Why This Recovery Is Different

The best explanation of why this economic recovery is both taking so long and especially affecting those at the lower end of the economic spectrum was given by economist Bryan Caplan who I quote in full here:

Nominal wages rarely fall – even when there’s high unemployment. Part of the reason is regulation, of course. But even under laissez-faire, employers have to cope with human psychology. Almost all workers think that nominal wages cuts are unfair. And while employers might be tempted to say, “Fairness be damned,” they have to face the fact that hurting worker morale hurts productivity and profits. (See here for lots of supporting evidence). [Broken link fixed.]

So how can the market get back to equilibrium? The simplest solution is to freeze nominal wages and wait for inflation to bring the real wage back to realistic levels. A more proactive solution, though, is to cut benefits, and hope workers don’t mind.

Cutting benefits sounds crafty. But on reflection, it might be even worse than cutting wages. Consider: Most workers’ main benefit is health insurance. If employers curtailed this benefit, would workers find it unfair? I don’t know of any survey research on this point, but I’ll bet that most workers would react viscerally to cuts in health insurance. Higher co-payments? Unfair! Tighter coverage? Unfair! Cheaper plan? Unfair, unfair, unfair!

It gets worse. Unlike wages, health insurance costs go up automatically – at a rate well above inflation. So even in the midst of severe unemployment, total nominal labor costs keep rising – unless employers choose to risk severe morale problems.

In past recessions, this was probably a small effect. Back in 1980, health care was only 9.2% of GDP. By 2009, this percentage had nearly doubled to 17.6%. To get a feel for the numbers, consider George Mason. My total Kaiser premium is $1448 per month. If this rises 5% per year, labor costs soar $2700 in just three years. Relative to an econ professors’ salary, that’s not much. But for lower-paid workers, it’s huge. Even if there were a “total pay freeze,” a worker who cost $30k in 2008 would cost 9% more in 2011.

My speculation: The high and rising cost of health insurance, combined with health insurance fairness norms, is a major reason why employment is recovering so slowly. If I’m right, we’ve got a serious problem with no easy solution. As always, though, we should start with the low-hanging fruit: Don’t mandate coverage, don’t punish firms for trying to control costs, and above all, don’t amplify workers’ dysfunctional beliefs about fairness with demagoguery. Sigh.

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