Economics 02/02/2010: Minimum Wage Blues

For those of you who missed my last Sunday Times article, here is an unedited version.

Last week, this newspaper reported about the successful Competition Authority probe into a price fixing cartel involving a number of car dealers. Of course, price fixing is illegal in Ireland. Illegal, that is, unless the perpetrator of it is the State. For proof, look no further than the price of unskilled labour – the minimum wage rate.

The end result of this law – a product of collusion between the Government and the Unions – is two-fold.

First, like any other collusive arrangement, the minimum wage leads to a long-term deterioration in the employment creation in the economy. Economists commonly link this to the deterioration in our overall competitiveness.

Second, minimum wage distorts incentives and choices of employers and employees. Over time, investment in skills, knowledge and aptitude fall for minimum wage recipients and lower-skilled, marginally more expensive employees, while businesses are incentivized to substitute their hours of work with physical capital. The age-old fear of machines displacing people is, thus, a logical denouement of the minimum wage.


The fact that the minimum wage laws reduce overall country competitiveness in the sectors heavily reliant on unskilled and low-skilled labour is undeniable. Ireland no longer registers meaningful contributions to its economy from mobile low-wage sectors. Only those lower skills activities that are captive by their nature – such as local protection services – remain here. However, the effects of the minimum wage on workers themselves are far less understood.

There is plenty of evidence that minimum wages lead to reduced employment of the lower-skilled and younger workers. Less known is the fact that minimum wage distorts education decisions of the young. Recent research from the Michigan State University shows that states that raised their minimum wage experienced increased unemployment amongst the low-skill teenagers who had previously dropped out of school. Higher-skill teenagers were more likely to get jobs, increasing their early exits from education. In other words, those who were best suited for early employment could not get a job, while those who were best suited for continued education were incentivised to drop out.

In the long run, minimum wage also shifts resources within various sectors of economic activity. Data for Ireland clearly shows that since introduction of the minimum wage here, traditionally labour-intensive sectors have seen their labour share of productivity decline, while capital share of value added has expanded. In some, labour productivity actually fell in absolute terms. These are the sectors, including hotel and restaurant services, construction, traditional manufacturing sectors, retail services and real estate activities and other, where minimum wage covers a larger overall proportion of the workforce. In contrast, other labour-intensive sectors, where wage structure was not dependent on minimum wage constraints, such as modern manufacturing, financial and professional services and wholesale and logistics services, have registered an above-average increase in overall share of value added attributable to skills and labour inputs. This trend, present in the data since introduction of the minimum wage, was not there prior to 2000.

And Ireland is hardly unique here. A study from the University of California recently showed that employers have reduced employment of the less skilled and increased employment of higher skilled workers with an emphasis on formal job training credentials in the wake of increases in minimum wage rates. For anyone concerned with the plight of the disadvantaged youths, these findings should ring the alarm bells.

Often, proponents of minimum wage laws argue that some studies have found little effect of the minimum wages on aggregate level unemployment. The problem, of course, is that such arguments neglect the issue of movement of people in and out of the labour force. While minimum wage hikes lead to higher average wages paid to those in employment, workers who lose their jobs often drop out of the labour force. As such, their numbers simply disappear off the unemployment count.

Hardly a right-wing liberal, Paul Samuelson, winner of the 1970 Nobel prize in economics had the following to say about the proposals to raise minimum wage: "What good does it do a …youth to know that an employer must pay him $2 an hour if the fact that he must be paid that amount is what keeps him from getting a job?"

This is a non-trivial observation, because it reveals one of the most damaging effects of the minimum wage laws in the modern economy. Nobel Prize winner Professor Gary S. Becker, suggested back in the 1970s that minimum wage acts as a dis-incentive for firms to invest in training of its lower-skilled employees. A recent pan-European study confirmed this to be the case across the EU, including Ireland.

The result of this is the creation of a two-tier economy, whereby those with no general and firm-specific skills remain at the very bottom of the economic hierarchy, while those with above-average skills are moving further and further up the skills chain. The companies, over time, respond to this separation by either choosing to invest more into machinery and technologies that can displace lower-skilled workers or by focusing their production processes on accumulating high quality staff.

This process drives the polarization of the overall Irish economy into what is known as ‘Modern’ and ‘Traditional’ sectors. It also drives deeper divisions amongst the lower-skilled and poorer workers by redistributing income within the lower earning segments of population. Some lower skilled get higher wages, others get permanent unemployment. In the US, a study by the National Bureau of Economic Research has shown that the 1997 hike in the federally mandated minimum wage has resulted in a 4.5 percent increase in the number of poor families.

But minimum wages do more damages than that. Generationally, it is the younger workers who tend to possess lower skills and have trouble signaling to the potential employers their latent abilities and aptitude. They also face higher unemployment rates, both at the times of growth and recession. For them, minimum wage laws create insurmountable barriers to escaping the twin trap of unskilled unemployment.

On the one hand, high minimum wage will increase the risk to the employer from hiring a wrong person, thus reducing the incentives to take on younger workers with unproven skills or performance records. On the other hand, the same workers need to gain access to positions which provide extensive on-the-job training in order to progress within the company. Even more importantly for the lower-skilled workers’ future, they need job environment that supports acquisition of generic skills and aptitude that can be transferred to other employers. Both of these investments are severely constrained by the presence of the minimum wage laws. The severity of this constraint is proportional to the gap between the minimum wage level and the average productivity of the workers seeking entry-level employment.

In other words, given the choice between hiring a young unskilled person for €8.65 per hour and a worker with more experience for the same rate, employers will always choose the latter. In times of robust growth, this might matter little, as other employment opportunities are abundant. Today, the picture is different.

Based on a comprehensive survey of minimum wage studies in the US, a 10 percent increase in the minimum wage tends to reduce employment of young workers by 1-2 percent during the times of abundant jobs creation. It is safe to assume that the rate is double in the times of tight labour markets.

Between 2006 and mid 2007, Irish minimum wage rose from €7.65 to €8.65 per hour, implying an associated decrease in employment of the younger workers of 1.3-2.6%, or up to 4,800 individuals amongst those under 25 years of age. Translated into the period of rising unemployment, the elevated rates of minimum wages in Ireland today are likely to be responsible for keeping up to 10,000 younger workers outside gainful employment.


In the end the problem with the minimum wage laws is that they always attempt to influence the supply and demand, just as any price fixing cartel would intend to do. The truth is, in such cases, invariably, the laws of supply and demand win – to the detriment of the most vulnerable and the youngest in our society. For their sake, it is time to rethink our minimum wage laws, before a new permanent class of young, unemployed and unemployable becomes a reality of Ireland’s post-crisis economy.


Box-out:

This week, Standard & Poor's has finally thrown in the towel and cut the ratings of the Irish banks’ bonds. While the news that our banking system stability overall is ranked alongside that of Slovakia and Korea galvanized business news desks attention, two interesting parts of the S&P analysis largely escaped the media. S&P explicitly provides the proof that the Banks Guarantee and Nama jointly underwrite a bailout of the Irish banks’ bondholders. Absent the two measures, AIB bonds would be rated BB/Negative/C+, while Bank of Ireland bonds would be at BB+/Negative/BB-. If not for taxpayers’ cash, bonds of our three largest banks sold to the public would require a health warning, stronger than the one posted on a packet of cigarettes. Only IL&P would stay above the waterline with BBB-/Negative/B absent state intervention. This, of course, would only be achievable assuming that the company’s life insurance business will continue to underwrite its banking branch – an idea that should be alien to anyone with an ounce of sense. In a separate comment, S&P also directly linked the poor prognosis for Irish banking sector to our sick economy. Of course this contrasts Government optimism around Nama. Remember – Nama promises to restore credit flows via ‘repairing’ banks balance sheets. S&P says that the balance sheets will remain sick after Nama as there is no real support for credit quality improvements coming from our weak economy. You decide whom you believe – Government’s contrived ‘supply will restore demand’ argument or S&P’s view that ‘weak demand will drag down supply’.