Robert Reich Gets These Seven Economics "Fundamentals" Very Wrong

Authored by William Anderson via The Mises Institute,

Nearly 40 years ago, Lawrence Reed published “Seven Fallacies of Economics” in The Freeman in which he noted that much of what the public believes about economics is fallacious because most people fail to understand simple opportunity cost. Given the current trends in political economy, it is a sad certainty that most if not all of the fallacies Reed listed are still taken as economic truths in much of the academic world.

Fast forward to former Secretary of Labor Robert Reich, who now is a public policy professor at the University of California-Berkeley, and is a popular economic and political commentator on the Internet, making good use of Youtube for his lessons accompanied by board drawings. As if to counter Reed’s economic wisdom, Reich presents his “7 Incredibly Clear Economic Fundamentals.” As one will see, they not clear, they are not “economic fundamentals,” and they certainly do not represent sound economic thinking.

Reich has a brief video in which he confidently presents his “truths” to an audience I suspect believes everything he says.

For those that don’t watch the video, he lays out his seven points as follows:

  1. Workers are consumers.  

  2. Consumer spending accounts for 70% of all economic activity in the United States.  

  3. People at the top spend a much smaller portion of their incomes than people in the middle class and below.  

  4. So when most of the economic gains go to the top, there's not enough purchasing power to keep the economy moving.  

  5. Which means that in order to have sufficient demand for goods and services, a larger share of total income has to go to the middle class and the poor.  

  6. Which requires a higher minimum wage, a bigger earned income tax credit, lower taxes on the middle class and the poor financed by higher taxes on the wealthy, and stronger unions capable of negotiating higher wages.  

  7. These don't hurt the wealthy. It's not a zero sum game. In fact, the wealthy will do better with a smaller share of a rapidly growing economy than they're doing now with a large share of an economy that's barely growing at all.

While I will deal with each point individually, it is important to note what is missing: any mention of capital.

To a leftist like Reich, capital is irrelevant and actually could be harmful, since it replaces labor, and “everyone knows” that labor is the source of all value. Furthermore, Reich would argue that capital formation doesn’t come about without spending, and unless authorities find a way to “put money into the hands of the middle class,” there won’t be enough economic activity to justify any investments into capital. In other words, there will be no capital investment if there is no demand for capital, and there will be no demand for capital if people don’t have enough money to spend. (No doubt, in discussions about capital, he would refer us to Thomas Piketty, who claims that returns to capital favor the wealthy and increase the rich-poor pay gap, so that over time, capital actually shrinks the economy unless government intervenes and re-distributes income from the wealthy to everyone else.)

The way to bring about more spending, reasons Reich, is to transfer money from the wealthy to the middle and lower-income groups, since people in those categories likely will spend a higher percentage of their income on consumption goods rather than investment (or, horrors, luxury) goods. At the same time, the government should ensure that minimum wages are raised to higher levels and that labor unions should be made stronger through government policies that protect them.

So, we have the following scenario: In order to keep the economy moving, workers must be paid higher wages brought about by higher minimum wage laws and expansion of labor union power. Reich claims that these points are “incredibly clear economic fundamentals.”

The only “incredibly clear” fundamental point is this: Robert Reich is as clueless on economics as he ever has been in his public career, and one is amazed that he did not do more damage to the U.S. economy while he was at the Department of Labor. There likely is not enough cyberspace to deal with all of the fallacies that Reich has presented, but I shall evaluate what I can.

Reich: Higher Costs Equal More Wealth

A number of economists, including some on the Mises page and others elsewhere, have exposed the “consumer spending comprises 70 percent of the economy” fallacy, and those knowledgeable about Austrian Economics are familiar with Say’s Law. Thus, I will not plow that ground, since others, such as Ludwig von Mises, have expertly explained how production is what drives consumption.

Reich’s thesis is that because workers are consumers, they would benefit from having higher rates of pay, since higher pay would raise their incomes, and higher incomes would allow for them to engage in more consumption, making them better off. Any of us that have received substantial pay raises will agree that economically speaking, we were better off afterward (ceteris paribus).

In watching his video, one gets the sense that Reich truly believes that if only – IF ONLY! – business owners understood what he understands: Paying high wages leads to higher wages and higher wages lead to more prosperity. All it takes to kick start the economy into overdrive is for government to mandate higher wages, empower labor unions to force up pay for their members, and have government impose massive taxes on high income earners along with returns to capital. The only way for business owners to experience universal prosperity is for the government to force up their production costs.

While Reich’s policy demands resonate with people on the left, his ideas are utterly fallacious.

First, and most important, Reich claims that if government engages in policies that increase costs of production, businesses will prosper more. Thus, higher costs lead to higher overall incomes and more prosperity.

The supposed example of this principle in action is the famous Henry Ford decision to nearly double the pay of many of his workers from about $2.50 to $5 a day, an action which some claim created the American middle class. As the argument goes, Ford raised the wages of his workers to that they could afford to purchase the products they were making. The real reason for his actions – to reduce crippling costs associated with high turnover rates in his workforce – often is lost in the “virtuous circle” of higher pay and higher consumption rhetoric.

To put it more succinctly, we are supposed to believe that by nearly doubling his labor costs, Ford magically produced a nationwide change in consumer behavior. One can make the argument that if business owners could double their other factor costs, then the economy would boom, since all factors of production produce incomes for someone.

(Yes, I am sure that Reich proponents would argue that other factors tend to be owned by rich people, and rich people don’t spend enough on consumption goods to keep the economic “circular flow” in place. We easily debunk that argument by noting that development of all factors of production require work forces comprised mostly of employees earning regular middle-class and below incomes, and the bulk of the factor payments would go to them.)

Such backward reasoning stands in contrast to the simple fact that when producers see increases in relative costs over time, the supply of goods they create will fall, not rise, which means real prices of those goods will go up. Thus, Reich turns everything we know about productivity on its head by claiming that government policies that increase factor costs and shrink production is the key to having a strong economy.

Economies grow when entrepreneurs are able to move resources from lower-valued to higher-valued uses, a process that over time reduces the real costs to society and permits the economy to produce more wealth. Forcing up costs through government edicts does not create more wealth; it destroys wealth.

My second point deals with the heart of Austrian Economics: economics is part of human action. In the Austrian paradigm, individuals act purposefully using means to achieve desired ends. In a market setting, individuals engage in production and exchange in order to meet their needs and improve their current lot in life. People produce in order to consume, and they consume because they perceive that doing so makes them better off.

Contrast that concept to the Reich economic paradigm: people produce in order to get money and they consume in order to clear the shelves of goods so that they can produce more goods to have incomes, which then allow them to consume further, keeping the cycle going. Austrians hold that people produce to consume; Reich believes that people consume in order to produce in order to consume in order to produce, and so on. Economic exchange is nothing more than a glorified hamster wheel that has no real purpose other than to repeat itself.

Reich is not giving “economic fundamentals,” since there is nothing “economic” about what he is saying. His pronouncements are not about economics at all, but rather are anti-economic, clarion calls to destroy wealth and spread poverty.