Economic growth, the minimum wage and sloppy economic thinking

Gerard Jackson

Now for some light entertainment. A number of leftists absolutely adore Ross Gittins (economics editor of the Sydney Morning Herald and an economic columnist for The Age). While these leftists rhapsodise over Mr Gittins’ unparalleled grasp of economics I find myself less than impressed with his opinions.

So how good is Gittins? On reflection, that should read: Just how bad is Gittins? Last July he revealed his deep understanding of economics in an article in which he basically agreed with certain so-called economists that there is no direct link with the minimum wage and the unemployment rate of marginal labour1. (Minimum wage rises don’t lift unemployment, analysts agree, Sydney Morning Herald, 12 July 2014). However, this post is not about Gittins’ failure to understand what is happening in the field of economics with respect to the minimum wage but his history of sloppy economic reasoning, of which the aforementioned article is one of his most recent examples.

I still recall with a certain amount of glee his laughable prediction that as baby boomers retire unemployment will fall. (Generation gap to create jobs turnaround, Sydney Morning Herald. 4 April 2001) and that this process would begin in 2002 after which labour shortages would emerge in about 2005 and then the shortages would worsen as the number of retirees continued to exceed the number of people entering the workforce. Yep, thanks to an army of cheery retirees happy days would be here again — and that’s why the Australian economy is now experiencing a severe labour shortage accompanied by rapidly rising wages.

Gittins’ was presenting a clear cut case of supply and demand in operation2. What Gittins was saying is that fewer workers mean that the supply curve for labour will shift upwards, widespread persistent unemployment will disappear and real wages will rise. The problem will then be one of labour shortages. Where will the labour come from to satisfy the demand of retirees? This is where his argument collapsed.

The supply and demand element of Gittins’ article was about the only thing he got right, though to be fair, he did say that his argument came from Population Ageing and the Economy, a paper produced for the then-Minister for Aged Care by Chris Richardson of Access Economics. So let us look at what Mr Richardson and Gittins had to say about the causes of unemployment. According to Gittins “people of working age may not have jobs: because they’re full-time students, because they’re at home rearing children — or because they’ve retired before they turned 65.”

All of this is perfectly true. It’s also totally irrelevant. What we are concerned with are not people who simply volunteer to leave the workforce but those who are able and willing to work but can’t get jobs. This brings us to Richardson’s fatuous opinion that “levels of unemployment through the 1980s and 1990s were partly explained by demography.”

Gittins’ statement about a “shortage of work” was just as fallacious as Richardson’s assertion about demography and unemployment. I’ll even go so far as to call them economic absurdities. Economics tells us that so long as there is sufficient land and capital available and labour markets are allowed to clear there can be no such thing as persistent widespread unemployment, despite Keynesian fallacies to the contrary.

That Australia has always had more than sufficient land and capital to employ everyone is indisputable. It also follows from this that the idea that there can be a shortage of work is ludicrous. How can such a situation exist while human wants are unsatisfied? To go any further on this matter would be to unnecessarily labour the point. It becomes clear, then, that the problem is one of over-priced labour. In other words, gross wage rates are above their market clearing values. (The gross wage is the total cost of labour to the firm). That the problem is one of over-pricing was tacitly admitted by Richardson when he said that “slowing down the labour supply will reduce underemployment”.

The question of underemployment was also raised. But underemployment is merely another name for sub-optimal employment, of which there are basically two forms. The first one occurs where factors are driven into alternative lines of production where the value of their output is less than the lines of production from which they have been excluded. This means that workers are underemployed when they have been priced out of jobs where their marginal product is more highly valued by the market. The second form emerges when short-time working is introduced. This sometimes involves work-sharing. This happened extensively under the Roosevelt administration.

So what Gittins’ argument amounts to is that the supply of labour will fall as the number of retirees increase. This fall in the labour force will then eliminate unemployment. Looked at in this light there is nothing special about this situation. On the contrary, once we apply economic reasoning to explain it we come to immediately understand the root cause of persistent widespread unemployment. We then find this glaring fallacy in Gittins’ article. He stated:

When the demand for goods and services runs well ahead of the supply of workers available to produce them, you get wages being bid up as businesses try to pinch each other’s employees, inflation taking off, profits being squeezed and an explosion in imports.

This is sheer nonsense. As I said earlier, a reduction in the labour force leads to an upward shift in the supply curve of labour (I use labour figuratively because the reality is that labour is not homogeneous and there are only labour markets, not one single market) which means that the supply curve will rise to meet the demand curve. Now the demand curve is no more than a descending schedule of labour’s marginal productivities, meaning that as you move up curve the value of labour services rise.

It should also be clear that the employers cannot pay more than the value of the worker’s service. That real wages actually increase is entirely due to being employed in higher valued lines of production. Those firms whose revenue is squeezed to the point of bankruptcy are firms that the new labour situation rendered sub-marginal. There is nothing inflationary about this. (The situation in England after the Black Death struck in 1348 provides a graphic historical example of this process at work). However, a situation where capital accumulation exceeds the rate at which the workforce grows is one in which real wages rise for everyone despite an increased labour supply. This is because capital accumulation lifts the demand curve for labour and shifts it to the right.

Now the only way that prices could rise is that if output lagged behind the money supply or there was a drop in total output relative to the money supply. Therefore, demand can never run ahead of output or labour services: the reason being that outputs are demands. Put another way, supplies constitute demands. Goods, not money, pay for other goods. Money is merely an indirect way of bringing these exchanges about. But what can run ahead of output is the money supply. This is what could cause prices to take off and imports to explode, not Gittins’ mythical labour shortage.

However, a genuine labour shortage could appear when a country’s capital structure expands at such a rate that the labour supply fails to keep up with it. I believe such a situation may have occurred in Germany during its period of rapid capital accumulation in the 1950s and 1960s. During the ’50s and ’60s with the result that the country imported what it called ‘guest workers’3. This leads to the conclusion that the only real and sensible way of continually raising real wages for everyone, and hence the standard of living, is to encourage capital accumulation.

Note:The subject of growth and real wages certainly requires a more detailed treatment. For example, the classical economists understood that economic growth is forgone consumption. Therefore, if governments implemented policies that successfully encouraged greater consumption at the expense of business spending then at a certain point the accumulation of capital would not merely have been significantly slowed down but will have gone into reverse, bringing about a process of capital consumption. Real wages would then have to fall. John Stuart Mill was expressing the classical view on this matter when he wrote:

The circulating medium existing in a country at a given time, is partly employed in purchases for productive, and partly for unproductive consumption. According as a larger proportion of it is employed in the one way or in the other, the real capital of the country is greater or less. If, then, an addition were made to the circulating medium in the hands of unproductive consumers exclusively, a larger portion of the existing stock of commodities would be bought for unproductive consumption, and a smaller for productive, which state of things, while it lasted, would be equivalent to a diminution of capital; and on the contrary, if the addition made be to the portion of the circulating medium which is in the hands of producers, and destined for their business, a greater portion of the commodities in the country will for the present be employed as capital…4

If the classical economists had only examined this process in detail, particularly in the light of John Rae’s path breaking work on capital, I doubt that the world would be in its present economic predicament. However, all is not lost. This crucial classical insight is one that the Austrian school of economics continually endeavours to bring into the public arena.

* * * * *

1The first thing to note is that the only minimum wage that matters is the effective minimum wage, the wage set above the market clearing rate. Secondly, the minimum wage equals the gross wage. This includes all additional costs of hiring labour. If these costs are sufficiently flexible cutting them can reduce the damaging effects of an increase in the effective minimum wage.

As expected, Gittins approving referred to the now discredited 1994 Card and Krueger study allegedly proving that there is no link between the minimum wage and youth unemployment. The eminent economist George Stigler’s take-down of Card and Krueger was devastating. He sarcastically noted of their approach that by “using these methods you could prove that no soldier was killed in WW II — a comfortable conclusion but one whose validity is open to considerable doubt.” (Thomas Sowell, Basic Economics: Citizen’s Guide to the Economy, Basic Books, 2000, p. 155).

In addition, Benjamin Zycher, vice president for research at the Milken Institute for Job and Capital Formation in Santa Monica, pointed out that their study had a very deep flaw: “The survey data upon which it depends are lousy”. This was confirmed by the Employment Policies Institute and David Neumark of Michigan State and William Wascher of the Federal Reserve. Neumark and Wascher concluded in one study that

In sum, we view the literature — when read broadly and critically — as largely solidifying the view that minimum wages reduce employment of low-skilled workers PARA (Minimum Wages and Employment, Foundations and Trends in Microeconomics, Vol. 3, No 1–2, 2007).

To be fair to Card and Krueger they were actually cautious about their findings. Nowhere did they emphatically state that raising the minimum wage above the market level would not cause unemployment. Now if Gittins is unaware of these facts then he is incompetent and lazy. If he is aware of them but chose to ignore them then he is dishonest. Either way, this reflects very badly on him and his unthinking supporters.

I personally believe that studies claiming to prove that raising the minimum wage above the market clearing rate does not cause unemployment are mainly ideologically motivated and designed to confuse the issue and discredit free labour markets.

2It’s rather amusing to find that in Gittins’ world the law of supply and demand works flawlessly with respect to retirees and the labour force but not with respect to minimum-wage workers.

3In the 1950s I recall a great deal of commentary concerning Germany’s ‘economic miracle’ and how the country was outpacing the British economy. This was a period in which Britain was marked by “stop-go” policies and labour shortages. (It really wasn’t much different for most of the 1960s). In my opinion Britain’s recurring current account problems and the so-called labour shortages were the product of pernicious Keynesian policies.

4John Stuart Mill, Principles of Political Economy, Vol II, University of Toronto Press 1965, p. 528.

12 thoughts on “Economic growth, the minimum wage and sloppy economic thinking”

  1. When I started reading this post it felt like gerry was just having a bit of a dig aainst gittins. Then about two thirds through I realised it was a blockbuster. The Mill quote really opened my eyes. The bloody notes contained more info then you would get from catallaxy in a month.

  2. The Mill quote got me too. I think what Gerry is saying is that if the argument against government spending was framed this way it would have more success.

  3. Nick is right about framing the argument. Steve Kates says he’s the expert on the classical economists but you never see quotes like this on Catallaxy. All I ever see there is Say’s Law and government spending is bad.

    BTW, guys, take a look nottrampis comments on the last post and Gerry’s reply. The exchange puts people like Sinclair Davidson and john Humphreys to shame.

  4. Gerry,

    First of all I am no fan of high minimum wages.

    I was hoping you would produce retort to Matt Cowgill’s article.

    A couple of thoughts off the top of my head.
    NZ reduced their NAIRU quite a bit through their labour market deregulation.( the whole 96 pages!)
    They have quite high minimum wages as well. I am wondering whether this somewhats ( only somewhat) obviates high minimum wages.

    The other thing is high minimum wages mainly affects the unskilled labour market.

    Finally how do you get rid of the problem. As I stated previously the five economists ( in Australia) came up with keeping the minimum wage steady thus allowing to decline over time but allowing family incomes to rise by the use of family tax credits but this is very expensive for a Government. Any thoughts?

  5. Nottrampis

    I have no time for the NAIRU concept. I think it is dreadfully misleading. With respect to New Zealand’s ‘high’ minimum wage one must ask the question: “High with respect to what?” All too often the minimum is discussed in absolute terms instead of relative terms. What matters is the ratio of the minimum wage to the value of the worker’s output. What the minimum wage is in some other country is completely irrelevant. This is a point that those who argue against a minimum wage invariably overlook.

    Another important point they are always missing is that it is not the minimum per se that matters but the ‘effective’ minimum wage, the one that exceeds the market clearing price of this particular type of labour. For some strange reason Australia’s free market economists resolutely refuse to make this important point. As for getting rid of the minimum wage, this will never happen until the public has been persuaded that the legislation does more harm than good.

    I’ll be tackling Cowgill when I go after monopsony theory. He was quite right to criticise Sloan for saying that monopsony is “laughable,” “dated” and “ignored.” What she and her pals at Catallaxy should do is explain in detail what is wrong with the theory instead of making smart-aleck comments. In fact, by actually admitting the possibility of monopsony they are in fact recognising its existence and by doing so undermining their own argument. A couple of examples are the H. R. Nicholls Society, and A Labour Market Fable by Alex Robson.

    I shall be coming from the angle that monopsony is a myth and the model is fallacious.

  6. Geeze Gerry we are agreeing to disagree on a fair few topics. No NAIRU!!

    I am looking forward to your contribution on monopsony.

    Also HOW do you get rid of high minimum wages? you simply cannot abolish them as that would have a terrible effect on families but I agree we must do this in the long term. this is why i liked the 5 economist’s solution.

  7. As I said before, Nottrampis, you will never get rid of the minimum wage until you get public opinion on side.

    As for monopsony, whatever I have to say on the subject has been said before. That our right are evidently unaware of the criticisms that will be raised is a disgrace.

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