A 6% cross the board pay cut would balance the state budgets. How?

Since early 2005, public sector pay has risen by 5% in real terms. Meanwhile, private sector pay has been flat.

This one fact explains much of the fiscal stress at the state and local level—why states such as New York, New Jersey, and California are in such a mess. State and local governments pay more than $1 trillion in compensation annually (actually, that’s an astounding number–I had no idea it was that high). If compensation is 5% higher than it should be, that’s $50 billion in excess pay costs for the state.

And lo and behold, that $50 billion would roughly cover the total size of the state budget gaps. For example, in February a survey found that the combined budget gap of all 50 states was $55 billion for the 2011 budget year and $62 billion for the 2012 budget year . (The survey was done by the National Governors Association and the National Association of State Budget Officers)

Public Sector Pay Outpaces Private Pay

There used to be a deal that government employees took inferior pay but were compensated by greater stability. I wonder if they now get both more stability and bigger raises. This data doesn’t really show that, because government and non-government workers are not really the same.  For example the government’s employees are on average better educated and more skilled.

 CLASS OF WORKER
   EDUCATION |   Private  Self empl      Gov't |     Total
-------------+---------------------------------+----------
  HS dropout |     18.38      13.70       7.86 |     16.36
     HS grad |     37.89      32.98      27.51 |     35.86
Some college |     24.44      22.93      23.75 |     24.18
College grad |     19.29      30.39      40.89 |     23.60
-------------+---------------------------------+----------
       Total |    100.00     100.00     100.00 |    100.00

In the CPS data (1976-2008), the proportion of college graduates employed in government (federal, state, and local) is roughly double that in private employment. In fact, the government employs 25% of college graduates (versus 14.5% of the population).  Therefore, looking at the differences between the two group’s income may reflect changing returns to education rather than government policy. Still, I expect  private sector janitors got much smaller raises in the last few years than government employed janitors.

I finally watched the lost finale and is in the disappointed, mildly bored, and wanting to know the answers to the questions I really cared about camp. I’m not at all dazzled or distracted by a bunch of moody and flawed people finding peace.

They promised us that they knew what they were doing all along. Having seen the opus, I don’t believe them. I have the distinct impression that they simply made it up as they went along and ran out of time. If they answered any questions we did care about, it was mostly by explaining that no, they were not important, but not convincingly. Then they raised a whole bunch of new questions but I no longer was emotionally invested.

I shared my disappointment with the makers of this college humor video:

A friend draws my attention to An Outsider’s View of Modern Macroeconomics a blog post over at Rajiv Sethi.

He has four major points about modern macro-economics:

I posted a brief comment in response, with a few constructive suggestions for mainstream macroeconomists from the perspective of an outsider. I have made these points on various occasions before, and reproduce them here (slightly edited and expanded with links to earlier posts):

1. Rational expectations is not a behavioral hypothesis, it’s an equilibrium assumption and therefore much more restrictive than “forward-looking behavior”. It might be justified if equilibrium paths were robustly stable under plausible specifications of disequilibrium dynamics, but this needs to be explored explicitly instead of simply being assumed.
2. Think about whether a theory of economic fluctuations should be shock-dependent (in the Frisch-Slutsky tradition) or shock-independent (in the Goodwin tradition). Go back and look at Goodwin’s  1951 Econometrica paper to appreciate the importance of the distinction.
3. Build models in which leverage, collateral, and default play a central role. The work of John Geanakoplos on this is an excellent starting point. He uses equilibrium theory but allows for heterogeneous priors (so differences in beliefs can persist even if they are common knowledge.) More broadly, take a close look at Hyman Minsky’s integrated analysis of real and financial activity.
4. Do not assume that flexible wages and prices imply labor market clearing. They do in equilibrium (by definition) but wage and price flexibility in disequilibrium can make matters worse. Keynes recognized this, and Tobin explored these mechanisms formally. Arbitrary assumptions of “sticky prices” are not necessary to account for persistent unemployment or under-utilization of capacity.

While these are decent ideas that if we could get anywhere with them would be likely to improve the state of modern macroeconomics, I cannot help but view this as recriminations for the murder before the autopsy. Since we don’t actually know really what caused the crisis I don’t see how we can tell if macro is really going off in the wrong direction. What do I mean? For example, It is difficult to refute the hypothesis of a rational-expectations world with sensible agents that happen to have guessed incorrectly about real world probabilities. There are probably default correlation, interest rate, inflation, and housing price paths beliefs compatible with the offered mortgage terms in the mid 2000′s. If that caused the crisis then I see little blame for economics .
I suspect that economics often focuses on foolish assumptions for modeling tractability or because the big-wigs of the profession think they are important even if the rank-and-file do not. But to know if we were really wrong I think we need to know more than we do now. This focus on recriminations is distracting us from all the important and fascinating political economy, finance, and macro-phenomena there are to learn about these days. We probably have learned more about the variance, correlation, and kurtosis of the distribution of financial and macroeconomic variables in the last 3 years than in the 50 years before them and I’d like to be talking about that.

I also think that point three is oversold. My experience is that there is massive herding behavior in the financial and intellectual areas, and so heterogeneous priors doesn’t deliver much in modeling realistic behavior. Credit is similarly important, but even despite the recession we like in a world which is the least credit constrained the world has ever seen, so I have trouble seeing borrowing frictions as an important source of economic behavior. 

I share his concern with sticky prices. I never liked them in macro courses and I still don’t. Wages really do appear to be rigid, but why? Sure, current employees don’t like wage vuts, but we see firms cu