The inevitability of debt
A barber today takes the same amount of time to cut a customer's hair as his 18th century predecessor. Credit: Getty   

What is the most important concept in economics that most people haven’t heard of?

The Baumol effect has got to be in the running, because it explains one of the great economic mysteries of the modern age: in a world that is immensely richer and more productive than the one experienced by our ancestors, why are governments and individuals struggling to get by without debt?

In particular, why are certain essential services – like social care or higher education – getting less affordable? It seems odd when there’s such an extensive range of other things – from artificial lighting to basic foodstuffs to computer processing power – that have got hugely more affordable over time.

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A big part of the answer is that while technology has enabled some occupations to become massively more productive – for instance, farming, mining and factory work – it’s made very little difference to others. To take just one example, a barber today takes roughly the same amount of time to cut a customer’s hair as his or her 18th century predecessor.

Yet despite being no more productive (on a hair cuts per hour basis), 21st-century crimpers are paid a multiple of their forebears – the service they provide therefore becoming correspondingly more expensive.

The Baumol effect, therefore, is the tendency of wages to rise in line with productivity improvements even in occupations that don’t become more productive.

That’s because if they didn’t, then workers would switch to occupations whose rising productivity did boost wages. As long as demand for, say, hair cuts remains steady (or increases), a diminishing supply of barbers would push up prices and therefore wages.

Governments tend to employ a lot of people doing things that technology hasn’t made massively more productive. Nevertheless, recruiting enough civil servants, police officers, soldiers, social workers, road sweepers, and so on requires that public sector wages remain competitive with the private sector. Hence the pressure on government budgets.

Much the same also applies to the public cost of supporting non-workers. To maintain minimum standards of social inclusion, things like pensions and welfare payment have to keep pace with wage levels. Obviously no amount of technology can improve the zero productivity of economically inactive individuals, so the Baumol effect applies to welfare budgets too.

Any politician who talks about cutting the size of the state or expanding access to public services needs to explain what they propose to do about the Baumol effect. If they don’t even know what the Baumol effect is then they’ve no business running our public finances.

But what about the escalating cost of things such as healthcare and higher education, where price increases have been running well ahead of general inflation, economic growth and wage levels, thus creating a crisis of affordability for governments and citizens alike?

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There are those who believe that these industries are abusing their market position to squeeze the rest of society. However, a new book by Alex Tabarrok and Eric Helland – Why Are The Prices So D*mn High? – puts the blame on the Baumol effect. Education and healthcare just happen to be labour-intensive industries where technology has not greatly increased the productivity of key workers like teachers and doctors; still, their salaries have to keep up with other skilled professions where productivity is increasing. Thus until the day we have robot teachers and AI doctors, education and healthcare is doomed to get more expensive.

On his Slate Star Codex blog, Scott Alexander says that this argument (if true) is oddly reassuring:

“It restores my faith in humanity. Rising costs in every sector don’t necessarily mean our society is getting less efficient, or more vulnerable to rent-seeking, or less-well-governed, or greedier, or anything like that. It’s just a natural consequence of high economic growth.”

Of course, not every affordability crisis can be explained by the Baumol effect. For instance, housing costs owe very little to wage levels. Though there is a problem with productivity in the construction sector, the overwhelming reason why the rent is so d*mn high is because of artificially constrained land supply and the unregulated greed of landlords and speculators.

One would prefer to believe that education and healthcare providers aren’t ripping us off in the same way – and are merely passing on unavoidable payroll costs.

However, Alexander uncovers evidence that there’s a lot more going on than the Baumol effect:

“…teacher salaries today are only 6% higher than teacher salaries in 1970. Meanwhile, per-pupil costs are more than twice as high. How is an increase of 6% in teacher salaries driving an increase of 100%+ in costs?”

Similarly, he finds that increases in doctors’ salaries appear insufficient to explain the rocketing expense of healthcare in recent decades.

Something else is driving up costs in these sectors – and ordinary Americans are paying the price:

“…in 1971, the average man would have had to work five months to earn a year’s tuition at a private college. In 2016, he would have had to work fourteen months… Student debt has increased 700% since 1990. College really does seem to be getting less affordable. So do health care, primary education, and all the other areas affected by cost disease.”

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As with the housing sector, the real problem is one of regulatory failure. Free marketeers blame regulators for creating unnecessary costs while state interventionists point to inaction against the exploitation of consumers.

The scary thing is that both sides are probably right.