Month: November 2015

The Democratic Presidential Debate, Economic Literacy, and the Minimum Wage

Theodore A. Gebhard

During last Saturday’s Democratic presidential debate Vermont Senator Bernie Sanders, Former Maryland Governor Martin O’Malley, and Former Secretary of State Hillary Clinton vigorously competed to display which one is most earnest in his or her support of raising the federal minimum wage.  In so many words, each claimed that it is necessary, as well as compassionate, to raise the minimum wage so that people can more easily rise to the middle class.  The argument is that if incomes are too low for some people, a law mandating higher incomes is justified.  Mrs. Clinton was a bit more nuanced, noting that the cost of living differs locally and thus, according to her reckoning, states and cities should implement minimum wages even above her proposed higher federal minimum wage of $12 an hour, if appropriate for a given locality.

Notwithstanding the substantial intrusion into economic affairs that governments at all levels undertake in contemporary times, I have long ago foregone any hope that political figures will take it upon themselves to obtain even a modicum of economic literacy before formulating their economic policy proposals.  Many, if not nearly all politicians, claim that reason and science should inform government policy, but few, if any, manifest any understanding that there are irrefutable laws of economics that cannot be repealed or altered by political action.  As a consequence, few areas of public policy are subject to more demagoguery than economic policy.  Minimum wage laws are a poster-boy-like example of such demagoguery.  Such was on great display in the presidential debate.

One of the most fundamental laws of economics is the law of demand, which states that as the price of something rises, the quantity purchased will decrease in a given time period, and vice versa.  The law rests on the fact that, in the real world, resources are scarce, and thus the process of satisfying human wants and desires requires making choices among alternative uses of those scarce resources.  Relative prices determined in free markets facilitate this process by permitting persons to make spending decisions out of a limited income according to the value they obtain per dollar spent on a good or service.  The lower the price, the higher is the value per dollar spent.  The higher the price, the less is the value per dollar spent.  Hence, if the price of something goes up – thus reducing the value per dollar spent – less will be purchased as other goods and services become a better bargain.

Artificially controlling specific prices in the economy distorts this process and creates inefficiency in resource allocation, as relative prices no longer fully reflect market forces driven by consumer preferences.  Wages are prices.  Hence, if wages for unskilled labor are artificially set above the market determined wage by means of minimum wage legislation, less unskilled labor will necessarily be purchased per period of time.  Moreover, the structure of wages throughout labor markets – skilled as well as unskilled – will be distorted, and economic efficiency will be compromised.  These outcomes are givens, and economists have known about them for a long time.

Why then do minimum wage laws persist?  Are not the harmful effects sufficient for voters to reject politicians who push these laws?  The answer, I believe, is that, although the harmful effects are real, they are generally not immediately visible, while the superficial, demagogic appeal of minimum wages is easy to articulate.  This appeal has several components, each of which was stated during the Democratic debate.  First, it is argued that raising the minimum wage will have a (politically) desired redistributive effect (Bernie Sanders).  Second, it is argued that raising the minimum wage will help to elevate people – particularly unskilled workers — into the middle class (Martin O’Malley and Hillary Clinton).  Third, it is contended that the empirical data show no significant adverse impact on employment because of raising the minimum wage, and therefore there is no downside to doing so (Hillary Clinton).

None of these claims, however, lives up to its full billing.  For example, even accepting a goal of income redistribution, minimum wage laws are a highly inefficient means to accomplish this end.  This is not controversial among economists.  Whatever income redistribution raising the minimum wage achieves, that redistribution is likely temporary at best, as employers adjust to the higher wage rate over time by substituting to other inputs such as new technology.  In addition, it only raises the income of those who continue to keep their jobs.  To the extent that the higher wage rate causes, at the margin, others to lose their jobs, their income falls to zero.  And, finally, the distribution comes at the expense of distorting relative prices, which can be considerable depending on the size of the wage hike.  In point of fact, there are far superior mechanisms to achieve income redistribution such as simple cash payouts or a negative income tax.  Either of these measures ensures that the incomes of the entire targeted group increase, and both avoid compromising efficiency because of price distortion.

As for elevating lower income people into the middle class, raising the minimum wage again is highly inefficient.  Vast amounts of evidence indicate that rising incomes are best achieved by education, stable families, and cultural factors such as personal discipline and a strong work ethic.  Entry level jobs – even at low wages – help to foster the personal characteristics, especially among young people brand new to the workforce, necessary to succeed in a work environment and eventually advance into higher paying positions with greater responsibility.   In addition, in few households is the primary income earner a minimum wage worker.  In fact, most minimum wage workers are younger than 24 years old.  (See here.)  Hence, although raising the minimum wage may have some impact on household income, the impact will be small.  A far better emphasis for public policy directed toward building the middle class would be on augmenting incentives for skills acquisition and maintaining stable families.

Mrs. Clinton’s assertion that the empirical evidence “shows” that there is little or no impact on employment following a hike in the minimum wage is similarly flawed.  It is indeed possible to construct studies that yield this result.  In so doing, the studies seemingly refute the basic law of demand.  In fact, however, they do not.  Rather, such studies rest on highly selective data (undisclosed by Mrs. Clinton) that severely cabins the contours of the analysis to exclude either one of two critical factors, or both, that otherwise explain the anomaly.  The first is that when the market wage for unskilled labor has risen above the existing minimum wage because of inflation the latter has no effect on employment rates.  The minimum wage is no longer a floor.  It serves no purpose.  Under these conditions, if the minimum wage is raised anywhere up to but not exceeding the market wage, it is perfectly consistent with the law of demand that there will be no significant employment effects.  Only when the minimum wage is hiked above the market wage, will employment effects take place.  Hence, data that selectively exclude wage hikes that actually exceed the market wage necessarily mislead on the question of employment impact.*

A second explanation for selective data showing little or no employment effects concerns the time frame considered.  In the immediate aftermath of an increase in the minimum wage, many, if not most, employers have capital equipment fixed in place.   In the short run, it will not be possible in many instances to substitute away from labor to a more capital-intensive production environment.  Thus, there may be little immediate job loss.  Over time, however, this will change as equipment wears out and is replaced, and as entry of new capital takes place.  For example, when I was growing up, most elevators required full-time human operators, engaging personally with bank tellers was the only way to withdraw funds from an account, and there were no self-checkout lines at grocery stores.  Today, none of these conditions is true.  Of course, one cannot claim that each of these changed conditions was solely caused by successive hikes in the minimum wage over the years, but undoubtedly those hikes contributed to the long run substitution away from low and unskilled labor in these occupations.  Moreover, this transition certainly took place in innumerable other sectors of the larger economy.

Finally, I want to close with a comment about union support for the minimum wage.  Although historically unions have been a strong Democratic Party constituent, it would seem odd, at least on the surface, that unions would much care about minimum wages.  Union jobs, after all, are typically at hourly wages much higher than the minimum wage.  There are at least two reasons, however, why unions can be counted on to advocate for higher minimum wages.  First, many union contracts contain clauses that structure union wages relative to the minimum wage.  That is, the union pay scale should always, in relative terms, be some percentage above the lowest pay scale.  Hence, when minimum wages are hiked, the union pay scale is similarly adjusted upwards.  Second, it is in the interest of skilled union workers to have the wage rates of unskilled workers continually increase.  Suppose for example that a particular task could be performed by two unskilled workers in an hour or one skilled union worker in an hour.  If the wage rate for unskilled work were $5 /hour and the wage rate for skilled work were $11/hour, the employer can be expected to employ two unskilled workers to do the task at a total of $10/hour.  Now suppose the minimum wage is hiked to $6/hour.  Under this circumstance, the employer will hire the skilled union worker at $11/hour, as the two unskilled workers would now cost $12/hour.  The higher minimum wage not only priced the unskilled workers out of the market, it also created a demand for union work.

In sum, the Democratic presidential debate on Saturday night revealed a great deal of departure from economic science among the three candidates.  This departure was especially apparent in the Q&As concerning the minimum wage.  Even more troubling is the possibility – and perhaps even probability as it concerns Mrs. Clinton – that the economic hokey pokey did not entirely owe to economic illiteracy, but rather owed simply to deliberate political demagoguery to gain votes at the expense of serious thought.

Addendum:   In watching the debate, I could not help but be reminded of the incessant cant from the political left about the alleged consensus among scientists concerning climate change and global warming.  On the basis of this alleged consensus, the science is supposedly settled, and outlying views are to be shunned and ridiculed.  Yet, as the basis for her assertions about the minimum wage, Mrs. Clinton solely cited former Obama White House adviser Alan Krueger, who co-authored a study of the impact on fast food employment in New Jersey and Pennsylvania following an increase in the minimum wage in those states.  The study, published in 1994 and using early 1990s data, claimed to find insignificant employment effects.  This study, however, is the poster boy of outlying studies concerning minimum wages, has often been criticized on methodological grounds, and runs contrary to the “consensus” among economists about the actual employment effects of minimum wage laws.  Mrs. Clinton’s hypocrisy on this score is stunning.

Notes:

* A simple example demonstrates the law of demand in this context.  Suppose the tasks performed by a worker earning $5/hour contribute $5.25/hour in incremental revenue to the employer.  Each hour thus generates $0.25 in accounting profit for the employer.  In fact, under this circumstance, it would pay the employer to pay the worker any wage up to $5.25/hour.  Now suppose the minimum wage is hiked to $5.50/hour.  Absent any concurrent increase in productivity on the part of the worker, it no longer pays the employer to keep the worker and the job is lost.  At the margin, all such workers will be let go.

Mrs. Clinton seems to understand this concept.  At Saturday night’s debate, she stated that she favored an increase in the federal minimum wage to $12/hour, but not to $15/hour.  But why?  From a worker’s standpoint, $15/hour is better than $12/hour, and will produce a higher annual income.  Indeed, why not increase the minimum wage to $100/hour and elevate everyone to the higher end of the middle class?  Implicit in Mrs. Clinton’s reluctance to go higher than $12/hour, at least at the present time, is surely a recognition of the adverse employment effects that the minimum wage produces.

Business Acumen and Economic Understanding

Theodore A. Gebhard

In a recent Wall Street Journal op-ed, Republican presidential candidate Donald Trump asserted that the Chinese government imposes a de facto tariff on all imported goods by intentionally devaluing the yuan.  (“Ending China’s Currency Manipulation,” Nov. 10, 2015)  According to Mr. Trump, the undervalued yuan makes international trade unfair and hurts China’s trading partners.  By Mr. Trump’s reckoning, it particularly hurts the United States by weakening American industry and costing millions of jobs.  He goes on to say that he will designate China a “currency manipulator” on day one of his presidency, if elected.  In addition, he will impose countervailing duties on “cheap Chinese imports” as retaliation for the unfair currency manipulation.

On the day after Mr. Trump’s op-ed, Mr. Doug Parker and Mr. Keith Wilson lament, also in a Wall Street Journal op-ed, that the United Arab Emirates and Qatar unfairly subsidize their respective airlines with massive cash infusions.  (“Rigging the Game on Open Skies,” Nov. 11, 2015)  Mr. Parker is the chairman of American Airlines Group and Mr. Wilson is president of the Allied Pilots Association.  Like Mr. Trump, Messrs. Parker and Wilson claim that these subsidies hurt the United States by costing hundreds of thousands of jobs in the American airline industry.

The views of Messrs. Trump, Parker, and Wilson are hardly unusual among business leaders and corporate executives.  A quick look at the International Trade Commission’s website reveals that the ITC currently has some 30 active “import injury” investigations open and another 12 active “anti-dumping and countervailing duty” investigations.  These investigations seek to determine if imports are priced “unfairly” and thereby cause injury to specific U.S. industries or companies.  The current investigations run across a wide range of products, including among others chemicals, various steel and iron products, bricks, sundry welded products, woven ribbons, plastic tape, copper products, sugar, uncoated paper, plastic bags, wooden bedroom furniture, and even tissue paper and ironing boards.  All of these investigations are responses to U.S. companies’ claims of injury owing to unfair import competition.

Each of the above-described contentions illustrates an important – yet, unfortunate — fact, namely that mercantilist views run strongly among business leaders and corporate executives.  This is particularly regrettable whenever such leaders and executives take to a public forum and mistakenly equate their knowledge of business with knowledge of sound economics.  In point of fact, business and economics focus on quite different matters.  The danger of equating business acumen with authority on economics is that the former’s narrow focus on business success leads to the promotion of policy prescriptions that, although beneficial to parochial interests, are often harmful to the general interest.  Protectionism is perhaps the most blatant and harmful example of this phenomenon.

Case in point are Messrs. Trump, Parker, and Wilson.  Although all three claim to be supporters of free trade so long as it is “fair trade” and promotes American prosperity, each defines success only in terms of mercantilist metrics.  Specifically, each looks to export growth and job creation as the measure of a successful trade policy.  This perspective, however, stands in direct contradiction to Adam Smith’s central point that the wealth of a nation is measured, not by the quantity of goods that it sends to other nations or by resource employment, but by the amount of goods and services available for consumption by its citizens.

In his seminal book, An Inquiry into the Nature and Causes of the Wealth of Nations, Smith explained (as I discussed in greater detail in an earlier post here) that the sole objective of economic activity in a world of scarcity is consumption.  If human beings did not need to consume or if there were no scarcity, there would be no need for economic activity, let alone trade or trade policy.  Under real world conditions, however, people not only need to consume to stay alive but also possess wants and desires for goods and services that go far beyond the basic necessities.  Scarce resources must therefore be constantly employed to produce those goods and services.

In terms of trade, Smith went on to explain that, rightly understood, exports are a cost to a nation and imports are a benefit.  Exports mean that a nation’s scarce resources, including human employment, are being used up for another nation’s consumption benefit.  By contrast, importing goods and services allows a nation to consume while conserving scarce resources for deployment in other productive activities, thus expanding domestic production of consumable goods and services and permitting even greater rates of consumption.  The result is an increase in the nation’s total wealth.  Exports, and the resources that go into those exports, are the price a nation must pay for its imports.  As with all exchanges, the lower the price the greater the surplus value to the buyer.

Given this central tenet of economics about the genuine wealth of a nation, whenever the United States can obtain goods and services more cheaply by means of importing them than by producing them domestically, it benefits.  U.S. consumers are made better off.  This benefit will accrue regardless of why the imported goods are cheap, i.e., even if they are cheap because of subsidies or so-called currency manipulation.  Indeed, if subsidies or artificially undervalued currency is the reason, the true harm falls on the citizens of the nations providing the subsidies or “manipulating” their currencies.  Not only are those nations using up their scarce resources for the benefit of American consumers, but their citizens are being taxed to fund the subsidies and are being exposed to higher domestic prices because of the undervalued currency.  It is a double whammy.

What is more, instead of a cost to the United States, the “jobs lost” that Mr. Trump and Messrs. Parker and Wilson claim occurs because of “unfair” trading practices are actually necessary to expanding domestic wealth. The freed up human and other resources are now available for new productive uses or for increasing the output rate of existing productive activities.  The available consumption pie is necessarily enlarged.  By contrast, the logical end of the Trump, Parker, and Wilson mercantilist argument is either autarky or at least significantly diminished trade, either of which must result in lower living standards for the American people.

To be sure, whether owing to market fundamentals or external foreign government policies, the vicissitudes of the international movement of goods and services, as well as capital, will result in certain industry-specific disruptions and transactional costs to individuals.  This inevitable consequence is by all means a basis for a compassionate nation to lend support to those who require retraining and other transitional assistance, but it is not a basis for protectionism and lower living standards.  To the contrary, every time that China devalues the yuan or another country subsidizes its export industries, we Americans should give a hearty thanks for the gift.