In public life, as in private life, one of the toughest challenges is having to make decisions in the face of incomplete information. This can be stressful, and when faced with this, people are generally left with two choices. First, they can recognize the limits of their knowledge and act with intellectual humility. Or, alternatively, they can pretend to know everything. Several hundred years ago, Voltaire offered this gem:
Doubt is not a pleasant condition, but certainty is absurd.
That line is in the running for the unofficial motto here at The Fog of Policy. I don’t have to tell you that our representatives in Washington, however, are less keen on doubt. Witness the reaction to a report this week from the Congressional Budget Office (CBO) on the effects of President Obama’s proposed increase in the minimum wage.
A headline from the report was that the President’s plan might cost half a million jobs. A spokesman for John Boehner, the Speaker of the House, gave this response:
With unemployment Americans’ top concern, our focus should be creating – not destroying – jobs for those who need them most.
The White House, unsurprisingly, did not take kindly to the report. Jason Furman, the Chairman of the Council of Economic Advisers, responded that, “zero is a perfectly reasonable estimate of the impact of the minimum wage on employment.”
So, how about it? Does raising the minimum wage cause the economy to lose jobs or not?
First, let’s take a look at the argument against raising the minimum wage. Basic economic theory – and common sense – tells you that firms only hire people when the marginal productivity of a new employee is greater than the marginal cost of hiring, which is another way of saying that companies hire when they think that it makes them more money. Raising the minimum wage increases the cost of hiring and should lead to fewer jobs, specifically for those workers whose productivity does not exceed the new and higher cost of hiring them.
In addition, raising the minimum wage increases the cost of producing goods because the labor component is now more expensive. In a competitive market, there isn’t much of a profit margin to make up the difference, so the cost has to be passed on to the consumer. With global trade being what it is, this can lead to American firms being less competitive, which in turn leads to lowered economic output and fewer jobs.
If you want an example, you can take a look at Puerto Rico (I’ve previously covered Puerto Rico’s special relationship with the US.) By some estimates, Puerto Rico has one of the world’s highest minimum wages relative to the economy’s median wage of any market in the world. Perhaps, not as a coincidence, Puerto Rico has abysmal unemployment and market participation rates (14% and 40%, respectively).
So, what’s the argument in favor of raising the minimum wage? One argument is simply the desire to put more money in the pocket’s of low-income people. Also, proponents argue, a higher minimum wage encourages people to work rather than seek assistance, which is both an economic benefit and an intrinsic good.
That’s all well and good, but it doesn’t address the potential unintended harm.
Champions of a higher minimum wage also point to a few empirical sources to argue against the idea that raising the minimum is an economic drag. The first involves a sort of natural experiment that is set up when two abutting counties reside in different states. This means that those counties are economically similar, but might have different minimum wages. A comparison of those cases seems to indicate no discernible effect on employment.
Another study looked at whether the effect of raising the minimum wage was different during an economic downturn than during periods of economic growth. They found no difference.
I haven’t looked at those studies in detail; maybe they were good studies, and maybe they weren’t. But the strongest argument against the idea that the minimum wage causes job loss might simply be that free-market types have sounded the alarm before, and they seem to have gotten it wrong. For example, before the minimum wage was established in 1938, business leaders warned that it would lead to Bolshevism and American decline. It sure would seem to be taking a long time. In 1966, they warned that raising the minimum wage to $1.75 an hour would devastate the American economy. In 1995, the claim was that raising the minimum wage would lead to recession. And we all remember the awful economic times Americans endured in the last five years of the Clinton 90s.
So, what gives? Why hasn’t basic economic theory been vindicated? Well, one possibility is that things would have been better without the minimum wage. (I’ll let proponents of that argument fight it out with proponents of the argument that the recent recession would have been worse without the President Obama’s stimulus.)
More convincingly, another possibility is simply that the minimum wage is actually pretty low. Accounting for inflation, today’s federal minimum wage ($7.25 per hour) is worth $2 an hour less than what it was in 1968. Being so low, you would expect the negative effects to be fairly small. A related argument is that the minimum wage doesn’t cover very many American workers, so the distortionary effects on prices is also modest.
It’s also important to remember that businesses are not perfectly efficient, and so a rise in the minimum wage might strain their profits or productivity, but that might in turn nudge them towards better practices. If your marginal unit of labor is more expensive, then you have a higher incentive to find ways to make it more productive. Optimists might see in that a sort of virtuous cycle, much as they argue that a higher minimum wage increases purchasing power and can drive economic growth.
Lastly, and importantly, a lot of minimum wage jobs are not in tradable sectors – how do you outsource burger flipping to India? Such businesses need to find another way to cope with higher labor costs, which they often do by passing that cost onto to the consumer. For example, doubling wages at McDonald’s (which is significantly more than is being currently suggested), has been estimated to increase the cost of a BigMac to $5.27 – an increase of $1.28.
I don’t know how big of an effect that would have on growth in the fast-food industry; it would depend on how elastic the demand for burgers is. But honestly, I really don’t think it would be a stretch to say that zero is a reasonable estimate.
So, what did the CBO report actually say? It forecasted that the President’s proposal would lead to half a million fewer jobs by the end of 2016, but also that it would pull nearly a million Americans out of poverty. In addition, up to 24 million Americans could see their wages rise as a result. They also said it might lead to greater economic growth.
That estimate seems credible – as an estimate. What it is not is an empirical fact about what will happen. Ultimately, the report doesn’t do much more than provide a more sophisticated model for what we’ve been talking about here. It adds decimal points to the model, but it doesn’t remove the underlying uncertainty.
Of course, that hasn’t stopped Republicans from using the CBO report as a cudgel to beat Obama over the head, rather than as an aid for thinking about a difficult economic topic. For a politician, it’s always much more satisfying to know something than it is to not know something, particularly when what you know is how wrong to other side is.
But, in the end we should probably all remember that forecasting, especially about the future, is difficult work.
Follow Pedro on Twitter @IamPedroA.
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