Raising the minimum wage

In last week’s state of the union address, President Obama called on Congress to consider raising the federal minimum wage from $7.25 to $9.

What could be down on that?  Almost by definition, the folks that would be affected are already struggling.  They’re earning LITERALLY the minimum pay a person can earn in this country.  They have the least amount of purchasing power of any worker in the US.  Anything that can be done to give them a boost up must be an economic good, right?

Well, like most economic maneuvers, as soon as you scratch the surface, starts getting complicated.  Minimum wage policy is actually weirdly controversial, and weirdly complex.

The economic effects of an increase in the minimum wage are pretty murky.  That’s because raising the minimum wage is NOT really a direct way of increasing our overall national wealth.  It’s a way of redistributing it.

Anytime the minimum wage is increased, someone has to pay for it, be it the producers, customers, or other laborers.  Not only that, but it seems reasonable to expect that sellers would react to an increase in wages across the board by upping their own prices, wiping out the effects of the pay bump, anyway.

The “raise or not to raise” question is a tricky one to navigate.  In today’s post, I’ll spell out what I think are the strongest arguments for and against raising the minimum wage.  

 You’ll have to decide for yourself which one convinces you more.  You're a grown up.  I trust you.

First off – what is the minimum wage

               

The lowest possible pay an employer can offer their employees.  Minimum wages were first introduced to the US as part of the Fair Labor Standards Act of 1938.

At the time of the FLSA’s passing, the minimum wage was set at $0.25 an hour ($4.08 in 2013 dollars), a rate well below what most laborers were already making at the time.  

Source

               

Setting the rate below what everyone was already earning took a lot of the controversy out of the FSLA.  It made the policy a “non-issue.”  Why would any reasonable employer balk to $0.25 an hour minimum, when he was already paying his workers double that voluntarily?

At the time, I think minimum wage laws were seen more as a safeguard against employers from cutting employee’s pay to some ridiculously low level out of the blue - not as a way of forcing employers to pay more than they already were.

Since 2009, the federal minimum wage is $7.25 an hour (which would be worth $7.78 in 2013 after adjusting for inflation, by the way).  Obama called for it to be raised to $9, a 24% increase.  

Individual states may also pass their own minimum wage laws.  Most states set the state minimum wage to be equal to the federal one.  A few set it higher.  In states with no minimum wage laws, or with minimum wages set below the federal standard, the federal minimum wage rate applies.

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Traditional argument against

Economists have always disliked minimum wage laws.  There's a couple variations on the theme, but central objection is typically that it can lead to an increase in unemployment.

Sure, minimum wage is no big deal when it’s lower than what employers were paying already, as was the case in 1938.

               

But what happens when the min wage is increased to a level higher than what most people are already earning?  That makes it more expensive to purchase an hour of a laborer’s time.  And like any other good for sale, the more expensive it is to buy an hour of a laborer’s time, the fewer hours will be bought.  Rising minimum wages could lead to rising unemployment, as it becomes more and more expensive to hire people.

Putting that argument into action

Some economists have argued the existence of minimum wages makes it more difficult for those with the most limited skill sets to get hired, which can perpetuate the cycle of poverty.

If all workers have to be paid $7.25/hour, then they must be able to produce $7.25/hour worth of value for their employer every hour.  But what if the person has little education, skills or experience?  If a person can only produce, say, $5/hour of value to the company, an employer is paying a $2.25/hour penalty to employ that person.

In the 50s and 60s, the American economist Milton Friedman used to refer to the minimum wage laws as “the most anti-Negro laws on the books.”  He was convinced the high minimum wages of the time were a major cause the huge unemployment numbers among African-Americans.

Friedman contended that since adult blacks in the 50s had grown up under Jim Crow, they received subpar educations and training.  They didn’t have the skill sets adequate to produce $1.25/hour of value (the min wage at the time), and so the minimum wage laws were making it impossible for them to get steady jobs.

The late 60s, early 70s saw minimum wages increase drastically.  In fact, minimum wages reached their highest levels in history in 1968, when it was set at $1.60 (which would be worth $10.59 in 2013).

One of the key campaigners for these increases were unions, particularly skilled workers’ unions.  Unions like the Teamsters and the United Auto Workers (whose members were not all minimum wage earners) were particularly active in the movement.

Still to this day, many economists are suspicious that skilled unions didn’t campaign for higher minimum wages out of any altruistic solidarity with unskilled labor, but rather as a way shutting out competition.

The accusation is that skilled workers realized new developments in industrial technology were going to make their skills less valuable, as an untrained, unskilled workforce could manufacture everything the tradesmen could through the use of larger and more precise machinery.  

The skilled workers may have realized a higher minimum wage would remove the unskilled from the labor pool, thus protecting their jobs at the expense of others.

Think about it this way – if US workers could convince Bangladesh to adopt a min wage of just $3 or $4, that could kill the incentive to offshore work there for some companies.  It makes Bangladeshi labor less competitive.

Another argument against – “distorting the market”

It’s probably the hardest one to explain.  But it easily economists’ number one gripe with minimum wages.  They “distort the market.”  But what does that mean?

What it all comes down to is the minimum wage is an arbitrary number.  $7.25, $9, $5…why any one of them?  It’s a number we kind of just plucked out of the sky in the past. 

And codifying an arbitrary number to be the min wage opens up opportunities for people to game the system, as I outlined in the previous section.  It affects the behaviors of those involved in unnatural ways.

Minimum wages have been falling steadily since the 70s.  Is that because they were too high back then and are just now returning to their "correct" levels?  Or did the 70s have the "correct' levels, and Congress has just been pulling it down ever since? 

We don’t know.  We can’t know.  If wages were set naturally, then concepts "correct" or "not correct" don't even apply.  Wages just are what they are, and what they are is what they should be.

Besides, why would we need a minimum wage in at all?  Why can’t wages just be settled out naturally?  Employers can’t just dictate pay – if they offer too little in pay, they’ll never be able to attract and maintain a workforce.  And if workers are dissatisfied with their pay, why can’t they just go to work for the competition?

And what if every employer in town was paying too little, and all of our wages are low?  Then the only shops and sellers who lower their prices accordingly will stay in business.  Wages will drop, but so will prices, and you'll be in the same place anyway.

I think a lot of Americans fear that if there were no minimum wage laws, employers would pay us all a penny an hour.  But there’s nothing guaranteeing that has to be the case! 

Germany has no minimum wage laws.  England didn’t either until 1999.

Both of those societies have some of the highest standards of living in the world – laborers are/were very well paid.  In both cases, employers still had to offer high pay in order to keep employees, and producers still had to sell at prices agreeable to the average income, which kept the workers from getting screwed on their pay.

Some arguments for raising the minimum wage

Ok, so regroup.  Economists traditionally never liked minimum wage laws, due to the associated risk of raising unemployment, or the cost of production.  And its viewed as a “market distortion” - an unnatural, arbitrary rate that can incentivize people to behave differently than they would otherwise.

On the surface, this looks like a pretty strong deductive argument.  Has some nice, simple logic to it.  Thing is – it’s very difficult to find examples of it being true in practice.

The introduction of the minimum wage in 1999 in the UK was not associated with any uptick in unemployment.

Source

A study by Arindrajit Dube, T. William Lester, and Michael Reich compared unemployment rates in US counties that straddled state lines, or bordered each other but where in two different states, ones having different minimum wage rates.  Over the 6 year period studied, they found no significant differences between unemployment rates in the counties in states with higher min wages vs those with lower ones.

There’s also an argument to be made that employers kind of need to hire as many people as they need to hire.  However much they need to pay, they’ll pay.  They may grumble about having to pay more for their workforce, and threaten lay-offs, but in the end of the day, they need the workforce they need, and will pay whatever price they must to get them.

And remember, upping the minimum wage can just be seen as a way of redistributing income as it diverts a larger share of revenues toward employees and away from the business itself. 

Some economists like this.  They fear if producers end up with claim to most of business revenue, they’ll just sit on it, or invest it back into their own companies.  If workers end up with a larger share of their employer's income (through a bump in their wages), they’ll go out and spend it in diverse places, thus stimulating the economy.

Intrinsic problem with minimum wage

I have one personal problem with minimum wage laws.  In my mind the system is inherently flawed in one VERY major way.

Minimum wage rates must be set by law and policy.  That means they only go up when the government says they go up.

Inflation is happening every minute of every day.  Which means the moment the government sets the min wage rate, that rate starts falling as inflation eats away at the pegged value.  The difference isn’t made up until the government gets around to upping the rate again.

When there is no minimum wage, wages are set by the natural movement of a market.  So the minute the prices of consumer goods go up, employers must react with an increase in pay, or else they risk employees looking for a new place to work.

So when there is a minimum wage, wages are set by a political system.  Which can be slow and inefficient.

In 2009, the min wage was set at $7.25, and hasn’t been changed since.  Between 2009 and 2012, a minimum wage earner, working 40 hours a week, would have lost $1,960 of pay to inflation.  Unless the minimum wage is updated daily to account for inflation, it will always be a screw job.

Obama would like to start adjusting the min wage for inflation annually.  That’s a swing in the right direction, but unless its being adjusted ever minute of everyday, min wage earners will still be losing a few hundred bucks in pay a year.

The Fed's S&P lawsuit

Why does Amazon let users review products?

Let's say your looking to buy a car, or a computer or a house.  It’s a big investment, so you want to be sure you’re getting your money’s worth.

But you don’t know much about the item your about to buy.  You have no idea how much RAM you need, or for that matter how to find out how much RAM the computer has, or for that matter, what RAM is.  You don’t know the repair history of the car, or whether or not that roof is as shoddy as it looks.

So what do you do?  You ask someone who does know.  You read the reviews on Amazon.  You pay an appraiser or a mechanic to give you the honest-to-God story on the items merits and value.  The info they provide can help you decide whether or not the deal is any good.

An expert’s opinion can clear up the information asymmetries that put kinks in the market.  If you don’t know what you’re buying, you don’t know if it’s a good deal.  The buyer needs to know what they’re getting themselves into to be sure they’re using their money wisely.

What is a rating agency?

The global banking and financial industry is complicated.  Like really complicated.  It’s a huge interconnected set of systems, each with their own rules, regulations, advantages and weaknesses.  

Financiers are professionals that learn to navigate this system, and study all the steps to its byzantine dance.  But they have the advantage.  That’s all they do.  It’s what they do.  So they're probably better at it than anyone else out there.

The rest of us - those outside the financial system, but interested in getting into it – would feel hesitant to just dive in.  So we hire a guide.  We give our money over to banks, or trust our savings to financial brokers.  And what do they do with our money?  They invest it as they see fit on out behalf.  

And how do banks, financiers and investment professionals determine how to invest your money?

That’s where it gets tricky.  On the small scale, these decisions are typically handled entirely within your bank.  Your local banker has made loans to every shop in town at one point or another.  Your neighbor’s mortgage was probably financed by the same broker that will finance yours.  

They really are experts on the local economy.  They understand best the simpler, straight-forward, small scale stuff.

But what about new types of investments?  Or ones that aren’t strictly local?  What about financial vehicles that are connected to multiple industries, or are influenced by events and regulations all over the world?

When bank’s themselves aren’t sure whether or not something is a good investment, they turn to what are called “rating’s agencies” to get that “expert evaluation.”  A rating agency is a company that examines big or new financial investments and lending deals.  They try to determines how risky they are, and how much wealth they stand to generate.

Houses have real estate appraisers, restaurants get their Michelin stars, and financial investments have ratings agencies.  Its an entire profession dedicated to measuring the risks and values of investments.  

Should I put my savings into stocks or bonds?  Should I trust my retirement funds to mortgage backed securities?  Can we safely hedge our risk through credit default swaps?  Ask the ratings agencies.

Who are these rating agencies?

These rating agencies function like advisers to banks and investment firms.  And because most of us are not banks and investment firms, the name Standard and Poor's (S&P), Moody’s or Fitch aren’t really household names.

But these “big three” companies have huge amounts of influence in the global financial system.  I don’t care where you live in the world, your bank reads these guys’ reports.  

Their opinions are the benchmark, the norm, the conventional wisdom when it comes to evaluating super-large scale investments.  Like the kind of multi-billion dollar investments that a Bank of America or an HSBC or an M&T might be making.

Ok, but so what’s wrong with that?  Your bank, your broker, or any Warren Buffet sized individual investor, they have to make tricky choices too.  They too are studying the information available, and constantly making what they think is the best move given the circumstances.  How is the local bank, mortgage broker, or money lender any more entitled to their opinion than these rating agencies? 

I mean, S&P, Moody’s and Fitch are full up with thousands of people who are just as smart, then the guys who work at your local bank.  Their estimation as to how the investment is going to work is as good as any other’s, right?

Well, in most cases, I’d say so.  When it comes to something like a simple company bond, or stock, or a 401(k), or IRA, they’re the golden child.  Evaluating these simpler items is a pretty straight forward process.  Not as many imponderables.  You don’t need to be an expert mechanic to understand the difference between an aging Civic and a new Mazda.  We don’t call in the appraisers to tell us if the ramble-shackle, no window, rotten porch house is really worth $100k.

But what about when it comes to something new, or complex?  Like a mortgage back security, or some kind of collateralized debt obligation?

The ‘housing bubble’

In the late 1990s  to early 2000s, banks became very reliant on ratings agencies to determine the value of derivative investments, particularly ones connected with real estate and housing. 

 

Many of the big rating agencies gave these puppies enthusiastic endorsements.  Only a few years later, they had all crashed and burned, and set off the chain reaction that gave us the financial crisis.

Were the endorsement an honest mistake?  A lot of assumptions and tricky estimations went into them.  And a lot of folks outside the rating agencies also seemed to think MBSs were a sure bet.

However, there is an odd incentive for raters to give good reviews of investments.

Ok, say I have an investment opportunity.  I need to find some folks to pitch in money on it.  I need some investors. 

If I tell investors “My idea is great!  It’s a sure fire money-maker!” they’ll be a bit skeptical.  Of course I think its great – I created it.

So I’ll go to a rating’s agency to see if I can get an "impartial professional" to verify my assessment.  There’s several ratings agencies I can go to in town, and I have to pay a pretty penny for their services.

There’s a suspicion going around that at some point the rating agencies started making their assessments extra enthusiastic, extra positive, as a way of competing with each other, and attracting more business.

Where the rating agencies motivated by profit to overstate the effectiveness of the financial vehicles?  Where they honestly duped?  Where the derivatives simply TOO intricate for anyone to know what the risks were?

The US govt has just announced its slapping S&P with a lawsuit over the whole thing.  They contend that S&P deliberately gave good ratings to housing derivatives to attract the business of those dealers looking to promote those derivatives.  

S&P got singled out because they were a little more involved in the housing derivatives, as well as a bit more enthused about them.  Its like the govt is accusing S&P of being really good at what they do, and S&P's defense is that they aren't.  Which is weird.

What the govt will have to prove is that S&P intentionally inflated their ratings, even though they understood how risky the housing securities were.  S&P will have to make the argument that it really made an honest mistake.  Its will be an interesting lawsuit.

For me, it all comes down to how scientific an industry investment rating is (or how scientific it fancies itself to be).  

When you fail to rate an investment correctly, is the proper parallel doctor committing malpractice, or an appraiser neglecting to get into the basement to look for cracks in the foundation?  

Or is it more like a movie critic giving a good review to a honestly horrible film?  Or a sports commentator failing to accurately predict the outcome of an upcoming match?

My opinion is that it really depends on the investment itself.  I think there’s a pretty straight forward, objective way to look at a bond, or a futures contract.  But when it came to the MBSs, CDOs and CDSs that got us into this mess, there’s too many predictions and assumptions that go into it.  In these cases, rating agencies are more of a foretuneteller or soothsayer then an real objective assessor.  

Either way, it’ll be interesting to see how this all plays out in the trial...