Monday, January 12, 2015

Wages aren't moving quickly... as normal

Part 1: Description of the issue
The New York Times today wrote an article about how wages are not currently rising with the unemployment rate being now at a 6 year low, currently at 5.6% for December. They described how the Federal Reserve is considering raising interest rates which will (and this is true) make it more expensive for small businesses to borrow and slow the recovery, to prevent it from overheating, and this will (also true) lower the demand for labor which will keep wages stagnant.

But the most important detail they left out is why the wages are staying low. The reason is fairly simple and has to do with an economic concept called "sticky wages" which was one concept envisioned by John Maynard Keynes at the beginning of the 20th century to help explain why the 1930s happened how it did. Sticky prices means that it takes time for prices to adjust as the economy changes, which means in the short run we observe prices can be too low or too high for a period of time as the economy. This is why wages aren't moving yet. This concept has been observed in all markets.

This is why we are currently seeing wages stay low. This is also why the Federal Reserve needs to keep interest rates low for the time being which will incentivize more small businesses to open, which will increase the demand for labor, which will increase the wage sooner than later. Small businesses will compete for the best workers which will mean that the best will pay more to the best workers which will lift the average wage, increase purchasing power for the average family, and help fight income inequality. If the Federal Reserve makes it too expensive for small businesses to open and borrow we will see the market cool too early. So far they have done this which is the right strategy.

Part 2: Solutions
This of course happens over the very long-run, and (as an educated guess) I wouldn't expect the wages to start naturally rising for another 3-5 years personally at this point. If we wanted to see the wage rise faster than that what we would want to do is pursue the following policy options which have the fewest negative side effects:
  1. Increase access to small business loans and grants from the Federal Government. More businesses means each individual business will have a smaller effect on the average wage which will push it up. It will give workers more bargaining power relative to businesses. This benefits people of all professions. (On our supply and demand diagram the demand for labor shifts to the right, pushing wages up and incentivizing people to start working)
  2. Improve our labor laws to make it more easy for workers to unionize. If businesses are able to form chambers of commerce, unionizing needs to become standard practice again. This again helps people of all professions. (On our supply and demand diagram supply will be more flat, making wages more steady and higher in each profession)
  3. Stop protecting large businesses from failure, and enforce our anti-trust laws. This makes it so each firm will have a smaller impact on the wage (forcing it up) and mean that the impact of a failure of any one firm in the future will have a smaller impact on the economy. Healthy economies have many businesses competing against each other in a competitive market, which pushes wages up (which directly makes a more equal society when it comes to income) and makes it so the failure of any one firm will not put the economy in great danger. In the short run the failure of one of these massive firms breaking up will be huge, but insuring that these large firms will go through restructuring and be reorganized as many smaller firms when they go belly up will be healthier for the economy, and have a direct effect on wages. (Demand becomes more vertical, meaning that they have a smaller impact on wages)
These are all free-market reforms and there is a very good reason for this. The first is deadweight loss which is observed any time there is a price floor (such as a minimum wage) or similar measures. I link to the Wikipedia article so readers who do not know about this can read about it, it is a fairly straightforward concept which naturally falls out of the standard analysis and is observed in reality. In the labor market deadweight loss is observed as unemployment, so in the long-run what we want to do is encourage policies which change the overall demand for labor to move in the direction towards higher wages. All three of the policy recommendations I have follow this logic, and are long-term solutions.

The other reason why I prefer these solutions is that they are less susceptible to politics. There is definitely a need for government in economics, and this has been understood for as long as economics has been around. The marriage between economics and politics is as old as both of the fields and the two will never be fully separated. But still, when making policies we want to have policies which would take years or decades to fully reverse so that if a government were to change the law (like the Republicans are currently trying to do with Dodd-Frank) it will take a long time to see the negative impacts, just to minimize human suffering so that there is a chance to have enough time to reverse the policies after the next election before the full negative consequences are observed.

Also, while minimum wages definitely help people at the very bottom of the income distribution it has a more or less negligible effect for workers who make above the new minimum wage, is easily modified by legislatures to be reduced or eliminated (ending the effects extremely quickly), and most importantly creates deadweight loss in the form of unemployment, both of which are major issues all economists try to avoid. More market-based reforms have the bonus of not having either of these very real problems.

Should we eliminate the minimum wage? Given the weakness of American unions (partially self-inflicted, partially not) this would be a huge mistake. Having poor unions significantly reduces the negotiating power of average workers with larger firms and means that if we didn't have the minimum wage we would see a lot more government benefits going to workers and this would exacerbate income inequality. In the long-run the goal is to have unions have the power they need to effectively work with employers to raise their purchasing power. With such an economy in the future the real effect of the minimum wage would be negligible and not save us nearly as much public funds for benefits as it currently does. We are unfortunately not at that stage at the moment.

We want to get more specialized work force, which has the advantage of making workers more productive and since there is a smaller supply of potential labor as labor becomes more specialized pushes wages up significantly. This effects everyone in the economy, and needs to be our long-term goal. The three policy recommendations above are a start to such an economy with minimal negative side effects.

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