How much is too much?

The last few months were topsy-turvy ones. In between I managed to read a book and start on others (more on that later).

Then Seattle’s $15/hr experiment caught my eye.

In short, Seattle plans to raise the minimum wage to $15/hr (the new minimum applies to companies with over 500 employees right now; implementation is in phases)1.

After it has been in effect for some time, verdicts are mixed. Some are calling it a failed experiment, some are saying it is showing signs of being a great success, frankly though, with the policy not fully implemented, it is actually too early to pass verdict on this bold move. Give it a year for the economy to start moving towards a new normal.

My interest is why are there two sets of economists on this issue. Some in support, some against (personally, the minimum wage is too low and should have been raised to around $12/hr for all workers already). A summary of the two positions:

  1. Those opposed to the minimum wage increase do so by reasoning that it will cause firms to downsize the expensive workforce thus leading to unemployment and a slower economy.
  2. Those in support argue that the higher wages mean that the consumers will get a larger discretionary income to spend and that will cause economic activity to grow.

Both sides present their own evidence in support of their argument based on the appropriate model.

  1. Higher prices lower demand and a higher price for labor will lower demand for the same. This result is also arrived at when carrying out a cost optimization exercise for a production function.
  2. Letting workers have more money to spend will cause aggregate demand in the economy to increase which leads to higher investments or growth in business capacity, which is economic growth.

So they’re both right? Or are they both wrong?

Explanation

BOTH the effects are occurring at the same time and will eventually strike a balance. Deciding which effect prevails is a difficult question to answer although some metrics will definitely help in making an educated guess.

First, how low is the minimum wage today compared to some other time period? Here’s a graphic from a CNBC article2:

Minimum wage, inflation adjusted in 2015 dollars (line) and the minimum wage in dollar terms (bars)
Minimum wage, inflation adjusted in 2015 dollars (line) and the minimum wage in dollar terms (bars)

Notice how the gap between the inflation adjusted value and the dollar value of the minimum wage evolves as the years go by. In short, workers are getting paid less now than ever before.

That gap represents the purchasing power of the minimum wage for that year. To get a clearer idea of what I mean when I say “the purchasing power of the minimum wage”, Buzzfeed has an article3 on how much tertiary education minimum wage can buy now versus earlier periods, which should begin to give one an idea about how low the minimum wage truly is at the moment.

University education is a bourgeoisie good and not a product for everyone? Would living in a one-bedroom house qualify as a working class good? This map in an article on Mic.com4 about the numbers of hours of work needed at minimum wage in different US states to be able to afford rent for a one-bedroom house by not spending more than 30% of earnings might be a better gauge then.

Picture showing the hours of work needed in different states to afford rent for a one-bedroom house without exceeding 30% of one's income
Hours of work needed in different states to afford rent for a one-bedroom house without exceeding 30% of one’s income.

So the purchasing power of the minimum wage (actually, the dollar itself lost value) is far lower today than what it was around 50 years ago. If the minimum wage has to regain the lost value, it has to be somewhere around $15/hr already ($7.25 + the purchasing power of the minimum wage around 1968). What was the economic growth rate back then? Around 5% or more, if my (at times faulty) memory serves me right.

So a higher minimum wage is justified or can be borne by the economy without economic doomsday becoming reality.

Here’s the question – can there be a minimum wage that is too high? Short answer – yes.

Before I start, anyone who makes the argument “Why not go ahead and just set the minimum wage at $30/hr?” without providing a logical foundation for their argument doesn’t understand economics to actually be taken seriously.

For starters, what makes any firm decide to invest (R&D or expanding production)? It’s not merely profit. A company looks at the potential benefits and losses when deciding to make an investment. If the benefits exceed the costs & potential losses, they very well can choose to invest. Obviously the benefit is revenue in the form of more product sold; the costs and potential losses stem mostly from using capital and labor in the production process. If the costs are too high, it will act to deter the investment. Costs are of two types – sunk costs and variable costs. Sunk costs are incurred mostly in setting up the production machinery and space required while variable costs are those incurred during production. A large component of variable costs are wages/salaries paid to labor. Variable costs have a larger influence on decisions to carry out production than sunk costs. So if the wages/salaries are too high then investment is unlikely to be undertaken as the overall income from the investment, defined as a percentage called the rate of return, will be too low. No investment means lower demand for labor. So wages can be too high.

What about now? A lot of companies are choosing to not invest, leading to record cash holdings by some of the largest companies in the world5 (Apple was reportedly more solvent than the US government6). So there are several companies in control of larger pools of liquidity than the US government itself. That is just the reality on the ground, more important is why did this situation come about in the first place? Could it have something to do with minimum wages being too high already or the fact that the companies are seeing low demand all over the world? What about the US?
Hint: A significant portion of the households in the US, even Europe, are deleveraging.

So companies are hoarding some of the largest cash reserves in history instead of allowing that money to enter the economy as wages/salaries or as payments incurred during investment. Nothing of that kind is occurring with the result that aggregate demand and investment are both depressed and not high enough to make the economy seem “livelier”.

Although trickle-down proponents will argue otherwise7 using a false analogy to show that the minimum wage is bad. The writer of the article takes the example of American Samoa where employment had come down by 30% after minimum wages went up. He conveniently forgets that American Samoa is not Seattle. Seattles’s economy8 is around 20 times larger than that of Samoa’s9.

In simpler terms, Seattle’s economy is far more resilient to shocks and can overcome them with less severe disruptions.

So which side is winning? The full effects have not become fully apparent yet and that is mainly because the full effects of having a higher minimum wage can take as long as a generation to be understood. Though Evans School of Public Policy and Governance is undertaking a project titled “The Minimum Wage Study”10 to track the effects of the minimum wage increase and gives a preview of the effects. The PDF of the report has the details; my recommendation is to read the report carefully if not the remaining news links.

References:
1 $15 minimum wage kicks in for thousands of Seattle workers: http://kuow.org/post/15-minimum-wage-kicks-thousands-seattle-workers
2 Adjusted for inflation, the federal minimum wage is worth less than 50 years ago: http://www.cnbc.com/2016/07/21/adjusted-for-inflation-the-federal-minimum-wage-is-worth-less-than-50-years-ago.html
3 These Charts Show How Much College A Minimum Wage Job Paid For, Then And Now: https://www.buzzfeed.com/gregschoofs/how-much-college-did-your-summer-job-pay-for
4 1 Map Shows How Many Hours You Need to Work Minimum Wage to Rent an Apartment in Any State: https://mic.com/articles/120428/1-map-shows-how-many-hours-you-need-to-work-minimum-wage-to-rent-an-apartment-in-any-state
5 US companies are hoarding $2.5 trillion in cash overseas: http://www.cnbc.com/2016/09/20/us-companies-are-hoarding-2-and-a-half-trillion-dollars-in-cash-overseas.html
6 Fun Number; Apple Has Twice As Much Cash As The US Government: https://www.forbes.com/sites/timworstall/2014/04/13/fun-number-apple-has-twice-as-much-cash-as-the-us-government/#60cfdb335570
7 The American Experience Of A Too High Minimum Wage: Employment Down By 35%, GDP Down By 23%: https://www.forbes.com/sites/timworstall/2016/04/24/the-american-experience-of-a-too-high-minimum-wage-employment-down-by-35-gdp-down-by-23/#5b449ac5c1c0
8 Seattle region’s economy ranks over many countries: http://knkx.org/post/seattle-regions-economy-ranks-over-many-countries
9 Estimated of size of Samoan economy: http://www.heritage.org/index/country/samoa
10 The Minimum Wage Study: https://evans.uw.edu/policy-impact/minimum-wage-study

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