Economics, Politics, Quick Fix

Why Linking The Minimum Wage To Inflation Can Backfire

Last week I explained how poor decisions by central bankers (specifically failing to spur inflation) can make recessions much worse and lead to slower wage growth during recovery.

(Briefly: inflation during recessions reduces the real cost of payroll, cutting business expenses and making firing people unnecessary. During a recovery, it makes hiring new workers cheaper and so leads to more being hired. Because central bankers failed to create inflation during and after the great recession, many businesses are scared of raising salaries. They believe (correctly) that this will increase their payroll expenses to the point where they’ll have to lay many people off if another recession strikes. Until memories of the last recession fade or central bankers clean up their act, we shouldn’t expect wages to rise.)

Now I’d like to expand on an offhand comment I made about the minimum wage last week and explore how it can affect recovery, especially if it’s indexed to inflation.

The minimum wage represents a special case when it comes to pay cuts and layoffs in recessions. While it’s always theoretically possible to convince people to take a pay cut rather than a layoff (although in practice it’s mostly impossible), this option isn’t available for people who make the minimum wage. It’s illegal to pay them anything less. If bad times strike and business is imperiled, people making the minimum wage might have to be laid off.

I say “might”, because when central bankers aren’t proving useless, inflation can rescue people making the minimum wage from being let go. Inflation makes the minimum wage relatively less valuable, which reduces the cost of payroll relative to other inputs and helps to save jobs that pay minimum wage. This should sound familiar, because inflation helps people making the minimum wage in the exact same way it helps everyone else.

Because of increasingly expensive housing and persistently slow wage growth, some jurisdictions are experimenting with indexing the minimum wage to inflation. This means that the minimum wage rises at the same rate as the cost of living. Most notably (to me, at least), this group includes my home province of Ontario.

I think decreasing purchasing power is a serious problem (especially because of its complicated intergenerational dynamics), but I think this is one of the worst possible ways to deal with it.

When the minimum wage is tied to inflation, recessions can become especially dangerous and drawn out.

With the minimum wage rising in lockstep with inflation, any attempts to decrease payroll costs in real terms (that is to say: inflation adjusted terms) is futile to the extent that payroll expenses are for minimum wage workers. Worse, people who were previously making above the minimum wage and might have had their jobs saved by inflation can be swept up by an increasingly high minimum wage.

This puts central bankers in a bind. As soon as the minimum wage is indexed to inflation, inflation is no longer a boon to all workers. Suddenly, many workers can find themselves in a “damned if you do, damned if you don’t” situation. Without inflation, they may be too expensive to keep. With it, they may be saved… until the minimum wage comes for them too. If a recession goes on long enough, only high-income workers would be sparred.

In addition, minimum wage (or near-minimum wage) workers who are laid off during a period of higher inflation (an in this scenario, there will be many) will suffer comparatively more, as their savings get exhausted even more quickly.

Navigating these competing needs would be an especially tough challenge for certain central banks like the US Federal Reserve – those banks that have dual mandates to maintain stable prices and full employment. If a significant portion of the US ever indexes its minimum wage to inflation, the Fed will have no good options.

It is perhaps darkly humorous that central banks, which bear an unusually large parcel of the blame for our current slow wage growth, stand to face the greatest challenges from the policies we’re devising to make up for their past shortcomings. Unfortunately, I think a punishment of this sort is rather like cutting off our collective nose to spite our collective face.

There are simple policies we could enact to counter the risks here. Suspending any peg to inflation during years that contain recessions (in Ontario at least, the minimum wage increase due to inflation is calculated annually) would be a promising start. Wage growth after a recession could be ensured with a rebound clause, or better yet, the central bank actually doing its job properly.

I am worried about the political chances (and popularity once enacted) of any such pragmatic policy though. Many people respond to recessions with the belief that the government can make things better by passing the right legislation – forcing the economy back on track by sheer force of ink. This is rarely the case, especially because the legislation that people have historically clamoured for when unemployment is high is the sort that increases wages, not lowers them. This is a disaster when unemployment threatens because of too-high wages. FDR is remembered positively for his policy of increasing wages during the great depression, even though this disastrous decision strangled the recovery in its crib. I don’t expect any higher degree of economic literacy from people today.

To put my fears more plainly, I worry that politicians, faced with waning popularity and a nipping recession, would find allowing the minimum wage to be frozen too much of a political risk. I frankly don’t trust most politicians to follow through with a freeze, even if it’s direly needed.

Minimum wages are one example of a tradeoff we make between broad access and minimum standards. Do we try and make sure everyone who wants a job can have one, or do we make sure people who have jobs aren’t paid too little for their labour, even if that hurts the unemployed? As long as there’s scarcity, we’re going to have to struggle with how we ensure that as many people as possible have their material needs met and that involves tradeoffs like this one.

Minimum wages are just one way we can do this. Wage subsidies or a Universal Basic Income are both being discussed with increasing frequency these days.

But when we’re making these kind of compassionate decisions, we need to look at the risks of whatever systems we choose. Proponents of indexing the minimum wage to inflation haven’t done a good job of understanding the grave risk it poses to the health of our economy and perhaps most of all, to the very people they seek to help. In places like Ontario, where the minimum wage is already indexed to inflation, we’re going to pay for their lack of foresight next time an economic disaster strikes.

Economics, Falsifiable

You Might Want To Blame Central Banks For Poor Wage Growth

The Economist wonders why wage growth isn’t increasing, even as unemployment falls. A naïve reading of supply and demand suggests that it should, so this has become a relatively common talking point in the news, with people of all persuasions scratching their heads. The Economist does it better than most. They at least talk about slowing productivity growth and rising oil prices, instead of blaming everything on workers (for failing to negotiate) or employers (for not suddenly raising wages).

But after reading monetary policy blogs, the current lack of wage growth feels much less confusing to me. Based on this, I’d like to offer one explanation for why wages haven’t been growing. While I may not be an economist, I’ll be doing my best to pass along verbatim the views of serious economic thinkers.

Image courtesy of the St. Louis Federal Reserve Bank. Units are 1982-1984 CPI-adjusted dollars. Isn’t it rad how the US government doesn’t copyright anything it produces?

 

 

When people talk about stagnant wage growth, this is what they mean. Average weekly wages have increased from $335 a week in 1979 to $350/week in 2018 (all values are 1982 CPI-adjusted US dollars). This is a 4.5% increase, representing $780/year more (1982 dollars) in wages over the whole period. This is not a big change.

More recent wage growth also isn’t impressive. At the depth of the recession, weekly wages were $331 [1]. Since then, they’ve increased by $19/week, or 5.7%. However, wages have only increased by $5/week (1.4%) since the previous high in 2009.

This doesn’t really match people’s long run expectations. Between 1948 and 1973, hourly compensation increased by 91.3%.

I don’t have an explanation for what happened to once-high wage growth between 1980 and 2008 (see The Captured Economy for what some economists think might explain it). But when it comes to the current stagnation, one factor I don’t hear enough people talking about is bad policy moves by central bankers.

To understand why the central bank affects wage growth, you have to understand something called “sticky wages“.

Wages are considered “sticky” because it is basically impossible to cut them. If companies face a choice between firing people and cutting wages, they’ll almost always choose to fire people. This is because long practice has taught them that the opposite is untenable.

If you cut everyone’s wages, you’ll face an office full of much less motivated people. Those whose skills are still in demand will quickly jump ship to companies that compensate them more in line with market rates. If you just cut the wages of some of your employees (to protect your best performers), you’ll quickly find an environment of toxic resentment sets in.

This is not even to mention that minimum wage laws make it illegal to cut the wages of many workers.

Normally the economy gets around sticky wages with inflation. This steadily erodes wages (including the minimum wage). During boom times, businesses increase wages above inflation to keep their employees happy (or lose them to other businesses that can pay more and need the labour). During busts, inflation can obviate the need to fire people by decreasing the cost of payroll relative to other inputs.

But what we saw during the last recession was persistently low inflation rates. Throughout the whole the thing, the Federal Reserve Bank kept saying, in effect, “wow, really hard to up inflation; we just can’t manage to do it”.

Look at how inflation hovers just above zero for the whole great recession and associated recovery. It would have been better had it been hovering around 2%.

It’s obviously false that the Fed couldn’t trigger inflation if it wanted to. As a thought experiment, imagine that they had printed enough money to give everyone in the country $1,000,000 and then mailed it out. That would obviously cause inflation. So it is (theoretically) just a manner of scaling that back to the point where we’d only see inflation, not hyper-inflation. Why then did the Fed fail to do something that should be so easy?

According to Scott Sumner, you can’t just look at the traditional instrument the central bank has for managing inflation (the interest rate) to determine if its policies are inflationary or not. If something happens to the monetary supply (e.g. say all banks get spooked and up their reserves dramatically [2]), this changes how effective those tools will be.

After the recession, the Fed held the interest rates low and printed money. But it actually didn’t print enough money given the tightened bank reserves to spur inflation. What looked like easy money (inflationary behaviour) was actually tight money (deflationary behaviour), because there was another event constricting the money supply. If the Fed wanted inflation, it would have had to do much more than is required in normal times. The Federal Reserve never realized this, so it was always confused by why inflation failed to materialize.

This set off the perfect storm that led to the long recovery after the recession. Inflation didn’t drive down wages, so it didn’t make economic sense to hire people (or even keep as many people on staff), so aggregate demand was low, so business was bad, so it didn’t make sense to hire people (or keep them on staff)…

If real wages had properly fallen, then fewer people would have been laid off, business wouldn’t have gotten as bad, and the economy could have started to recover much more quickly (with inflation then cooling down and wage growth occurring). Scott Sumner goes so far to say that the money shock caused by increased cash reserves may have been the cause of the great recession, not the banks failing or the housing bubble.

What does this history have to do with poor wage growth?

Well it turns out that companies have responded to the tight labour market with something other than higher wages: bonuses.

Bonuses are one-time payments that people only expect when times are good. There’s no problem cutting them in recessions.

Switching to bonuses was a calculated move for businesses, because they have lost all faith that the Federal Reserve will do what is necessary (or will know how to do what is necessary) to create the inflation needed to prevent deep recessions. When you know that wages are sticky and you know that inflation won’t save you from them, you have no choice but to pre-emptively limit wages, even when there isn’t a recession. Even when a recession feels fairly far away.

More inflation may feel like the exact opposite of what’s needed to increase wages. But we’re talking about targeted inflation here. If we could trust humans to do the rational thing and bargain for less pay now in exchange for more pay in the future whenever times are tight, then we wouldn’t have this problem and wages probably would have recovered better. But humans are humans, not automatons, so we need to make the best with what we have.

One of the purposes of institutions is to build a framework within which we can make good decisions. From this point of view, the Federal Reserve (and other central banks; the Bank of Japan is arguably far worse) have failed. Institutions failing when confronted with new circumstances isn’t as pithy as “it’s all the fault of those greedy capitalists” or “people need to grow backbones and negotiate for higher wages”, but I think it’s ultimately a more correct explanation for our current period of slow wage growth. This suggests that we’ll only see wage growth recover when the Fed commits to better monetary policy [3], or enough time passes that everyone forgets the great recession.

In either case, I’m not holding my breath.

Footnotes

[1] I’m ignoring the drop in Q2 2014, where wages fell to $330/week, because this was caused by the end of extended unemployment insurance in America. The end of that program made finding work somewhat more important for a variety of people, which led to an uptick in the supply of labour and a corresponding decrease in the market clearing wage. ^

[2] Under a fractional reserve banking system, banks can lend out most of their deposits, with only a fraction kept in reserve to cover any withdrawals customers may want to make. This effectively increases the money supply, because you can have dollars (or yen, or pesos) that are both left in a bank account and invested in the economy. When banks hold onto more of their reserves because of uncertainty, they are essentially shrinking the total money supply. ^

[3] Scott Sumner suggests that we should target nominal GDP instead of inflation. When economic growth slows, we’d automatically get higher inflation, as the central bank pumps out money to meet the growth target. When the market begins to give way to roaring growth and speculative bubbles, the high rate of real growth would cause the central bank to step back, tapping the brakes before the economy overheats. I wonder if limiting inflation on the upswing would also have the advantage of increasing real wages as the economy booms? ^