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Krugman on the Minimum Wage

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Paul Krugman suggests that cutting the minimum wage won’t help employment. My hope here is to uncover his errors.

First, Krugman makes the argument for cutting the minimum wage. He states:

Here’s how the fallacy [of composition] 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.

Of course, that’s not the argument that is typically made at all.Most students of Principles of Microeconomics should have heard the argument against the minimum wage. The real story goes like this:

Demand for labor is downward sloping. The supply of labor is upward sloping. This establishes an equilibrium wage where the quantity demanded and supplied are equal. A minimum wage, if it does anything at all, pushes the wage above this level, so that there is a greater quantity supplied than demanded. We call this surplus supply “unemployment”.

The argument doesn’t rely whatsoever on changes in the relative prices of products. Rather, it relies on the fact that the demand for labor is downward sloping – which comes from marginal productivity, and that the supply of labor is upward sloping – which comes from, for example, “reservation wages” being met for more workers.

Back in the day, Keynes suggested that this story is inadequate at the macro level. The problem is that the marginal revenue product of labor depends on demand for the product – but that demand depends on income, and income depends on wages. So, if wages fall, then incomes fall, which drives down the demand for the product – which, in turn, drives down the demand for labor – in the same proportion that wages fell. So, in the end, there’s no impact on employment. The decrease in wages caused a corresponding decrease in employment.

However, within the Keynesian framework there is a way for cutting wages to still “fix unemployment”. The fall in prices means that the real value of money has increased – so people have excess real money, and try to divest themselves of this extra money by buying bonds. Buying bonds pushes down the interest rate, which, in turn, stimulates investment, which, in turn, stimulates employment.

Krugman says that this story doesn’t work once we’re in a liquidity trap. Interest rates are already at their lower bound, so buying more bonds won’t decrease them – and therefore, investment doesn’t get stimulated, and therefore employment doesn’t increase.

So, where, specifically, does Krugman go wrong?

(1) The demand for labor depends on the expected discounted marginal revenue product. So, what matters is not the present demand for the product, but the expected future demand. For Keynes’s original argument to work, we need a feedback from present prices to expected future prices, so that as one falls the other does so – and does so proportionally. This is not necessarily true – in fact, it’s probably not true.

Suppose that right now the price of oil is $50 a barrel, and I expect it to go up to $100 a barrel next year. Then, tomorrow, the price of oil shoots up to $75 a barrel. Do I revise my expected future price up to $150, to keep the proportions the same? Maybe, maybe not. But, I will say that “not” certainly feels more likely.

So, what happens if demand doesn’t fall in proportion with the current price of the product? Employment increases as wages fall. Even if a decreased current price arising from the fall in income does decrease the expected price to some degree, as long as it is less than the fall in present wages, the level of employment will increase.

(2) The entire apparatus fails to realize that there is significant variation in wages across workers – even within the same industry or even the same firm.

Why does this matter? Because it breaks the argument down entirely. For example, suppose that workers are divided into groups based on seniority. In that case, the fact that new workers are hired at lower wages than before doesn’t mean that ALL workers are paid lower wages. So, wages don’t fall in proportion with the minimum wage – which means that incomes don’t fall by that proportion, so demand for the product doesn’t fall in proportion, so product prices don’t fall in proportion, so demand for labor doesn’t fall in proportion. In the end, what does this mean? In short, that the Principles of Microeconomics story is basically right. When marginal wages fall, employment goes up – and the fact that not all wages move together prevents the Keynesian feedback.

(3) The framework ignores that excess real balances can be drawn down by buying things.

To be fair, Krugman acknowledges this, but writes it off as insignificant. Here’s what he says:

Somebody is going to ask, what about the real balance effect? Doesn’t a falling price level make people wealthy, by raising the real value of the money they hold. The answer is, consider the magnitudes. Before the crisis, the monetary base — the system’s “outside money” — was around $800 billion. (It’s a much more confusing situation now, so I won’t try to parse the current numbers here). This means that even a 10 percent fall in the price level, which is very hard to achieve, would raise real wealth by only $80 billion. Compare this with the effects of the decline in housing and stock prices, which reduced household wealth by $13 trillion in 2008. The real balance effect is totally trivial.

The problem? Krugman looks at the wrong number. It’s not the monetary base (reserves + currency) that matters. It’s the quantity of money balances, something more like M1, MZM, M2, or the Austrian Money Supply. Let’s just look at MZM (which includes checking accounts, savings accounts, and money market accounts). Right now, MZM sits at about $9.5 trillion. So, a decrease in prices of 10% would lead to an increase in wealth of about $950 billion. True, this is less than 10% of the $13 trillion decline, but it’s not “totally trivial”.

Why does this matter? Because it’s one more reason that a decrease in wages won’t lead to a proportional decrease in prices – which means that a decrease in wages will increase employment.

A significant part of the Keynesian argument against free markets (and for minimum wages) rests on the argument that Krugman presents. The assumptions that this argument rests on are simply not true. Meanwhile, the assumptions underlying the argument for lower wages increasing employment are far more reasonable.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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