A Procyclical Minimum Wage

Cardiff Garcia has a good rundown on the minimum wage debate. He’s looking for someone to persuade him either way, and I’ll try to explain my qualified support for a minimum wage. For many, the debate is about the relative value of a minimum wage, which is theoretically inefficient, against wage subsidies which are not. However, as Paul Krugman pointed out earlier this year (though this is nothing new) the minimum wage and Earned Income Tax Credit (EITC) are really compliments, at least to the extent your goal is ensuring workers and not employers capture the benefits.

Here’s the pith in just a few sentences. As far as welfare goes, the government should not really be concerned about the wage paid by employers as much as the wage received by workers. If we decide that everyone needs $15 dollars an hour to live a comfortable life, then the government should not require that employers pay at this level, but promise to cover the differential between the market clearing rate (for unskilled laborers). The problem is labor supply is not perfectly inelastic, so this becomes subsidy for employers who can pay less.

There’s another problem with the EITC – it’s somewhat procyclical. There’s some econometric evidence to this effect, but it’s pretty easy to see that a program dependent on employment is not very countercyclical. This is not a problem per se but the marginal value of government spending – not just in increasing the welfare of the poor, but in moderating business cycles – is much higher in recession.

We should institute a procyclical minimum wage – relatively high when growth is good, and low when growth is bad. Actually, at least in the short run, this will address Tyler Cowen’s problem as well:

What about when the wage profile for low-skilled workers is sloping downward over time?  One would expect the opposite result to hold, namely that employers are less likely to hold on to workers when confronted with a mandated wage increase.

For much of the 1990s, the labor market for less skilled workers was in decent shape.  Since 1999 or so often it has been in bad or declining shape, excepting the “bubbly” years of 2004-2006.  Therefore a minimum wage hike today would be more likely to boost unemployment than the minimum wage hikes of the past.  And that unemployment is more likely to be long-term, corrosive unemployment than in previous decades.

I do understand that a minimum wage hike, in the eyes of some, is more “needed” today, perhaps for distributional reasons.  But can we admit it is more likely than average to lead to additional unemployment?

There are many ways to make a minimum wage procyclical, but a simple heuristic might be keeping the portion of the workforce on minimum wage constant over time. That means when the labor market is tight the minimum needs to be raised to keep the level constant, and vice-versa in a loose market like today. There’s a pretty good argument that a minimum wage is like fiscal stimulus the government doesn’t have to pay for, advocated most vocally by billionaire Nick Hanauer. He thinks that’s a good thing, but huge cash piles or not, a recession is precisely the worst time to ask the private sector to pay more.

This would work in tandem with a wage subsidy guaranteeing some minimum income that is acyclical. In good times, the required employer pay rate increases, easing the government’s deficit. The disemployment effect during this time will be relatively negligible as per Cowen’s logic but also because inflation is higher during boom times allowing the employer to erode the real wage rate if the employee turns out to be bad.

When times are bad, the wage employees need to pay falls, which increases demand for labor, and the government picks up the tabs. Sure it’s partly a subsidy to employers, but one precisely when they need it.

This has the free benefit of making the EITC a lot more countercyclical. It also eases political constraints of efficient stimulus. The government can choose to make the minimum wage zero in slow times – something I’ve advocated before – which would in effect be providing free labor to employers. This sounds a lot better once you consider that at least today employers seem to think the long-term unemployed are approximately useless.

A procyclical minimum wage in tandem with a wage subsidy is in effect a countercyclical stimulus program. It also directly encourages hiring in a way the standard program does not. Here’s to the market determined minimum wage.

  1. Matthew said:

    A counter-cyclical minimum wage would have been fine for most of the recessions in the past. But it appears that recessions of the future will all have to deal with the zero-lower-bound, so we need to start adding caveats to policies. One such caveat is that at the zero lower bound, reducing the minimum wage is likely also strongly pro-cyclical due to the paradox of toil problem. In principle, at the ZLB, raising the minimum wage would be stimulative, ultimately resulting in more employment. But, this could perhaps be more effectively accomplished by leaving the minimum wage where it is and simply raising the EITC, which should also be stimulative at the ZLB.

    • Note Ive argued for a 4% inflation target to reduce the risk of a ZLB situation but that is a different conversation.

      Im not sure I fully agree that this is relevant to the Paradox of Toil. Consider that this increases the fiscal stimulus in a weak economy while also improving supply side conditions. Its more like a payroll tax cut, something Krugman would support.

  2. Hi Ashok,
    A low minimum wage is a subsidy to socially unproductive firms. But I hear you… Those firms need to be supported too because they provide jobs… and jobs is priority. On balance, at the moment, you are right.

    Obviously though, if firms start receiving subsidies for wages, they can take advantage of that like in the restaurant business. It can take years for the base wage of a restaurant worker to rise. Businesses lobby against those changes.

    A problem I see, is that the economy is depressed due to low wages. The reasons stem from import prices to low domestic investment in productive capacity. Your proposal would recommend even lower wages at the moment due to economists thinking that we are still in a long process of recovery with lots of spare capacity. But if you lower wages in that environment, the demand becomes even weaker.
    So in effect I agree with you that raising the minimum wage towards the end of the business cycle when the labor market is tight can help increase demand and return income share to labor. But there are two problems…1. One economist might say it is time to lower the min wage, and the other might say it is time to raise it. Politically, you will have inaction. 2. If you raise the min wage too much at the end of the business cycle without productivity growth as support, you could trigger a contraction.
    The key is to have a good model to know where you are in the business cycle in order for your idea to work. I have a model that would work for that, but there doesn’t seem to be a clear model among most economists. Even P. Krugman says we don’t know enough about the limits of the business cycle.
    Yet, I like your idea. It is in line with how the Mondragon cooperative in Spain was able to keep everyone employed. They lowered those who work by 80% and by lottery decided which 20% would have to go home for a year with lower pay. As the economy gets back on its feet, workers are brought back on at a higher pay. It is a pro-cyclical approach that worked.
    Getting consensus for an approach like that is most likely beyond the emotional economic maturity of the US.

    • Thanks for the comment. Several points.

      1. If a subsidy to employers and capital is really so much of a problem, I would rather deal with that via better tax strategies than pursuing a less efficient policy like the minimum wage without wage subsidies.

      2. I believe it is impossible to know where in the business cycle we are. If a credible model predicted recession in ten months we would have recession now.

      3. My proposal, as I understand, would not recommend lower wages. It would simply guarantee the wages via a government transfer rather than compulsive regulation. It moves the burden from the employer to the government.

      • #1… I hear you.

        #2… Many people with lots of money know when a recession is likely maybe a year ahead of time.. They can see the numbers behind the financial statements. And they make preparations to protect themselves. They begin to protect cash flow. Not all of course, but many. We saw this as big banks began to make bets against the claims of their clients. They knew months ahead of everyone else that trouble was coming. That is an unfair advantage in a democracy.
        If a credible model predicted a zone within which a recession could occur, then many more people could protect themselves. Especially those with less money. The recession would not be such a shock.
        The economy has to run its course anyway. Even if you said there was going to be a recession.
        There is a benefit from an early warning system, not just for extreme weather.

        #3… In theory, it is a good idea. In the political world, once you create a case to lower the minimum wage, you will find it very hard to raise it back up. The ball has been dropped on this for years. Now we are behind the curve, and wages need to rise.

  3. Kaleberg said:

    A low minimum wage is not just a subsidy for inefficient companies, but a subsidy for economic and technological stagnation. Businesses need to have constant pressure to innovate and use labor more efficiently or productivity will not rise. The Black Death, for example, led to the Renaissance and, eventually, to European powers controlling much of the world. The government induced labor shortages of the 18th century led to the Industrial Revolution and massive increases in productivity. The United States was noted for its labor shortages and high wages, and it developed into one of the most powerful nations in the world. The minimum wage started to get behind in the 1970s and has fallen further since, meanwhile economists started to fret about slow productivity growth and investors started to fret about low rates of return on investment. Maybe it is time to consider the obvious.

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