Saturday, 19 December 2009

The Krugman v. Sethi minimum wage argument – let’s all wade in.

There has been an argument over the last week or so between Paul Krugman, Rajiv Sethi and others on the question as to whether cutting minimum wages would boost employment.

Latest to join in is Stefan Karlsson who is definitely not at his best in this post. (S.Karlsson’s best is extremely good.)

Stefan’s first mistake (his 2nd para) is to claim that the idea that minimum wage cuts won’t raise employment is an idea adhered to by present day “leftist” economists. Not true. One of the big contributions to economics made by Keynes and others in the 1930s was to point out the flaws in the “wage cuts raise employment” argument. Nowadays there is widespread acceptance of these flaws.

In his 6th para (“Secondly, even if...”) Stefan seems to say, quite rightly, that wage bargaining is a “zero sum game” between employers and employees in that whatever employees lose by a reduced minimum wage, employers gain.

In his 7th para (“And since income...”) Stefan then claims that lower labour costs in the US will induce foreigners to buy more US produced stuff, hence the minimum wage cut WILL raise employment. But hang on – Stefan has just admitted that wage bargaining is a zero sum game: i.e. the TOTAL cost of producing a widget in the US is not influenced by the proportion of GDP going to employees as compared to that going to employers.

Moreover, even if the above increased demand from abroad DID occur, it STILL would not influence employment in the long run. Reason is that the US balance of payments must balance in the long run. To illustrate with a simple example, assume the US external trade position is exactly in balance immediately before the minimum wage cut. Then the cut takes place, and demand from abroad increases. At some point the US dollar will appreciate, to get the trade position back into balance. That will involve REDUCED demand from abroad for US products and/or reduced exports from the US to elsewhere.

Then in the second sentence of the same para (“And since income...”), Stefan claims that “That same substitution effect would increase demand for products made by American workers by American capitalists”. I.e. “capitalists” have more money to spend, thus they increase demand. But wait a minute – where did these “capitalists” get their extra money from? They got it from employees as part of the “zero sum game”.

Well if “capitalists” spend more because their income has increased, then employees are going to spend LESS because their income has declined, seems to me! Net effect: about zero.

Getting more technical.

Having said all that, there actually IS a mechanism via which a minimum wage cut WOULD raise employment. Very brief and crude exposition of this argument is thus.

Employers raise numbers they employ to the point where the output of the last or least productive person employed equals the minimum wage (or the union wage in a union dominated environment). And no, I’m not confusing micro with macro. Thus if the minimum wage is reduced, employers would expand the numbers they employ.

There is no automatic mechanism here for increasing aggregate demand. But if having reduced the minimum wage, demand WERE increased, then employment would rise.

This wheeze is NOT a cure for the current recession. The problem at the moment is sheer lack of demand. But if and when unemployment reverts to more normal levels, then the above minimum wage point starts to become relevant. That is, it could facilitate an increase in demand with less inflation than would otherwise be the case.

But there is a problem: the above involves people working for a wage that is regarded as unacceptably low on social grounds. Solution: in work benefits, or some form of employment subsidy.

Some ideas on how this might work here. But a better exposition is in the pipeline. Watch this space.


  1. I have a hard time getting engaged in this debate because it all seems to come down to one's institutional starting point and politically-desired end-point. The Keynesian view holds in the nominal realm; The Austrian view holds in the real realm. And with each pushing the logic in opposite directions, I get dizzy.

  2. Anonymous: yes people interested in economics do to some extent have entrenched positions, and political bias: but that is universal – it’s not confined to economics. But I don’t think the bias is as bad as you claim.

    Re getting dizzy: don’t try to do too much at once, or you WILL get dizzy. Study a problem, then leave it and sleep on it. Your subconscious will sort some of it out overnight. Then hack away at the problem again a day or two later. Then some more sleep. Then more hacking. That’s what I do.

    Also, once you get a solution or partial solution to a problem write it down. Someone once said that writing draws ideas up from the subconscious, or words to that effect. I.e. once an idea or part of a solution to a problem is out of the brain down in writing, that leaves room for another idea to pop up. I.e. bloggers blog for their own benefit: to sort out their own ideas!

  3. Good advice! Thanks for the thoughtful response.


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