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Has the Labor Market Adjusted? – A Keynesian Price Floor and Employment Dynamics

August 6, 2013
the Economy: Home and the World
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A new paper, from Jonathan Meer and Jeremy West at Texas A&M, suggests that minimum wage does have adverse consequences on the labor market: just not in the way most economists think. Meer and West argue that employment levels are a red herring in estimating consequences of a price floor and hence we should look at net job growth. Indeed they conclude:

Using a long state-year panel on the population of private- sector employers in the United States, we find that the minimum wage reduces net job growth, primarily through its effect on job creation by expanding establishments.

I don’t want to critique this study as much as use it as a window into an equally curious debate: sticky wages and a Keynesian recession. The standard theory holds that downward wage inflexibility results in disemployment as wages are kept artificially high for any number of reasons.

In many ways, the sticky wage thesis posits the same transmission mechanism as the classical view that minimum wage creates unemployment (the policy ramifications are unclear, and I support an increase in the minimum wage, but that’s because I think more unemployment of the right kind is good). Meer and West offer both empirical and theoretical reasons why observing employment growth, and not level, is economically appropriate which implies that employment growth – adjusted for population – is a better indicator of potential gap than unemployment rate.

This is important considering “potential income” is a remarkably abstract concept based on estimates of long-run supply-side factors that cannot be evident contemporaneously. Indeed, if the Keynesian argument is to be accepted in whole, contraction of aggregate supply is one possible reason we are not experiencing outright deflation.

Consider the historical relationship between change in the potential gap and population-adjusted employment growth:

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This is a pretty scary graph because it looks like we’ve caught up with our pre-recession rate of employment growth.  Unemployment will continue to fall, but will not accelerate if the wage rate is again appropriate. Historically, at every other such point, the pace of recovery slows down. Because it’s over. This paints a prominently different picture than suggested by unemployment levels:

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And, indeed:

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(Edit: I want to point out here that this pattern isn’t new, and I’m not the first to point it out. I only find it suddenly relevant in the context of the paper I cited which tells us that if stickiness and minimum wages act similarly, we’re now at the point where the sticky effect is less relevant. This can be a good thing since it implies job growth is faster, but it also means the recovery will not be accelerating. That’s a big “if” but has theoretical appeal in concert with the fact that historically other points at which job creation reaches it’s pre-recession peak represent an adjusted labor market. One way to interpret this is a continuing recovery without the acceleration our output gap might suggest I’ve suggested below a few reasons why this may not be the case).

While the level of unemployed workers remains uncomfortably high, the rate at which that level is falling is back at its pre-recession high – and there is little precedent for it to rise any further.

This does not mean the recession is over, or that aggregate demand is sufficiently high. It does mean that, were we to use the same logic as Meer and West, sticky wages and a dis-equilibrated labor market cannot sufficiently explain our troubles.

This has five possible implications:

  1. The Meer and West employment dynamic cannot be translated to a Keynesian “sticky minimum wage”, if you will. This may well be the case – the empirical foundation of their paper considers the economy at all times. The conclusion we strive to make concerns economies specifically mired in recession, which may be a confounding variable.
  2. Wages are not as sticky as we believed and even the low dose of price level inflation since 2008 has been sufficient to adjust the market.
  3. Aggregate supply has contracted more than we would like to admit.
  4. An amalgam of points (2) and (3) suggest that the potential gap is not as high as estimated by the CBO.
  5. Excess capacity and other Keynesian forces are far stronger than we previously anticipated.

As far as policy is concerned, the result in its crudest suggests we are no longer in a Keynesian short-run, if sticky wages are the only important factor. This means that while inflation will have its traditionally expansionary effect through the money illusion and wealth and “hot potato” effects, it will no longer move the labor market towards equilibrium. In other words, the marginal benefit of a change in the price level is falling towards zero.

The evidence is too clear that further deficit-spending will not spark the bond vigilantes and that debt monetization will not bring rise to runaway inflation; therefore, it is unlikely that the United States should engage in any further austerity by prolonging the sequester and January payroll tax hikes.

However, we should perhaps question the modality of sticky wages vis-a-vis the unemployment rate, and focus on employment growth which suggests a more robust recovery relative to supply. This is not a call for a smaller government. Indeed with interest rates at historical lows, now is as good a time as ever for the government to engage in sound investments like green energy, smart grids, or infrastructure. Now is as good a time as ever to risk monumental tax reform that brings in too little, rather than too much.

Ultimately, the evidence for large output gaps and lacking demand is far greater than the evidence against – and perhaps in the throes of fiscal crisis we should have engaged in more aggressive stimulus. Indeed, just one paper suggesting a relationship elsewhere unfound and theoretically unprecedented should not change our interpretation of the economy too seriously.

But Meer and West have given us a unique prism to consider not just minimum wages, but maximum employment.

(That last sentence had more cadence than content: the point is not maximum unemployment, as much as a maximum rate of recovery – to many that is disheartening).

NAIRU, Structure, and the Case for a Minimum Wage

August 4, 2013
the Economy: Home and the World
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The non-accelerating inflation rate of unemployment – or NAIRU – is the level of employment above which we risk dislodged inflationary expectations tempting a positive wage-price feedback loop. Almost everything in macroeconomics comes back to NAIRU which is broadly determined by “supply-side” factors like technology, institutions, etcetera.

NAIRU, a practical tool, is closely associated with two more abstract concepts of general equilibrium: the natural rate of unemployment, and full employment. NAIRU is becoming an increasingly irrelevant concept. I think the “natural labor employment demand” has fallen, but this is not really the same thing. This is closely linked with a case for higher minimum wage, as I’ll explain below.

Technology

Consider a world where all consumer goods are automatically produced. Everyone, aside from a small cohort of designers and technocrats is unemployed, and receive goods and services through basic income. NAIRU makes no sense for the labor force as a whole. The rental rate on a robot is only the cost of replacing depreciated capital, without permanently strong patents, labor substitution will increase prices which will tempt further increases in the wage rate (or taxes on technocrats to finance a higher basic income). Hence NAIRU for workers is 100%.

On the other hand, since technocrats aren’t substitutable the opportunity cost is only the wage rate determined by an imperfect market – which naturally includes rents since the barriers to technical skill are non-zero. By definition, NAIRU for technocrats is non-zero since the supply-side of the economy is entirely determined by supply of technocrats. Since markets are imperfect, and rents are high, any increase in wages will come from taxes on capital returns rather than price inflation.

This is an extreme case, but the United States is moving towards an increasingly capital dominated economy. NAIRU was a useful concept when the labor-share of income was 70%, but as it falls to and below 40% – as I imagine it will within two decades – the unemployment of labor becomes a useless concept.

Inequality

The rate of unemployment – perhaps the most ubiquitous economic statistic – is useless in periods of high inequality. When unemployment rate is high, economists today like to claim that GDP is “below potential”. The “output gap” is measured – sensibly – in dollar terms. Unemployment rate, instead, is measured in unit terms.

The output gap includes auto-workers made redundant, as well as factories shut down, and fields unplowed (that of labor, capital, and land respectively). In the previous section I noted the diminishing relevance of NAIRU considering the rising preponderance of capital; but even within labor markets it is a crude measure at best.

Let’s say in an economy, I had a factory rented at $5 billion, an airplane rented at $5 million, and a screwdriver rented at $5. In a recession, suppose I couldn’t afford to lease the screwdriver. What is unemployment? I’d say it’s epsilon, but someone sufficiently crazy can say it is 33% – since one-third of capital units are disemployed.

But let’s say in an economy I have 2 engineers, 8 scientists, and 90 fry cooks. If 20 fry cooks were disemployed by recession, we’d freak out about 20% unemployment, and yet if both engineers were disemployed we’d be content at 2% unemployment. The unit rate of unemployment purports that we are all equal and that, believe it or not, isn’t the case.

An increase of technology allowing for the replacement of precisely one doctor is more disinflationary than that allowing for the replacement of precisely one fry cook. This distinction is not relevant when we are talking about socioeconomics – where unit rate dominates – or when inequality is irrelevant. Neither, when we speak of shifts in NAIRU in 2013, is the case.

Form

We can be disemployed in many forms. A single-mother wishing to work two shifts to save for her son’s college may be given only one. An auto-worker may be laid off. A physician’s assistant may be asked to work only part-time. Not all of these, in practice, are actually measured but each represents an equally valid claim to unemployment as stipulated by economists.

The way many economists talk, NAIRU moves in tension with aggregate supply. That is, when David Brooks suggests NAIRU has increased, he’s saying the output gap isn’t as big as we think it is, and hence fiscal or monetary stimulus cannot be beneficial any longer (never mind the fact the low inflation today suggests he’s wrong anyway). 

That means an increase in NAIRU – as such – isn’t a good thing. But Americans, especially poor Americans, are among the most overworked people in the world. Technology-biased capital change can, on the one hand, increase the unit rate of unemployment. It can also redistribute hours – something I’ve suggested before – which  can have powerful social benefits.

The scenario I set up in the linked post purports a world with large technological automation augmented with a basic income and high quality social programs. In this case, there would not necessarily be an increase in “hour unemployment” as the quantity of labor supplied in hours falls – resulting in a lower equilibrium.

The point here is twofold:

  1. NAIRU can become relevant if measured in hours,
  2. Under proper and justifiably stipulated economic institutions such an unemployment will be illusory, under standard reasoning.

The Case for a Minimum Wage

A common refrain on the economic right suggests that any significant increase in the minimum wage increases NAIRU. Take this from Peter Tulip, a staff economist at the Federal Reserve, asking whether “Minimum Wages Raise the NAIRU”:

Probably yes.

A high minimum wage (relative to average wages) raises nominal wage growth and hence inflation. This effect can be offset by extra unemployment; so the minimum wage increases the Non-Accelerating Inflation Rate of Unemployment or NAIRU.

This effect is clearly discernible and robust to variations in model specification and sample period. It is consistent with international comparisons and the behavior of prices.

I estimate that the reduction in the relative level of the minimum wage over the last two decades accounts for a reduction in the NAIRU of about 11⁄2 percentage points. It can also account for the substantial reduction in the NAIRU in the USA relative to continental Europe. 

My approach to NAIRU – predicated on high inequality and forceful capital-biased tailwinds – renders this type of analysis wanting, for a couple reasons:

  • A higher NAIRU can be “felt” through shorter shifts and fewer months worked – neither of which are socially debilitating. Furthermore, because the fewer hours are worked at a higher wage rate, it is not clear that living standards will fall too steeply. 
  • Minimum wages subsidize labor-substituting innovation. The opportunity cost of replacing one fry cook with automated robots falls as the minimum wage rises – this suggests an expansion of aggregate supply.

None of this is necessarily a good thing and is premised on the assumption that the government will work with employers in crafting policy that supports hour reduction and wage sharing policies. This is how U3 in Germany miraculously fell over the last decade. As the wage share of income falls, it will be incumbent on any government to impose more progressive taxes and perhaps even a basic income: but this isn’t necessary for my theory – except in the extreme.

If you share my conviction that a large part of the American population either works too much, or would like to, leaving little time for family, then a minimum wage sends the market that signal, without causing the unemployed any strife. 

The NAIRU is an idea whose time has gone.

Unemployment Insurance is like Ice

June 10, 2013
the Economy: Home and the World
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Paul Krugman has a post correctly bashing the nonsensical criticisms to unemployment insurance (UI):

Here’s what is true: there’s respectable research — e.g., here — suggesting that unemployment benefits make workers more choosy in the search process. It’s not that workers decide to live a life of ease on a fraction of their previous wage; it’s that they become more willing to take the risk of being unemployed for an extra week while looking for a better job.

 His analogy:

One way to think about this is to say that unemployment benefits may, perhaps, reduce the economy’s speed limit, if we think of speed as inversely related to unemployment. And this suggests an analogy. Imagine that you’re driving along a stretch of highway where the legal speed limit is 55 miles an hour. Unfortunately, however, you’re caught in a traffic jam, making an average of just 15 miles an hour. And the guy next to you says, “I blame those bureaucrats at the highway authority — if only they would raise the speed limit to 65, we’d be going 10 miles an hour faster.” Dumb, right?

His analogy is actually too easy on the crowd. Here’s why that’s the case, from the Massachusetts government:

Unemployment Insurance is a temporary income protection program for workers who have lost their jobs but are able to work, available for work and looking for work.

Receipt of UI benefits is contingent on one staying in the labor force. So when people tell you “UI increases unemployment” they may be right in a technical sense (and Krugman suggests why that’s wrong today). Even if so, the U3 measure has a numerator and a denominator, broadly:

  • Numerator: People in the labor force who a) don’t have a job but b) have actively looked for the past four weeks
  • Denominator: People in the labor force.

The biggest “increase” in unemployment from UI, then, comes from the “have actively looked for the past four weeks” by decreasing the number of discouraged workers. While demographic shifts are one cause of labor force exit, studies suggest that explains only 50% of the phenomenon.

Therefore, I think Krugman’s gone too easy. Even to the extent UI increases unemployment, it’s a “good” thing, by increasing labor market flexibility which has huge supply-side dividends. I have a high prior it decreases hysteresis, and chances are the only people who don’t are those who reject hysteresis outright (no comment there).

Most of us agree that worker protections are a good thing. Even “pragmatic libertarians” like Megan McArdle support unemployment insurance on “humanitarian” grounds. There are two ways we can help workers, either through the ridiculous French system of making it illegal to fire workers (which also makes it harder to fire them) or through a “flexicure” system where the state provides generous unemployment insurance and reemployment credit.

The former shrinks labor supply, the latter increases it by creating a healthier labor market. So if I could modify Krugman’s analogy I would go thusly:

In a recession cars at the front start moving slowly which makes the whole pack slower. The government can’t convince the first cars to go faster, so it decreases, literally, the friction of the road ahead by icing it. Now, the first cars can’t control themselves and start going faster. Allowing cars at the back to do the same. As they start going faster, heat generated increases, and the ice starts melting rather quickly. 

There you have the last benefit of UI, too. It’s an automatic stabilizer. Politicians couldn’t screw it up even if they wanted to.