She wants to give you a raise.

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Can Government Raise Wages? It's Worth a Try

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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One of Hillary Clinton's economic policy ideas is that the government should try to push up wages. Japanese Prime Minister Shinzo Abe has also considered such a policy, and it has received enthusiastic support from economists such as Princeton’s Alan Krueger and Alan Blinder. But John Cochrane, a senior fellow at the Hoover Institution and a former University of Chicago finance professor, is bitterly opposed:

As economists, we are supposed to start with a problem. What is the market failure that stops companies form putting in productivity enhancing profit sharing programs? ... The idea that forcing companies to pay out greater wages is … brand-new, made-up-on-the spot economics, designed to buttress policies decided on for other reasons.

Is Cochrane right? Certainly, 10 or 15 years ago, the idea that politicians could force up gross domestic product by pressing companies to raise wages or share profits would have been considered a fringe idea. Should society give this idea serious consideration?

It all comes down to the burden of proof. Should we assume that markets work well, and that a special reason is needed in order to try an intervention? Or should we assume that there are all kinds of opportunities out there for tinkering to work, and try them out without first getting a theoretical consensus?

It’s important to see the big picture here. Every economics student learns about the “equity-efficiency tradeoff.” This is the idea that government can redistribute wealth from rich to poor, but only at a cost -- the more redistribution gets done, the more overall economic output shrinks. The classic metaphor is that of a leaky bucket: While you’re carrying water from one person to another, some of it leaks through the bottom and gets wasted.

But sometimes this analogy doesn’t work. There are cases when government tinkering with the economy can actually increase overall productivity. These are called “market failures,” because they represent situations where the unfettered free market isn’t optimal. Classic examples include pollution, monopolies and scientific research. Strategic interactions, in particular, can lead to a lot of market failures, as in the infamous Prisoner’s Dilemma.

A crucial question is how common market failures really are. If they’re rare, then only in extreme situations should we have the government intervene to improve the economy. That has been the default assumption of most economists for decades. But some people believe that such circumstances are a lot more ubiquitous. British economist John Kay has proposed that market failure should be seen not as a limited set of special cases, but as the norm.

If that’s true, then we shouldn’t need to wait for theoretical justification in order to try out new policies designed to improve productivity. If market failures are everywhere, there’s a decent chance that any given policy intervention will hit one, even if we don’t know what it is in advance.

Let’s take wage policies as a case in point. Some people have suggested government incentives for companies to adopt profit-sharing plans. Evidence shows that when companies do this, their productivity tends to jump up by a modest amount -- maybe around 4 or 5 percent.

Is this causation, or just correlation? Cochrane asks: If profit-sharing makes companies more productive, why don’t all companies do it? It’s a reasonable question. In 1990, economists Martin Weitzman and Douglas Kruse pondered it. They conclude:

A society’s labor payment system seems to be one of the more likely candidates for historical inertia, institutional rigidities, and imitation effects. The profit sharing-productivity link is obviously complicated and depends on different environmental factors, some of a public-goods nature.

 

This is a very John Kay style argument. Basically, Weitzman and Kruse -- two highly respected economists -- essentially shrug, and say, “Look, lots of stuff is going on; maybe the government can help.”

I tend to find Weitzman and Kruse’s attitude, and John Kay’s, more compelling than Cochrane’s. The economy is so complicated that it will probably be many decades before we understand all of its deep structures and mechanisms -- if we ever do. We shouldn’t wait to try policies until there’s a compelling, watertight theoretical case, because in econ there rarely is one.

That doesn’t mean we should cavalierly go around initiating government programs on the off chance that they might be helpful. Even when markets fail, government is sometimes too incompetent, politicized or unwieldy to improve the situation. Also, trying out policies has risks -- if an intervention ends up hurting rather than helping, people’s livelihoods will suffer.

So I suggest an intermediate position: Go slow. Experiment with policy interventions like minimum wage hikes, wage subsidies and profit-sharing incentives. Try them out in limited locations -- just one or two states, for example. Don’t try out extreme versions first -- go for a light touch until the initial evidence comes in. Then see how the pilot program works, make sure the evidence is scrutinized carefully, and -- if the policy shows unambiguous good results -- expand it to the federal level.

Economic policy shouldn’t be enslaved forever to free-market assumptions. But government policy is powerful stuff, and we should use it cautiously. As the Deng Xiaoping, a pretty successful policymaker, once said, we should “cross the river by feeling the stones.”

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
Tobin Harshaw at tharshaw@bloomberg.net