Sunday, February 16, 2014

The Minimum Wage As Economic Alchemy


Believed in (Chemical) Alchemy

Touts Economic Alchemy Instead
A few days ago President Obama issued an executive order requiring firms that provide goods or services to the federal government to pay employees working pursuant to such contracts a "minimum wage" of $10.10 per hour, substantially higher than the current federal minimum wage of $7.25 per hour. (See here for the story.)   The requirement will take effect slowly, over time, as new contracts are awarded and current contracts renewed in the ordinary course of business. 

The President also used the event announcing the order to advocate national legislation raising the minimum wage to the same level, $10.10 per hour, which he said, was "just like" what he had done with his executive order.  The President claimed that such legislation would "is not going to depress the economy.  It boost the economy [because] it will give more businesses more customers with more money to spend.  It will grow the economy for everybody."  (See here for a video of the President's remarks.)
Any parallel between the President's Executive Order, on the one hand, and the proposed increase in the national minimum wage is illusory.  Indeed, the juxtaposition of the two policies will help illustrate why raising the minimum wage applicable to private markets will, if anything, reduce overall employment and stunt economic growth.  Assertions to the contrary, as explained below, are reminiscent of arguments by alchemists that, with enough practice, humans could learn how to transform lead into gold. 
Take the Executive Order first.  Presumably such contractors will simply pass the costs of higher wages on to the federal government.  (The Secretary of Labor claims this will not be necessary, because paying workers more will increase their productivity.  But of course if this were true firms would increase wages voluntarily so as to reap such gains.).  The federal government, in turn, will spend more to receive the same services.  If one subscribes to the Keynesian macroeconomic paradigm, the net impact of such additional spending will depend upon the method of financing it.  For instance, the government could simply raise taxes or cut spending elsewhere, thereby offsetting the stimulatory impact of increased spending for the services provided by such contractors.  However, the government could finance such additional spending by borrowing, in which case the net impact of the Executive Order on aggregate demand could be positive, partly offset, of course, by the impact of higher interest rates resulting from more government borrowing.
What, though, about the proposed legislation raising the minimum wage to $10.10 per hour in private markets? Unlike federal contractors, other private employers cannot simply pass along the entire cost of higher wages to their customers who, after all, lack the power to raise taxes or issue ever-increasing debt.  Thus, as Nobel Laureate George Stigler explained long ago, basic price theory predicts that increasing wages by legislative fiat will reduce current employment. See George J. Stigler, The Economics of Minimum Wage Legislation, 36 American Econ. Rev. 358 (1946).   After all, firms will hire any employee whose marginal product equals or exceeds the prevailing market wage. At some firms, the marginal product of the firm's least productive employee will just equal or barely exceed the prevailing wage. Legislation that coercively raises the prevailing wage by a non-trivial amount will thus force some firms to pay one or more employees more than their marginal product, an irrational decision for firms free to lay off one or more workers. As a result, the minimum wage will cause some firms to discharge one or more employees, just as a state-imposed increase in the price of steel or electricity will cause firms to reduce their consumption of such inputs.  Thus, two economists recently estimated that a ten percent increase in the minimum wage would reduce employment among minimum wage workers by between two and four percent. See Eric French and Daniel Aronson, Product Market Evidence on the Employment Effects of the Minimum Wage, 25 J. Labor Economics 167 (2007).   Some individuals will lose their jobs altogether, while some will work fewer hours in the same jobs.  The President's proposal, of course, would raise the minimum wage by far more than that, namely, by thirty-nine percent.

Of course, some on the political left continue to resist the predictions of basic microeconomic science, claiming that raising the minimum wage will have little if any impact on employment for low wage workers.  A recent post by William Poole at the Cato Institute provides some additional confirmation of the predictions that some on the left reject, as if such confirmation was necessary.  In particular a recent paper for the National Bureau of Economic Research concluded, after surveying numerous studies of the impact of minimum wage increases, that such coercive increases reduce employment, particular for low-skilled workers.  Poole's post quotes from the abstract of the paper, which summarizes its findings:

"[T]he oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries. Two other important conclusions emerge from our review. First, we see very few - if any - studies that provide convincing evidence of positive employment effects of minimum wages, especially from those studies that focus on the broader groups (rather than a narrow industry) for which the competitive model predicts disemployment effects. Second, the studies that focus on the least-skilled groups provide relatively overwhelming evidence of stronger disemployment effects for these groups."  (emphases added).

Thus, minimum wage legislation will, to paraphrase the President, mean fewer, not more, "customers with money to spend."

One might still argue that raising the minimum wage will, despite these disemployment effects, still stimulate the economy.  After all,  raising the federal minimum wage will increase the income of some of those employees fortunate enough to keep their jobs.  Such increased wages may even reflect a more just remuneration for these individuals' hard work than a purely competitive market would products.  Perhaps increased spending by these workers will offset the reduced spending by those who lose their jobs.

Unfortunately, legislation that raises the minimum wage does not magically create the money necessary to pay those employees who retain their jobs higher wages.  If it did, Congress should increase the minimum wage to $25 per hour or more!   Instead, to pay higher wages, business must reduce their profits (assuming they have profits), increase their prices (and suffer reduced sales), or both.  In other words, even if one assumes away negative employment effects,  increasing the minimum wage is  a zero sum game.  Yes, some workers will have more money to spend.  However, businesses and their customers will have less money to spend.  To be sure, low wage workers may spend a higher percentage of their income than business firms or their consumers, but even this is not certain. After all, many minimum wage workers are members of middle class or even upper middle class households. Indeed, according to one study, a significant majority of minimum wage workers are in the middle and upper classes, with the result that low income individuals receive only a small fraction (fifteen percent) of the benefits of higher wages, even assuming no negative employment effects.

In short, basic economic science informed by empirical evidence predicts that increasing the minimum wage will reduce employment, thereby reducing the number of customers "with money in their pockets."  Moreover, additional spending by those employees who retain their jobs will not offset the combination of reduced spending by those who lose their jobs, businesses who see profits fall and consumers who pay higher prices.  Arguments to the contrary rest on some form of economic Alchemy, whereby legislation that does not increase output or income but instead reduces employment magically rearranges purchasing patterns of consumers and business so as to increase aggregate demand.   The theory of chemical alchemy did not work for Rudolf II (pictured above) who, as Holy Roman Emperor, subsidized research on the topic.  Nor will it work for President Obama and those members of Congress who vote for such legislation, once again rejecting economic science.  (See also here.)

One need not rely solely upon scientific theory to rebut the claim that increasing the minimum wage will stimulate the economy. After all, the Nation has in the past experimented with the manipulation of wages as a means of inducing economic recovery, and the results were not encouraging. In particular, during the Great Depression, Congress, via the National Industrial Recovery Act ("NIRA"), imposed so-called "Codes of Fair Competition," including minimum wages, on over 500 American industries.  By coercively raising wages, it was said, enforcement of the Codes would increase "purchasing power" and thus increase workers' demand for goods and services, stimulating the economy and counter-acting the Depression.

While the Supreme Court unanimously invalidated the NIRA in 1935, see Schechter Poultry v. United States, 295 U.S. 495 (1935), Congress doubled-down on this approach to macroeconomic stabilization,  passing the National Labor Relations Act that same year.    The Act, whose preamble asserted that free market wage setting had the effect of  "depressing wage rates and the purchasing power of wage earners" required private firms to allow employees to form unions --- labor cartels --- if they wished, as a means of increasing purchasing power and thus aggregate demand.   Three years later, Congress passed Federal minimum wage legislation as part of the Fair Labor Standards Act.

While there was some popular enthusiasm for these policies, those who knew better predicted they would make things worse.   For instance, a report commissioned by Columbia University concluded that the NIRA "would make for general impoverishment and would solve the problem of 'poverty in the midst of plenty' by removing the plenty."  See Economic Reconstruction: Report of the Columbia University Commission, 20 (1934).  Moreover, as previously explained on this blog, in an open letter to President Roosevelt, John Maynard Keynes argued that the NIRA probably impeded recovery and that FDR's sympathizers in England wondered "whether some of the advice you get is not crack-brained."  Henry Simons at the University of Chicago also argued, again in 1934, that labor unions and other monopolistic combinations exacerbated the Depression by artificially raising wages and prices.   See Henry Simons, A Positive Program for Laissez Faire (1934). 

Empirical research by economic historians confirms the prediction by the Columbia Report, Keynes and Simons.  For instance, President Obama's first Chair of the Council of Economic Advisers, Christina Romer, concluded that the NIRA raised prices and wages and thus slowed economic recovery. See Christina D. Romer, Why Did Prices Rise in the 1930s?, 59 J. Econ. Hist. 167, 187-93, 197 (1999).   More recently, two UCLA economists, Harold Cole and Lee Ohanian, concluded that various New Deal policies, including the NIRA and NLRA, both deepened and lengthened the Great Depression, particularly by artificially increasing wages. Indeed, these scholars conclude that these policies prolonged the Depression by seven years.  (See also pp. 1664-66 of this source summarizing the findings of Professors Romer, Cole and Ohanian.)

None of this is to say that States or even the national government should stand idly by while some individuals are unable to earn enough income to lift themselves and their families out of poverty.  Instead, in the opinion of this blogger, society should take steps to increase the rewards that individuals receive for work.  Fortunately, society has already put into place a mechanism to do just that, namely, the Earned Income Tax Credit.  Indeed, according to this tax calculator, an individual with two children who earned the minimum wage at a full time job would pay no federal income tax and also receive a $5,372 refundable tax credit in 2012.  The same individual would also receive $2000 in refundable child tax credits combined,  thereby increasing his or her effecive wage to over $10.00 per hour and household income by more than 40 percent.  It is thus no surprise that, in a 2013 Op-Ed, Professor Romer, mentioned above, endorsed increasing the Earned Income Tax Credit instead of increasing the minimum wage.  Such an approach would also help stimulate the economy, at least according the Keynesian paradigm, so long as the government borrowed the money necessary to pay for such increased spending.   Hopefully "cooler heads will prevail," and Congress and the President will follow Professor Romer's advice instead of clinging to economic theories that, like Alchemy, were debunked long ago.