  New college or high school graduates are typically ineligible for unemployment benefits but are also struggling to find work.  In addition, there are millions of discouraged workers who have stopped searching for work because of the weak economy.

Conventional wisdom suggests that when new jobless claims fall below 400,000 per week the unemployment rate will decline.  That is no longer true because hiring and new business formation remain sluggish and there are millions of discouraged workers that will re-enter the labor force at the first signs of a recovery in hiring.  The unemployment rate will not fall below 8% until there is a substantial increase in hiring.  A leading indicator for a hiring rebound is when new jobless claims stay well below 350,000 per week for a sustained period.

The Challenge of Measuring Labor Productivity Gains

Five out of six private sector workers are employed in service-producing (rather than goods-producing) industries.  Much of our domestic production is also in services.  There is no doubt that computers, information technology and the internet have increased the productivity of service workers, especially those in business and scientific fields, over the past two decades.  However these productivity gains are extremely difficult to measure.  The Bureau of Labor Statistics makes a valiant effort to measure labor productivity gains in service industries.  A more careful examination of the detailed productivity data released by the BLS at the end of May casts doubt on our ability to measure productivity in the service sector.

Measuring labor productivity gains in the goods producing sector is relatively straight-forward.  An increase in labor productivity occurs when more physical units of output (of a given quality) are produced per hour worked.  The biggest challenge in measuring productivity in goods-producing jobs is adjusting for changes in the quality of the good being produced.

In service-producing industries it is extremely difficult to disentangle increases in the cost of an hour of a service-producer’s time and the quantity of the services provided.  Consider a situation where the cost of an hour of a lawyer’s time increased by 20% over a five-year period.  Is that a price increase, holding the quantity and quality of services rendered?  Or are more legal services being provided per hour because of productivity gains due to the internet and improvements in computer databases.  The same question can be asked for engineers, architects, consultants or accountants.

The following chart illustrates BLS measures of productivity gains (in output per hour) in three service-producing industries between 1987 and 2010.

Productivity fell in bars (technically drinking places serving alcoholic beverages) over the past twenty-three years.  It is unclear what makes a bartender less productive.  Apparently Americans are sipping their alcoholic beverages more slowly than we were in 1987.  It is even more surprising that janitorial service providers saw a bigger increase in productivity than engineering service providers over the past two decades.  Again it is unclear whether the BLS can measure how much more productive janitors have become.  Perhaps it takes 55.7% less time to clean floors than it did in 1987.  Or maybe are floors aren’t quite as clean as they used to be.

It is imperative that we accurately measure productivity gains in the service economy when we try to measure real GDP growth and price inflation.  If productivity measures for many detailed service-producing industries are inaccurate can more aggregated measures of real output and prices be reliable?  It is a challenge to accurately measure the quality and quantity of output in many industries in our information and service-based economy.  It isn’t exciting to devote more of our resources to developing better measures of prices and quantities in these industries, but it may be warranted.

Should President Obama Suspend the Davis Bacon Act?

Professor Robert Frank argues for more government spending on infrastructure in an opinion piece in the New York Times.  Frank writes that both Mitt Romney and President Obama should be “willing to take the one politically feasible step that could help mend the economy quickly: an accelerated program of infrastructure repairs.”  Frank’s column is quite similar to one written in October 2011 by informal Obama advisor Richard Thaler, who wrote that infrastructure investments are “on sale” because of low interest rates.  Frank seconds this argument by writing “many skilled people who can do these jobs are unemployed today. If we wait, we’ll have to bid them away from other useful work. And with much of the world still in a downturn, the required materials are cheap.”

The problem, as I noted in an earlier blog post, is that labor costs for government construction projects are dictated by the Davis Bacon Act and not by competitive labor market conditions.  The Davis Bacon Act states:

every contract in excess of $2,000, to which the Federal Government or the District of Columbia is a party, for construction, alteration, or repair, including painting and decorating, of public buildings and public works … and which requires or involves the employment of mechanics or laborers shall contain a provision stating the minimum wages to be paid various classes of laborers and mechanics.

minimum wages shall be based on the wages the Secretary of Labor determines to be prevailing for the corresponding classes of laborers and mechanics employed on projects of a character similar to the contract work in the civil subdivision of the State in which the work is to be performed . . .

The prevailing wages set by the Secretary of Labor are generally substantially higher than the median wage in BLS surveys, even in areas where the construction industry has been decimated by the recession.  The following chart shows the change in construction employment in four counties especially hard hit by the recession.

One would expect that construction workers would be willing and able to work on infrastructure projects for relatively low rates of pay in these counties.  In Clark County, Nevada, for example. construction employment fell by more than one half.  Unfortunately the prevailing wages set by the Secretary of Labor for heavy construction projects in Clark County do not reflect the slack in the labor market:

• Flagperson                                                      $41.44 per hour
• Carpenter                                                        $45.11 per hour
• Structural Ironworker                                   $56.74 per hour
• Crane Operator                                               $66.75 per hour

These hourly wages are, on average, about 12.8% higher than they were in 2007 when the construction sector in Las Vegas and Clark County was booming.  The prevailing wages in Riverside, Maricopa and Miami-Dade counties are similarly high and have also increased over the past few years even though the demand for construction labor has plummeted.

Government infrastructure projects are expensive because prevailing wages are above the market wages measured by the Bureau of Labor Statistics.  High labor costs make infrastructure projects much less of a bargain than Professors Thaler and Frank have argued.

What can President Obama do? He can suspend the Davis Bacon Act until the economy, especially the housing market and construction sector, has recovered.  Suspension of the Davis Bacon Act is not without precedent in the case of a national emergency.  President George W. Bush suspended Davis-Bacon in Alabama, Florida, Louisiana and Mississippi in the fall of 2005 as the region recovered from Hurricane Katrina.

Mr. President, we face an emergency in the construction sector.  Housing prices have not recovered from the recession and employment in the construction sector is far below its pre-recession levels.  Professors Frank and Thaler are correct – it makes sense to invest in infrastructure projects when they are “on sale.”  The Davis Bacon Act stands in the way of getting important construction projects completed at a reasonable cost to taxpayers.  In addition, a bold move like suspending Davis Bacon could encourage Republicans in Congress to support other job initiatives that you favor.

Public Sector Unions and Lessons from the Elections in Wisconsin, San Diego and San Jose

Voters in Wisconsin decided to retain Scott Walker as their governor.  Last year Walker’s job security was in doubt because he dared to take on public sector unions.  In the end Walker was rehired by voters perhaps because he signed legislation that reduced the size of the state budget deficit and limited the collective bargaining rights of government workers in Wisconsin.  In San Diego voters scrapped the city’s defined benefit pension plan for city workers and replaced it with a defined contribution (similar to a 401k) plan for most new hires.  San Diegans were apparently frustrated by city government officials who repeatedly increased pension benefits for workers without finding a way to pay for higher compensation.  Pension reform also passed by a wide margin in San Jose, California, where the cost of pensions for city workers have also soared.  In San Jose government workers will either have to contribute more for their generous defined benefit pension plan or can opt in to a less generous plan.

Wisconsin, San Diego and San Jose are not generally considered places that are hostile to unions, but the message from voters to politicians seems clear.  Voters are uncomfortable with politicians receiving political and financial support from public sector unions and then negotiating for union contracts with those same unions.  Voters perceive that they are paying too much for the total compensation (including pension and health care benefits) of government workers.  The data indicate that the voters are probably correct.

It is difficult to directly compare the wages and salaries of government and private sector workers.  However, it makes economic (and common) sense that workers are much less likely to quit a job for which they are relatively overpaid.  The following chart compares the quit rates for state and federal government employees to private sector workers in the information, business services, education, health care and financial services sectors.  This comparison is more appropriate than comparing government employees to private sector workers, overall, because government employees are primarily white-collar workers whose next best private sector opportunities would be in these sectors.  The chart clearly shows that quit rates in the public sector are only about one-third the rate of comparable workers in the private sector. 

Government workers don’t quit their jobs because their compensation, including pension and health benefits, is higher than they would receive for comparable work in the private sector.  Protests from public sector unions are to be expected because no workers, even those who are relatively overpaid, want to make concessions to management.  We will have an indication that the pension and collective bargaining reforms have gone too far if quit rates in government jobs increase above those in comparable private sector jobs, and government agencies receive fewer applications per job opening than their counterparts in the private sector.  Until that happens voters can be assured that public sector wages and benefits are high enough to attract and retain workers.

Public sector unions, which were virtually nonexistent 50 years ago, are the last stronghold of the American labor movement.  Private sector unionization rates have dropped well below 10% and members of public sector unions outnumber private sector union members.  The elections yesterday dealt quite a blow to organized labor which was unable to sway public opinion.  Unions desperately wanted to oust the Wisconsin governor and members of the state Senate who neutered their ability to collectively bargain for compensation.  Expect more governors and state legislatures to follow Wisconsin’s lead, and other cities to follow San Diego and San Jose and reduce the compensation and benefits of state and local government employees.

A Second Best Response to Inefficient Tax and Entitlement Policies

Miles Kimball, an economist from the University of Michigan, blogged last week about his idea for turning the economy around: “Federal Lines of Credit” or FLOCs.  A FLOC is a government issued credit card with a line of credit of $2,000 per taxpayer ($4,000 per couple).  Money spent using the credit card would be paid back through higher Federal withholding taxes over the next five or ten years.  Kimball argues that FLOCs can deliver the biggest bang for the buck in fiscal policy.  Although Reihan Salam of the National Review Online called FLOCs “an intriguing idea” there may be better ways to address the problems that FLOCs are designed to solve.

The idea behind FLOCs is that many working class households are credit-constrained and unable to smooth consumption when their income drops in an economic downturn.  These households reduce consumption in response to a temporary decline in income because of capital market imperfections and their inability to borrow out of future earnings.  They would spend more, raise aggregate demand and improve our weak recovery if they could borrow at lower interest rates.    

A FLOC is a new government program designed to mitigate the impact of credit constraints by directly lending to households.  Working class households are credit-constrained because so little of their wealth is held in financial assets.  Part of this problem is due to our tax and entitlement policies.  Our tax code encourages wealth accumulation through home ownership instead of financial assets; retirement savings are directed into the social security system, IRAs, 401ks, and company pension plans.  Our tax code also penalizes workers for drawing down these assets to smooth consumption during economic downturns.

If the U.S. had a consumption tax, rather than an income tax, households would be encouraged to save more and fewer would be credit-constrained.  If the social security system were replaced with individual retirement accounts, where individuals could withdraw a portion of their accumulated assets or at least borrow against them, fewer households would be credit-constrained.  Households would respond to a job loss or reduction in the length of their workweek by drawing down the assets they had saved for a rainy day and consumption and aggregate demand would not fall as much.  Taxes would be paid on funds withdrawn from savings and retirement accounts but no additional penalties would be imposed.

Most middle aged and older workers have contributed a substantial amount to retirement plans that can’t easily be used to smooth consumption.  There are over 5 million unemployed workers who are age 40 and above.  Many of these workers contributed many tens of thousands of dollars into the social security system, an IRA, a 401k plan, or their pension fund.  Why introduce a new government program so that these households can borrow $2,000 to $4,000 from the Federal government?  Let these workers borrow against their own accumulated assets.  Better yet, reform these programs and the tax code so that workers are given a greater incentive to save and are not penalized for smoothing consumption.

A tax code that encourages saving and doesn’t penalize dissaving to smooth consumption and an entitlement system based on individual retirement accounts will encourage more consumption smoothing in recessions.  Smarter tax and entitlement policies will not eliminate capital market imperfections so there may still be a reason to consider FLOCs for younger workers.  I would like to see Miles Kimball, a self-proclaimed supply side liberal, advocate comprehensive tax and entitlement reform so that more households have better opportunities to maintain higher consumption levels through tough economic times.

May 2012 Welch Employment Index: The Labor Market Recovery Has Slowed

The Welch Consulting Employment Index is 94.5 for May 2012, up 1.1% from May 2011 (seasonally adjusted).  An index value of 94.5 means that full-time equivalent employment (from the BLS household survey) is 5.5% below its level in the base year of 1997, after adjusting for both population growth and changes in the age distribution of the labor force.  The index is up about 2.6% from its trough in July 2011, but almost all of the gains were in the second half of 2011.  The index is down slightly over the past three months.  The current value of the index is 6.9% lower than the pre-recession peak reached in January 2007.

The Welch Consulting Employment Index, disaggregated by gender, shows that the labor market recovery has been weaker for women than men over the past year.  Of course, men lost more jobs than women during the first year of the recession and therefore had more ground to make up in the past three years.  The index for men is 92.3 for May 2012, up 1.5% over the past twelve months, but down 7.7% from its pre-recession peak.  The index for women is 97.3 for May 2012, up 0.5% over the past twelve months, but down 6.1% from its pre-recession peak.  Finally, since President Obama took office in January 2009, the employment indices are down 1.6% for men and down 3.5% for women.

Technical Note: Full-time equivalent employment equals full-time employment plus one half of part-time employment from the BLS household survey.  The Welch index adjusts for the changing age distribution of the population by fixing the age distribution of adults to the 1997 base year.  The Welch Index adjusts for population growth by fixing total population to its 1997 level.  Seasonal effects are removed in a regression framework using monthly indicator variables.