The Sanders Fiscal Stimulus and Verdoorn’s Law

Noah Smith on the Friedman flap:

“If Friedman and others are right, it would up end most of mainstream macro, and would force a dramatic reconsideration of economic policy. But Friedman’s paper seems far-fetched because the normal action of stimulus -- putting unemployed people back to work -- wouldn't be nearly enough to create the kind of growth Friedman projects. In addition, we would need a huge boost to the growth rate of productivity. Usually we think of productivity gains as coming mainly from technological advancements, something that is very hard for government policy to affect. The notion that fiscal stimulus, in addition to raising employment, also boosts productivity growth was first suggested in 1949 by a Dutch economist, Petrus Johannes Verdoorn. According to what's known as Verdoorn’s law, all you have to do is boost gross domestic product growth -- for example, by fiscal stimulus -- and productivity will soar as well.”

What is this Verdoorn’s Law?

The importance of increasing returns for economic growth was revitalized only in the early twentieth century by Allyn A. Young (1928), who emphasized not only the reduction in the average cost of production brought by output growth in manufacturing but also the product diversification that characterizes an increase in the division of labor. Verdoorn’s law, an attempt to quantify this relationship, is named after the Dutch economist P. J. Verdoorn, who published a paper in 1949 in which he measured the impact of economic growth on labor-productivity growth in manufacturing for a group of countries in the late nineteenth century and early twentieth century. In general terms, Verdoorn’s law implies the existence of a stable and positive causal relationship from the growth rate of output to the growth rate of productivity in manufacturing in the long run. … The theoretical foundation of Verdoorn’s law is the existence of economies of scale in manufacturing, that is, the fact that the average cost of production falls with an increase in the amount of goods produced. The sources of economies of scale within a firm or industry are usually divided into two categories: static or dynamic. Static economies of scale come from the fact that most processes of production incur a fixed cost, that is, a cost that has to be paid no matter whether anything is produced. As a result, the higher the level of production, the lower the average fixed cost per unit produced and consequently the higher the economy of scale. It should be noted that static economies of scale are reversible because, if production is reduced, the average fixed cost rises. Dynamic economies of scale come from the productivity gains associated with innovations brought about by the increase in production. The intuition here is that the dynamic economies arise from learning by doing and as such are irreversible. Even if the level of production falls, the new knowledge acquired from experience does not vanish.

There is more on the empirical inquiries that occurred after Kaldor drew attention to this idea in 1966. I have been saying Team Bernie needs to hire economists to model out the economic effects of his policy proposals. This Verdoorn effect might be something worth exploring.