DRI-332 for week of 6-16-13: What Lies Ahead for Us?

An Access Advertising EconBrief:

What Lies Ahead for Us?

Last month, Federal Reserve Chairman Ben Bernanke announced that the Fed Open Market Committee is contemplating an end to the $85 billion program of bond purchases that has been dubbed “Quantitative Easing (QE).” The announcement was hedged over with assurances that the denouement would come only gradually, when the Fed was satisfied that general economic conditions had improved sufficiently to make QE unnecessary. Nonetheless, the announcement produced a flurry of speculation about the eventual date and timing of the Fed’s exit.

The Fed’s monetary policy since the financial crisis of 2008 and the stimulus package of 2009 is unique in U.S. economic history. Indeed, its repercussions have resounded throughout the world. Its motives and means are both poorly understood and hotly debated. Shedding light on these matters will help us face the future. A question-and-answer format seems appropriate to reflect the mood of uncertainty, anxiety and fear that pervades today’s climate.

What was the motivation for QE, anyway?

The stated motivation was to provide economic stimulus. The nature of the stimulus was ambiguously defined. Sometimes it was to increase the rate of inflation, which was supposedly too low. Sometimes it was to stimulate investment by holding interest rates low. The idea here was that, since the Fed was buying bonds issued by the Treasury, the Fed could take advantage of the inverse relationship between a bond’s price and its yield to maturity by bidding up T-bond prices, which automatically has the effect of bidding down their yields. Because $85 billion worth of Treasury bonds comprise such a large quarterly chunk of the overall bond market, this will depress bond yields for quite a while after the T-bond auction. Finally, the last stimulative feature of the policy was ostensibly to indirectly stimulate purchase of stocks by driving down the yields on fixed-income assets like bonds. With nowhere to go except stocks, investors would bid up stock prices, thus increasing the net worth of equity investors, who comprise some 40-50% of the population.

How was driving up stock prices supposed to stimulate the economy?

The ostensible idea was to make a large segment of Americans feel wealthier. This should cause them to spend more money. This sizable increase in overall expenditures should cause secondary increases in income and employment through the economic process known as the “multiplier effect.” This would end the recession by reducing unemployment and luring Americans back into the labor force.

How did the plan work out?

Inflation didn’t increase much, if at all. Neither did investment, particularly when viewed in net terms that exclude investments to replace deteriorated capital stock. Stock prices certainly rose, although the consumption increases that followed have remained modest.

So the plan was a failure?

That would be a reasonable assessment if, and only if, the stated goal(s) of QE was (were) the real goal(s). But that wasn’t true; the real goal QE was to reinforce and magnify the Fed’s overall “zero interest-rate policy,” called ZIRP for short. As long as it accomplished that goal, any economic stimulus produced was a bonus. And on that score, QE succeeded very well indeed. That is why it was extended and why the Fed is stretching it out as long as it can.

Wait a minute – I thought you just said that even though interest rates have remained low, investment has not increased. Why, then, is the Fed so hot to keep interest rates low? I always heard that the whole idea behind Fed policies to peg interest rates at low levels was to stimulate investment. Why is the Fed busting our chops to follow this policy when it isn’t working?

You heard right. That was, and still is, the simple Keynesian model taught to freshman and sophomore economics students in college. The problem is that it never did work particularly well and now works worse than ever. In fact, that policy is actually the proximate cause of the business cycle as we have traditionally known it.

But even though the Fed gives lip service to this outdated textbook concept, the real reason it wants to keep interest rates low is financial. If the Fed allowed interest rates to rise – as they would certainly do if allowed to find their own level in a free capital market – the rise in market interest rates would force the federal government to finance its gargantuan current and future budget deficits by selling bonds that paid much higher interest rates to bondholders. And that would drive the percentage of the federal government budget devoted to interest payments through the roof. Little would be left for the other spending that funds big government as we know it – the many cabinet departments and myriad regulatory and welfare agencies.

Even if you don’t find this argument compelling – and you can bet it compels anybody who gets a paycheck from the federal government – it should be obvious to everybody that the Fed isn’t really trying that hard to apply traditional stimulative monetary policy. After all, stimulative monetary policy works by putting money in public hands – allowing banks to make loans and consumer spending to magnify the multiplier effects of the loan expenditures. But Bernanke lobbied for a change in the law that allowed the Fed to pay interest to banks on their excess reserves.  When the Fed enforces ZIRP by buying bonds in the secondary market, it pays banks for them by crediting the banks’ reserve accounts at the Fed. The interest payments mean that the banks don’t have to risk making loans with that money; they can just hold it in excess reserves and earn easy profits. This is the reason why the Fed’s money creation has not caused runaway inflation, as government money creation always did in the past. You can’t have all or most prices rising at once unless the newly created money is actually chasing goods and services, which is not happening here.

But the mere fact that hyperinflation hasn’t struck doesn’t mean that the all-clear has been sounded. And it doesn’t mean that we’re not being gored by the horns of a debt dilemma. We certainly are.

Being gored in the bowels of a storm cellar is a pretty uncomfortable metaphor. You make it sound as though we have reached a critical economic crisis point.

We have. Every well-known civilizational collapse and revolution, from ancient Rome to the present day, has experienced a financial crisis resembling ours. The formula is familiar. The government has overspent and resorted to money creation as a desperate expedient to finance itself. This has papered over the problem but ended up making things even worse. For example, the French support for the American colonies against Great Britain was the straw that broke the bank of their monarchy, fomenting the French Revolution. The Romanovs downfall occurred despite Russia’s increasing rate of economic growth in the late 1800s and because of financial profligacy and war – two causes that should be familiar to us.

It sounds as though government can no longer use the tools of fiscal and monetary policy to stimulate the economy.

It never could. After all, the advent of Keynesian economics after 1950 did not usher in unprecedented, uninterrupted world prosperity. We had recessions and depressions before Keynes wrote his General Theory in 1936 and have had them since then, too. And Keynes’s conclusions were anticipated by other economists, such as the American economists Foster and Catchings in the late 1920s. F.A. Hayek wrote a lengthy article refuting their arguments in 1927 and he later opposed Keynes throughout the 1930s and thereafter. The principles of his business-cycle theory were never better illustrated than by real-world events during the run-up to the recession and financial crisis in 2007-2008 and the later stimulus, ZIRP and QE.

It seems amazing, but Keynesian economists today justify government policies by claiming that the alternative would have been worse and by claiming responsibility for anything good that happens. Actually, the real force at work was described by the Chairman of Great Britain’s Bank of England, Mervyn King, in the central bank’s February Inflation Report:

“We must recognize [sic], however, that there are limits to what can be achieved via general monetary stimulus – in any form – on its own. Monetary policy works, at least in part, by providing incentives to households and businesses to bring forward spending from the future to the present. But that reduces spending plans tomorrow. And when tomorrow arrives, an even larger stimulus is required to bring forward yet more spending from the future. As time passes, larger and larger doses of stimulus are required.”

King’s characterization of transferring spending or borrowing from the future accurately describes the effects of textbook Keynesian economics and the new variant spawned by the Bernanke Fed. Keynesians themselves advertised the advantage of fiscal policy as the fact that government spending spends 100% of every available dollar, while private consumers allow part of the same dollar to leak into savings. This dovetails exactly with King’s account. The artificially low interest rates created by monetary policy have the same effect of turning saving into current consumption.

Today, we are experiencing a grotesque, nightmarish version of Keynesian economics. Ordinarily, artificially low interest rates would stimulate excessive investment – or rather, would drive investment capital into longer-maturing projects that later prove unprofitable, like the flood of money directed toward housing and real-estate investment in the first decade of this century. But our current interest rates are so absurdly low, so palpably phony, that businesses are not about to be suckered by them. After all, nobody can predict when rates might shoot up and squelch the profitability of their investment. So corporations have pulled up their financial drawbridges behind balance sheets heavy with cash. Consumers have pulled consumption forward from the future, since that is the only attractive alternative to the stock investments that only recently wrecked their net worth. This, too, validates King’s conclusions. Whether “successful” or not, Keynesian economics cannot last because the policy of borrowing from the future is self-limiting and self-defeating.

Didn’t I just read that our budget deficit is headed lower? Doesn’t this mean that we’ve turned the corner of both our budget crisis and our flagging recovery?

If you read carefully, you discovered that the improvement in the federal government’s fiscal posture is temporary, mostly an accounting artifact that occurs every April. Another contributing factor is the income corporations distributed at year-end 2012 to avoid taxation at this year’s higher rates, which is now being taxed at the individual level. Most of this constitutes a one-time increase in revenue that will not carry over into subsequent quarters. Even though the real economic benefits of this are illusory, it does serve to explain why Fed Chairman Bernanke has picked this moment to announce an impending “tapering off” of the QE program of Fed bond purchases.

How so?

The fact that federal deficits will be temporarily lower means that the federal government will be selling fewer bonds to finance its deficit. This, in turn, means that the Fed will perforce be buying fewer bonds whether it wants to or not. Even if there might technically be enough bonds sold for the Fed to continue buying at its current $85 billion level, it would be inadvisable for the federal government to buy all, or virtually all, of an entire issue while leaving nothing for private investors. After all, U.S. government bonds are still the world’s leading fixed-income financial instrument.

Since the Fed is going to be forced to reduce QE anyway, this gives Bernanke and company the chance to gauge public reaction to their announcement and to the actual reduction. Eventually, the Fed is going to have to end QE, and the more accurately they can predict the reaction to this, the better they can judge when to do that. So the Fed is simply making a virtue out of necessity.

You said something awhile back that I can’t forget. You referred to the Keynesian policy of artificially lowering interest rates to stimulate investment as the “proximate” cause of the business cycle. Why is that true and what is the qualifier doing there?

To illustrate the meaning, consider the Great Recession that began in 2007. There were many “causes,” if one defines a cause as an event or sequence of events that initiated, reinforced or accelerated the course of the recession. The housing bubble and ensuing collapse in housing prices was prominent among these. That bubble itself had various causes, including the adoption of restrictive land-use policies by many state and local jurisdictions across America, imprudent federal-government policies promoting home-ownership by relaxing credit standards, bank-regulation standards that positioned mortgage-related securities as essentially riskless and the creation and subsidy of government-sponsored agencies like Fannie Mae and Freddie Mac that implemented unwise policies and distorted longstanding principles of home purchase and finance. Another contributor to recession was the decline in the exchange-value of the U.S. dollar that led to a sharp upward spike in (dollar-denominated) crude oil prices.

But the reign of artificially low interest rates that allowed widespread access to housing-related capital and distorted investment incentives on both the demand and production side of the market were the proximate cause of both the housing bubble and the recession. The interest rates were the most closely linked causal agent to the bubble and the recession would not have happened without the bubble. Not only that, the artificially low interest rates would have triggered a recession even without the other independent influences – albeit a much milder one. Another way to characterize the link between interest rates and the recession would be to say that the artificially low interest rates were both necessary and sufficient to produce the recession. The question is: Why?

For several centuries, an artificial lowering of interest rates accompanied an increase in the supply of money and/or credit. Prior to the 20th century, this was usually owing to increases in stocks of mined gold and/or silver, coupled with the metallic monetary standards then in use. Modern central banks have created credit while severing its linkage with government holdings of stocks of precious metals, thus imposing a regime of fiat money operating under the principles of fractional-reserve banking.

In both these institutional settings, the immediate reaction to the monetary change was lower interest rates. The effect was the same as if consumers had decided to save more money in order to consume less today and more in the future. The lower interest rates had complex effects on the total volume of investment because they affect investment through three different channels. The lower rate of discount and increased value of future investment flows greatly increase the attractiveness of some investments – namely, those in long-lived production processes where cash flows are realized in the relatively distant future. Housing is a classic example of one such process. Thus, a boom is created in the sector(s) to which resources are drawn by the low interest rates, like the one the U.S. enjoyed in the early 2000s.

The increase in employment and income in those sectors causes an increase in the demand for current consumption goods. This bids up prices of labor and raw materials, provided either that full employment has been reached or that those resources are specialized to their particular sectors. This tends to reduce investment in shorter-term production processes, including those that produce goods and services for current consumption. Moreover, the original investments are starting to run into trouble for three reasons: first, because their costs are unexpectedly increasing; second, because the consumer demand that would ordinarily have accompanied an increase in saving is absent because it was monetary expansion, not saving, that produced the fall in interest rates; and third, because interest rates return to their (higher) natural level, making it difficult to complete or support the original investments.

Only an increase in the rate of monetary expansion will allow original investments to be refinanced or validated by an artificial shot of consumer demand. That is what often happened throughout the 20th century – central banks frantically doubled down on their original monetary policy when its results started to go sour. Of course, this merely repeated the whole process over again and increased the size and number of failed investments. The eventual outcome was widespread unemployment and recession. That is the story of the recent housing bubble. This mushrooming disaster couldn’t happen without central banking, which explains why 19th century business cycles were less severe than many modern ones.

I don’t recall reading this rather complicated explanation before or hearing it discussed on television or radio. Why not?

The preceding theory of business cycles was developed by F. A. Hayek in the late 1920s, based on monetary theory developed by his mentor, Ludwig von Mises, and the interest-rate theory of the Swedish economist, Knut Wicksell. Hayek used it to predict the onset of what became the Great Depression in 1929. (Von Mises was even more emphatic, foreseeing a “great crash” in a letter to his wife and refusing a prestigious appointment in his native Vienna to avoid being tarred by exposure to events.) Hayek’s theory earned him an appointment to the London School of Economics in 1931. It was cited by the Nobel committee that awarded him the prize for economic science in 1974.

But after 1931, Hayek engaged several theoretical controversies with his fellow economists. The most famous of these was his long-running debate with John Maynard Keynes. One long-term consequence of that debate was the economics profession’s exile of capital theory from macroeconomics. They refused to contemplate the distinction between long-term and short-term production processes and capital goods. They treated capital as a homogeneous lump or mass rather than a delicate fabric of heterogeneous goods valued by an intricate structure of interest rates.

That is why Keynesian macroeconomics textbooks pretend that government can increase investment by creating money that lowers “the” interest rate. If government could really do this, of course, our lives would all be radically different than they actually are. We would not experience recessions and depressions.

Public-service radio and television advertisements warn consumers to beware of investment scams that promise returns that are “too good to be true.” “If it sounds too good to be true,” the ad declares sententiously, “it probably is.” What we really need is a commercial warning us to apply this principle to the claims of government and government policymakers – and, for that matter, university professors who are dependent upon government for their livelihood.

It turns out to be surprisingly difficult to refute the claims of Keynesian economics without resorting to the annoyingly complicated precepts of capital theory. Ten years before Keynes published his theory, the American economists Foster and Catchings developed a theory of government intervention that embodied most of Keynes’ ideas. They published their ideas in two books and challenged the world to refute them, even offering a sizable cash prize to any successful challenger. Many prominent economists tried and failed to win the prize. What is more, as Hayek himself acknowledged, their failure was deserved, for their analysis did not reveal the fallacies inherent in the authors’ work.

Hayek wrote a lengthy refutation that was later published under the title of “The ‘Paradox’ of Saving.” Today, over 80 years later, it remains probably the most meticulous explanation of why government cannot artificially create and preserve prosperity merely by manipulating monetary variables like the quantity of money and interest rates.

There is nothing wrong with Hayek’s analysis. The main problem with his work is that it is not fashionable. The public has been lied to so long and so convincingly that it can hardly grasp the truth. The idea that government can and should create wealth out of thin air is so alluring and so reassuring – and the idea of its impossibility so painful and troubling – that fantasy seems preferable to reality. Besides, large numbers of people now make their living by pretending that government can do the impossible. Nothing short of social collapse will force them to believe otherwise.

The economics profession obsessively studied and research Keynesian economics for over 40 years, so it has less excuse for its behavior nowadays. Keynes’ main contentions were refuted. Keynesianism was rejected by macroeconomists throughout the world. Even the head of the British Labor Party, James Callaghan, bitter denounced it in a famous speech in 1976. The Labor Party had used Keynesian economics as its key economic-policy tool during its installation of post-World War II socialism and nationalization in Great Britain, so Callaghan’s words should have driven a stake through Keynes’ heart forevermore.

Yet economists still found excuses to keep his doctrines alive. Instead of embracing Hayek, they developed “New Keynesian Economics” – which has nothing to do with the policies of Bernanke and Obama today. The advent of the financial crisis and the Great Recession brought the “return of the Master” (e.g., Keynes). This was apparently a default response by the economics profession. The Recession was not caused by free markets nor was it solved by Keynesian economics. Keynesian economics hadn’t got any better or wiser since its demise. so there was no reason for it to reemerge like a zombie in a George Romero movie. Apparently, economists were reacting viscerally in “we can’t just sit here doing nothing” mode – even though that’s exactly what they should have done.

If QE and ZIRP are not the answer to our current economic malaise, what is?

In order to solve a problem, you first have to stop making it worse. That means ending the monetary madness embodied in QE and ZIRP. Don’t try to keep interest rates as low as possible; let them find their natural level. This means allowing interest rates to be determined by the savings supplied by the private sector and the investment demand generated by private businesses.

In turn, this means that housing prices will be determined by markets, not by the artificial actions of the Fed. This will undoubtedly reverse recent price increases recorded in some markets. As the example of Japan shows only too well, there is no substitute for free-market prices in housing. Keeping a massive economy in a state of suspended animation for two decades is no substitute for a functioning price system.

The course taken by U.S. economic history in the 20th century shows that there is no living with a central bank. Sooner or later, even a central bank that starts out small and innocuous turns into a raging tiger with taxpayers riding its back and looking for a way to get off. (The Wall Street Journal‘s recent editorial “Bernanke Rides the Bull” seems to have misdirected the metaphor, since we are the ones riding the bull.) Instead of a Fed, we need free-market banks incapable of wangling bailouts from the government and a free market for money in which there are no compulsory requirements to accept government money and no barriers to entry by private firms anxious to supply reliable forms of money. Bit Coin is a promising development in this area.

What does all the talk about the Fed “unwinding” its actions refer to?

It refers to undoing previous actions; more specifically, to sales that cancel out previous purchases of U.S. Treasury bonds. The Fed has been buying government bonds in both primary and secondary bond markets pursuant to their QE and ZIRP policies, respectively. It now has massive quantities of those bonds on its balance sheet. Technically, that makes the Fed the world’s largest creditor of the U.S. government. (Since the Fed is owned by its member banks, the banks are really the owner/creditors.) That means that the Federal Reserve has monetized vast quantities of U.S. government debt.

There are two courses open to the Fed. One of them is hyperinflation, which is what will happen when the Fed stops buying, interest rates rise to normal levels and banks have no alternative but to use their reserves for normal, profit-oriented purposes that put money into circulation for spending. This has never before happened in peacetime in the U.S. The other is for the Fed to sell the bonds to the public, which will consist mostly of commercial banks. This will withdraw the money from circulation and end the threat of hyperinflation (assuming the Fed sterilizes it). But it will also drive bond prices into the ground, which means that interest rates will shoot skyward. This will create the aforementioned government budget/debt crisis of industrial strength – and the high interest rates won’t do much for the general business climate for awhile, either.

Since it is considered a public-relations sin for government to do anything that makes the general public uncomfortable and which can be directly traced to it, it is easy to see why the Fed doesn’t want to take any action at all. But doing nothing is not an option, either. Eventually, one of the two aforementioned scenarios will unfold, anyway, in spite of efforts to forestall them.

Uhhhh… That doesn’t sound good.

No spit, Spurlock. Yet, paradoxical as it might seem at first, either of these two scenarios will probably make people more receptive to solutions like free banking and free-market money – solutions that most people consider much too radical right now. There are times in life when things have to get worse before they can get better. Regrettably, this looks like one of those times.

DRI-259 for week of 2-10-13: Coverage of President Obama’s SOTU Minimum-Wage Proposal

An Access Advertising EconBrief:

Coverage of President Obama’s SOTU Minimum-Wage Proposal

As advertised, President Barack Obama’s 2013 State of the Union (SOTU) address outlined the economic agenda for his second term in office. Among its planks was a proposal to raise the minimum wage to $9.00 an hour from its current $7.25. The reputation of economics as “the dismal science” is vindicated by the coverage of this proposal in the news media, which is indeed nothing short of dismal.

The Wall Street Journal‘s Coverage of Obama’s Minimum-Wage Proposal

The Wall Street Journal is the leading financial publication in America – indeed, in the world. On page four of its morning-after coverage of Obama’s SOTU message, the Journal provided a five-column box headlined “Bid on Minimum Wage Revives Issue That Has Divided Economists,” written by reporters Damian Palette and Jon Hilsenrath. The pair predicts that “President Obama’s proposal… is likely to rekindle debates over whether the measure helps or hurts low-income workers.” And the debates will be between “White House officials” who “say the move …is aimed at addressing poverty and helping low-income Americans” and “Republicans and business groups, which have traditionally said raising the minimum wage discourages companies from hiring low-skilled workers.”

The article rehearses the specifics of the President’s proposal, which raise the minimum wage in stages to $9.00 per hour by 2015, after which it would be indexed to the rate of inflation. It reminds readers that Mr. Obama originally proposed to raise the minimum to $9.50 by 2011. It reports confident projections by “Administration officials” that at least 15 million Americans would directly benefit from the increase by 2015, not counting those now earning above the minimum whose wages would be driven higher by the measure.

Three paragraphs in the middle of the piece gloss over the views of “economists and politicians [who] are divided over the issue.” These consist of two economists, one proponent and one opponent, and one central banker. David Neumark of the University of California Irvine unequivocally maintains that “the effects of the minimum wage are declines in employment for the very least skilled workers,” while “a lot of the benefits …leak out to families way above the poverty line.” Alan Krueger from PrincetonUniversity, currently Chairman of the President’s Council of Economic Advisors, “found positive effects” from the minimum wage on fast-food workers in New Jersey. The authors do not remark the apparent coincidence that Neumark and Krueger studied precisely the same group of workers in reaching their conclusions. Janet Yellen, Vice-Chairman of the Federal Reserve, was quoted as refusing to endorse the minimum-wage increase on grounds of its irrelevance to current conditions, while admitting its adverse effects would probably be small.

The authors close out by summarizing the political strategies of the White House and Republicans in proposing and opposing the measure. The authors toss in a few numbers of general economic significance – surging stock market, recent increase in hiring, persistently slow economic growth, nagging high unemployment, decline in median real income since 2000. They cite the most recent minimum-wage increase in 2009 and note that 19 states already have statewide minima in excess of the current federal minimum.

The reader will notice that the Journal‘s headline refers to a revival of a debate between economists. Yet the article only cites two economists and the debate consists of approximately five lines out of five columns of prose – just over 4% of the article’s 120 lines. A reader who isn’t already thoroughly familiar with the issue will learn virtually nothing at all about why the minimum wage is bad or – for that matter – why its proponents think it is good. The closest thing to analysis are cryptic references to “discourages companies from hiring,” “declines in employment” and – most mysterious of all – “benefits” that “leak out to families way above the poverty line.”

Between 90% and 95% of the article is devoted to politics. And that is utterly superficial. The world’s leading financial publication has devoted substantial space to a Presidential proposal of economic significance, yet its readers would never suspect that the subject is one of the most highly research, well-considered and settled in all of economics. The minimum wage has been a staple application in microeconomics textbooks for over a half-century. Along with policy measures like free international trade and rent control, the minimum wage has generated the most lopsided responses in opinion surveys taken of economists. In percentages ranging from 75% to 90%, economists have resoundingly affirmed their belief that minimum wages promote higher unemployment among low-skilled workers – among their many undesirable effects.

Yet today Wall Street Journal reporters imply that it’s a 50-50 proposition. Or rather, they imply that economists are evenly divided on the merits of the measure. The article mentions a revival of a debate without explaining the terms of the debate or its previous resolution. Indeed, even the arguments of the proponent economist – the Chairman of the CEA, no less! – go unmentioned.

Something more than mere journalistic incompetence is on display here. The WSJ reporters are showing contempt for the discipline of economics. The only significant thing about economists, they imply, is that they are “divided.” The economics itself is hardly worth our attention.

Economists have only themselves to blame for their low repute. But readers deserve a truthful and complete understanding of the minimum wage.

The Minimum Wage As Seen by Economics – and Economists

The minimum wage is a species of the economic genus known as the “minimum price.” Other species include agricultural price supports, imposed for the ostensible purpose of increasing the incomes of family farmers. The idea behind all minimum prices is to make the price of something higher than it would otherwise be. The alternative embodies in “otherwise” is to allow the price of human labor to find its own level in a free labor market. That level is the point at which the amount of labor workers wish to supply is equal to the amount that businesses want to hire. Economists call the wage that equalizes the quantity of labor supplied with the quantity demanded the equilibrium wage.

In practice, the minimum wage is always legislatively pegged at a higher level than the current equilibrium wage. Otherwise there would be no point to it. And in practice, the minimum wage applies only to low-skilled labor. This is because wages reflect the value of labor’s productivity and low-skilled labor is the least productive kind. What is the effect of a higher-than-equilibrium wage for low-skilled labor?

Holding the price of anything above its equilibrium level produces a surplus of that thing. A surplus of human labor is called “unemployment” in layman’s terms. Thus, a minimum wage produces unemployment where there would otherwise be no (persistent) unemployment.

If this sounds pretty categorical, cut-and-dried and matter-of-fact, that’s because it is. Supply and demand are economics. More precisely, they are what we today label “microeconomics.” Since there is no macroeconomic theory left standing that is worthy of the name, that leaves us with supply and demand and very little else.

The federal minimum wage was first introduced in the Fair Labor Standards Act of 1938. It first began attracting attention from academic economists after World War II when George Stigler wrote a celebrated article outlining its basic effects in 1946. The first edition of Stigler’s legendary textbook on microeconomic price theory appeared in 1949. This may have been the debut of the minimum wage as a textbook application – a way of illustrating what happens when the principles of supply and demand are flouted by government.

Stigler may have been the first future Nobel Laureate to oppose the minimum wage, but he headed up what became a long procession with few absentees. Since then, it has been rare to find an intermediate (junior-senior level) micro textbook that didn’t feature an analysis of the minimum wage and the effects of the labor surplus it causes. This practice has crossed political lines. Liberal economists write textbooks, too, but they were pitiless in their view of the minimum wage – at least until recently, anyway. Alan Blinder, former CEA member under President Bill Clinton, was embarrassed by the revelation that his political support for a minimum wage conflicted with his textbook’s unsparing criticism of it.

The Effects of a Minimum Wage

The effects of a minimum wage are those of a minimum price generally, translated into the specific context of the market for low-skilled labor. The overarching effect, whose implications far exceed the obvious, is the surplus of labor created. The resulting unemployment, in and of itself, confounds the expectations of minimum-wage proponents. Their stated purpose is to increase the monetary incomes, hence real incomes, hence well-being of low-income workers. But you can only benefit from a higher wage if you have a job from which to earn that wage. The low-skilled workers whose jobs are lost because of the minimum wage are harmed by it, not helped. Moreover, they have nowhere to go except the unemployment line. Ordinarily, people who lose their job look for another job. But low-skilled workers are already scraping the bottom of the barrel – when that residue is suddenly denied them, they’re out of luck.

But what about the people who don’t lose their job? They benefit, don’t they? True enough, at least as a first approximation. The minimum wage should be viewed as transferring income from some low-skilled workers to other low-skilled workers. It is tempting to say it transfers income from some poor workers to other poor workers, but this is not always true. Sometimes it transfer income from poor people to rich people or, more precisely, to the offspring of rich people. That outcome will be explained below.

Wait a minute – what about employers? To hear the left wing talk, the problems of the poor are mostly the fault of greedy bosses who refuse to pay the poor what they’re worth. (The ever-popular formulation is that employers owe their workers a “living wage.”) At least the minimum wage sticks it to those greedy bastards, doesn’t it?

The answer is: Yes and no, but mostly no. In the short run, owners of businesses share the cost of the minimum wage with workers who are driven out of work. Business owners share that cost because higher wages mean higher costs, and higher costs will reduce revenues and profits and drive marginal businesses out of business. The reduced supply of goods will drive prices to consumers higher.

In the long run, though, the higher price gradually attained by the market in response to the higher costs will restore the business rate of return (i.e., profit) to its “normal” level. So, the remaining businesses in the market do not suffer long-run harm from the minimum wage. In the long run, the burden of the minimum wage is borne by consumers of the products produced using low-skilled labor and by low-skilled workers who remain out of work or whose prospects for work and productivity are permanently reduced by their sojourn into unemployment.

In other words, the minimum wage does not exact class revenge against evil, greedy businessmen. It harms poor, low-skilled workers and consumers – who are mostly ordinary people. Is it any wonder, then, that even liberal economists have traditionally refused to endorse the minimum wage as a means of transferring income to the poor?

Wait – There’s More. A LOT More

If John Paul Jones were an economist, he might interject at this point that we have not yet begun our analytical fight against popular misconceptions about the minimum wage. The artificial surplus created by the minimum wage has even more insidious implications.

In a competitive market, the tendency toward equality between quantity supplied and quantity demanded of the good or service being provided exerts a restraining influence on the actions of buyers and sellers. If you show up to rent an apartment or house and the landlord doesn’t like the color of your skin, he might decide to not to rent to you. But when there are exactly as many buyers as there are apartments and houses on the market, this will cost him money. The economic history of the world – and the history of discrimination in the American South and South Africa, among other places – very strongly confirms that competition and economic incentives are the best means of overcoming racial discrimination.

But when the market is in surplus, the picture changes dramatically. Now the landlord can afford to discriminate among would-be buyers by turning down one he doesn’t particularly like, because he knows that others are out there waiting for his unit.

The logic applies to buyers as well. Under competitive conditions, employers cannot afford to discriminate against workers for any reasons not related to productivity. They know only too well how hard it is to find good help when the market is tight. But when unemployment is high, an employer with a “taste for discrimination” can afford to indulge it. (It is idle to talk about whether that behavior is against the law or not. In practice, the case for discrimination cannot be proved; legal cases are won by imposing heavy costs on defendants until they give up and settle by admitting guilt whether true or not. And the cases are prosecuted in the first place for political or economic reasons, not to achieve justice for defendants.)

One of life’s supreme ironies is that the very people who cry the loudest for an end to racial discrimination and lament the injustice of our racist society are the same people who lobby in favor of the minimum wage. By creating a surplus of low-skilled labor and reducing the effective cost of discrimination to zero, the minimum wage surely makes it easy for employers to exercise whatever racist urges they might feel.

…And More

The minimum wage is anti-black in its effects not only because it promotes discrimination, but also because it places blacks at an objective disadvantage. One thing employers look for is experience. On average, blacks are younger than other ethnic groups and have less experience. Thus, they are less able to cope with the labor surplus created by the minimum wage.

Both minimum and maximum prices bring the issue of product quality to bear on the decisions of businesses. When businesses can’t raise prices due to maximum prices, or price controls, they try to reduce product quality instead. Similarly, when businesses suddenly face an increase in the minimum wage, they look to offset its effects by retaining only their highest-quality low-skilled workers. That is, they retain the best-dressed, most punctual, technologically adept workers rather than the shabbier, less reliable, socially and technically awkward workers. All too often, the workers let go are the ones who need the job the most – namely, low-income blacks picking up the necessary skills to succeed in the working world. Their places are taken by the sons and daughters of the well-to-do, whose cultural and economic advantages gave them an occupational leg up when they entered the labor market. This is what David Neumark meant by benefits leaking out to the well-to-do.

Black (illicit) markets are an inevitable by-product of minimum and maximum prices. In this case, the existence of a labor surplus means that there are people willing to work at a lower wage than the prevailing wage. By offering sub-standard working conditions and employment “off the books,” some employers can induce workers into work that they wouldn’t accept in a competitive labor market. This is still another ill effect of the minimum wage and another way in which low-skilled workers bear its brunt.

The late Milton Friedman was outraged by popular efforts to depict the minimum wage as the salvation of the poor and underprivileged. He called it the most anti-black law on the books.

The Card-Krueger Study

In 1993, two economists made a bid to overturn the decades-old economic consensus against the minimum wage. David Card and Alan Krueger conducted a phone survey of fast-food establishments in New Jersey and Pennsylvania. They chose these two adjoining states because New Jersey had raised its minimum wage prior to the study period, during which Pennsylvania’s law remained unchanged. Their study found that New Jersey’s employment of low-skilled labor increased by 13% relative to Pennsylvania’s. They ascribed this to the fact that the higher wage had certain desirable effects on the labor force.

Both the general public and the economics profession went gaga over this single result. Despite decades of studies and negative results by dozens of distinguished economists, this one study was said to have revolutionized thinking on the minimum wage. In reality, its effects were more political than economic.

An attempt to replicate the study by the National Bureau of Economic Research used payroll records from the businesses surveyed by Card and Krueger rather than relying on the phone surveys. Apparent anomalies had been found in both the New Jersey and Pennsylvania date using the phone surveys, so the payroll records were substituted as a check on the results. Sure enough, recalculation of the results using the payroll records reversed the results of the study – New Jersey employment was now found to have declined by about 4% relative to Pennsylvania’s.

Alan Krueger parlayed the popularity of his study into the Chairmanship of the President’s Council of Economic Advisors. David Card has recently written a book about the subject of the minimum wage. But there is little reason to accept the results of their original study at its face value.

The Political Purpose of the Minimum Wage

Economists have long known that the true purposes of the minimum wage are political rather than economic. Low-skilled labor is a substitute for unionized labor and higher-skilled labor. By making low-skilled labor less attractive to employers, the minimum wage makes union labor more attractive. That is why unions have supported a minimum wage since long before it was actually adopted, both in the U.S. and in places like South Africa.

Unions are one of the strongest and most numerous constituent groups of the Obama administration. That is why the President has now opted to advance this proposal to increase the minimum wage. Yet The Wall Street Journal‘s piece – which purported to describe the economics and politics of the measure – did not breathe a word of this.

Note: The first draft of this post erred by saying that the minimum wage was introduced in the Wagner Act of 1935, rather than the Fair Labor Standards Act of 1938.