Greg Ip

Articles by The Economist’s U.S. Economics Editor


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Jan 28th 2014, 20:39 by G.I. | WASHINGTON, D.C.

 If asked to compile a list of economists’ mistakes over the last decade, I would not know where to start. Somewhere near the top would be failure to predict the global financial crisis. Even higher on the list would be failure to agree, five years later, on its cause. Is this fair? Not according to Noah Smith: these, he says, were not errors of economics but of macroeconomics. Microeconomics is the good economics, where economists by and large agree, conduct controlled experiments that confirm or modify established theory and lead to all sorts of welfare-enhancing outcomes.

To which I respond with two words: minimum wage.

One of the first things we learn in microeconomics is that demand curves slope down: raising the price of something reduces the quantity demanded. A minimum wage should reduce the demand for low-skilled workers as surely as a price floor on milk will reduce the amount bought.

Yet ask any two economists – macro, micro, whatever – whether raising the minimum wage will reduce employment for the low skilled, and odds are you will get two answers. Sometimes more. (By contrast, ask them if raising interest rates will reduce output within a year or two, and almost all – that is, excepting real-business cycle purists – will say yes.)

Are there reasons a higher minimum wage will not have the textbook effect? Of course. And a great deal of research has gone into trying to determine them: perhaps the demand for low-skilled labour is highly inelastic in certain circumstances. Perhaps employers have monopsonistic power and set both wages and the level of employment below equilibrium levels. Perhaps there are offsetting general equilibrium effects, e.g. if low-wage workers spend more of their income than their employers or customers, then shifting income from the latter to the former raises aggregate demand. And so on.

But microeconomists are kidding themselves if they think this plethora of plausible explanations makes their branch of economics any more scientific or respectable than standard macroeconomics. Microeconomists and macroeconomists working in good faith approach their problems with open minds, trying to develop models then figure out why they do, or don’t, yield the predicted results. There may be instances where macroeconomists build models that are mutually exclusive, and then win Nobel prizes for them (again, see Noah Smith). That is the exception; generally, what we see over time is macroeconomists building on each others’ work; rational expectations, sticky wages and financial frictions have all been used to refine, rather than supplant, basic macro models. Still, in both macro and micro, economists develop views and pursue research that tends to confirm those views.

What is true of all economics is that as soon as you wander into policy, you find the debate hijacked by policy advocates who write, report and promote research that reinforces their side of the debate while ignoring or disparaging the other. Do higher capital requirements reduce lending? (Yes: it raises the cost of capital! No: Modigliani-Miller tells us firms are indifferent to capital structure! Yes: banks aren’t like other firms!) Do higher marginal tax rates reduce the work effort and tax paid by the rich? (No: their labour supply is inelastic! Yes: They reclassify their income to avoid taxes!) Does Obamacare hurt part time employment? Does it lower labour supply? Do tougher emissions requirements cost jobs? Does net neutrality lead to more investment in technology? Or less?

It is fair to say that when it comes to the minimum wage, Barack Obama is a policy advocate, not an economist. Tonight in his State of the Union Address, he will repeat his call to raise the federal minimum wage. Today he has announced he will use his executive authority to entitle employees of federal contractors to a higher minimum wage. In its release the White House says:

 A range of economic studies show that modestly raising the minimum wage increases earnings and reduces poverty without jeopardizing employment.

Well, “range” is a pretty imprecise word. There’s also a range of studies that shows raising the minimum wage doesn’t reduce poverty and does jeopardize employment.

The White House also says:

 Low wages are also bad for business, as paying low wages lowers employee morale, encourages low productivity, and leads to frequent employee turnover—all of which impose costs.

Here the White House violates another axiom of microeconomics: it has argued that compelling someone to do something they wouldn’t do voluntarily makes them better off. Under what assumptions can forcing a business to pay a higher wage be good for its business? The White House press release, which also cites the example of retailer Costco which pays well above the minimum wage, seems to invoke efficiency wage theory. This theory, which incoming Federal Reserve chairwoman Janet Yellen helped develop, suggests firms may pay above the market-clearing wage because to pay less would damage morale and productivity and raise turnover. This theory can certainly explain why some firms, such as Costco, sometimes choose to pay above the market wage. But it cannot justify forcing all firms to do so all the time. This would presume that numerous firms are systematically hurting themselves through their small-minded refusal to pay more. Sure, there are situations where people can be forced into doing something that makes them better off (wearing a seatbelt, getting vaccinated) but is it plausible that WalMart or McDonald’s know their own business so poorly that they are systematically hurting themselves by paying too little? Isn’t it more likely that they have weighed the tradeoff between low wages and poor morale and chosen the combination that maximizes profits?

Microeconomics tells us that it is far more efficient to abolish the minimum wage and address poverty directly through the earned income tax credit or wage subsidies. This would imply that McDonald’s is actually enhancing social welfare by encouraging its employees to take advantage of food stamps and other safety net programmes. Economists know this, yet many advocate a higher minimum wage and disparage McDonald’s anyway. Why? As Noah Smith points out in a different post, “Probably because “earned” income gives people a feeling of dignity, while “handouts” reduce dignity.” (In some cases, it’s because Congress won’t offer up more money for the working poor, so a higher minimum wage is a second best solution; but as Republicans get behind wage subsidies, that may change.) In this case, economists are not acting as economists, but as philosophers.

They are doing the same in the debate over income inequality. Economists can offer explanations for why inequality has risen and what might reverse it, but they cannot advance positive reasons for what the right level of inequality is; this is function of social preferences outside the realm of empirical or even theoretical economics. (At least, they can’t make the case on microeconomic grounds. There are macroeconomic reasons to fret over higher inequality because shifting income from the high consuming poor to the high saving rich reduces aggregate demand.) Fundamentally, economists are troubled by inequality for the same reason non-economists are: it doesn’t seem right.


Written by gregip

January 28, 2014 at 10:56 am

Posted in Uncategorized

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