Thursday, December 17, 2009

Could A Lower Minimum Wage Boost Jobs?

Mark Thoma outlines his argument that reducing the minimum wage is not an effective approach to improving this particular economic crises. Some of the problems of this approach are that firms have too much excess capacity to hire and employees will have less money to spend. See the following post from Economists View.

Conservatives are using the recession to revive their long-standing opposition to the minimum wage. The argument they are making this time is that cutting the minimum wage will add substantially to employment, and this is starting to get some attention in the press. But a cut in the minimum wage would likely make things worse, not better.

Why? There's a more sophisticated story below, and I may be oversimplifying too much, but basically when things are bad -- when firms cannot sell all that they are (or could be) producing -- a cut in the wage does not generate any new employment, it simply reduces income. Why hire more people when you aren't selling anywhere near to existing capacity (in the story below, even if interest rates did fall as a result of the wage cut, I don't think it would generate much investment due to the excess capacity that firms have)? In fact, the reduction in income from the fall in wages makes it even harder to sell the goods that are (or could be) produced, and that will cause firms to lay off even more workers, which lowers income even more, and a downward spiral ensues.

The point is that in a severe recession, a cut in the wage rate may not generate any new employment, instead it simply lowers income and demand, and that makes things even worse.

Here's a more detailed version of the story:

Would cutting the minimum wage raise employment?, by Paul Krugman: It seems that more and more Serious People (and Fox News) are rallying around the idea that if Obama really wants to create jobs, he should cut the minimum wage.

So let me repeat a point I made a number of times back when the usual suspects were declaring that FDR prolonged the Depression by raising wages: the belief that lower wages would raise overall employment rests on a fallacy of composition. In reality, reducing wages would at best do nothing for employment; more likely it would actually be contractionary.

Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.

But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. And why should it do that?

Well, the textbook argument — illustrated in this little writeup — runs like this: lower wages lead to a lower overall price level. This increases the real money supply, and therefore liquidity. As people try to make use of their excess liquidity, interest rates go down, leading to an overall rise in demand.

Even in this case, it’s hard to see the point of cutting wages: you could achieve the same effect, much more easily, simply by having the Fed increase the money supply.
You can view the rest of this article at the New York Times site.

This post has been republished from Mark Thoma's blog, Economist's View.

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1 comments:

January 21, 2010 at 8:39 AM Anonymous said...

Fallacy with the fallacy: why is there an assumption that current wages would decrease? If the lowering of minimum wage applied to anyone entering the work force (or starting a new job), businesses can hire more employees at a lower rate to produce more products/services. Any good business is looking to drive more performance (hence the reasoning for outsourcing to cheaper labor). While at it, dramatically lower the taxes on business to allow them to have more cash flow to circulate in the market.

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