John Feehery: Speaking Engagements

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Baumol’s Cost Disease

Posted on May 15, 2009
Baumol’s Cost Disease

I ran into a good friend of mine, who works on the Senate Finance Committee. He is the kind of guy who thinks about abstract economic theories and tries to apply them to the real world. He has been a veteran of many political wars, and served on the Committee the last time they took up a big effort to nationalize health care in this country.

This long-time staff member told me about an economic theory called Baumol’s Cost Disease, an economic theory about the rising wages of service sector jobs.

As Wikipedia defines it: “Baumol's cost disease (also known as the Baumol Effect) is a phenomenon described by William J. Baumol and William G. Bowen in the 1960s. It involves a rise of salaries in jobs that have experienced no increase of labor productivity in response to rising salaries in other jobs, which did experience such labor productivity growth. This goes against the theory in classical economics that wages are always closely tied to labor productivity changes. The rise of wages in jobs without productivity gains is caused by the necessity to compete for employees with jobs that did experience gains and hence can naturally pay higher salaries, just as classical economics predicts. For instance, if the music industry pays its musicians 19th century style salaries, the musicians may decide to quit and get a job at an automobile factory where salaries are commensurate to high labor productivity. Hence, musicians' salaries are increased not due to labor productivity increases in the music industry, but rather due to productivity and wage increases in other industries.”

So, why is this obscure economic theory important?

When Hillary Clinton tried to pass her health care plan in the early nineties, she ran into one Democrat who knew something about obscure economic theories, Daniel Patrick Moynihan. Moynihan was very skeptical of the cost figures that Clinton’s people were citing because he knew that they were ignoring Baumol’s theory. The Clinton team assumed efficiencies and increased productivity from government-run health care that Moynihan thought would simply not occur. But what would occur was wage-inflation, which would make the Clinton program even more expensive. As Moynihan said in his book, Miles To Go, “Activities with Baumol’s disease migrate to the private sector. It follows that it will be the undoing of modern government if too much migration is allowed. And so I approached universal health care with caution.”

Moynihan had been involved in a dispute with the New York Metropolitan Orchestra. The band members wanted to get paid more, but that demand for more pay was not accompanied by any increase in productivity. After all, it takes about as much time to do Mozart now as it did a hundred years ago. So the solution they all came up with to deal with this budget problem was to get money from the National Endowment for the Arts, which, course, is funded by the taxpayers. Moynihan saw the same dynamic happening to health care, and he was very wary of such a move, because he thought it would bankrupt the country.

My friend on the Senate Finance Committee fears that the Obama Administration is making the same economic assumptions as the Clinton team. He also fears that they are ignoring Baumol’s cost disease theories.

This obscure economic theory can be boiled down to one central fact. The government is going to take on a huge funding liability that puts our nation is worse financial shape in the long run. Ignoring Baumol’s cost disease will almost certainly make America more financially unhealthy in the future. Where is Daniel Patrick Moynihan now when we really need him?