Answering Tim Harford on the Minimum Wage

In Saturday’s Financial Times Tim Harford asks the question “Can the Minimum Wage Create Jobs?”  The simple answer is yes, but not as many as it destroys. Any policy has winners and losers and the minimum wage is no exception. The losers are young and unskilled workers who become more expensive but no more productive to prospective employers. The winners include semi-skilled workers who compete with minimum wage workers and producers of the capital equipment that companies use to economize on unskilled labor. Crony capitalism is not limited to tax breaks, subsidies and bailouts; the minimum wage can also benefit unions threatened by cheaper non-union workers.

Harford cites the “amazing” and controversial Card and Krueger study which showed that a higher minimum wage didn’t reduce employment in fast food restaurants in New Jersey. Putting aside possible problems with their data discussed by other economists, Card and Krueger looked for job losses at restaurants with the least labor intensive food preparation methods in the history of mankind. (e.g. most have outsourced the task of filling cups with ice and soft drinks to their customers to save labor costs). A higher minimum wage raises the relative cost and price of made-to-order sandwiches in labor intensive competitors and may actually increase demand at fast-food restaurants. The Card and Krueger study says nothing about how a higher minimum wage affects the aggregate employment of unskilled labor.

Harford correctly notes that minimum wage laws attempt to treat a symptom of a larger problem. The real problem is that many young workers lack the skills that employers demand. Unfortunately the minimum wage makes it more difficult for young adults to acquire vocational skills because it makes on-the-job training programs less viable. Companies will provide general training only if workers “pay” for it through a lower wage because a company loses its investment when trained workers (who received full pay) leave. The minimum wage limits the ability of young workers to “pay” for on-the-job training and apprenticeships. This is especially costly if vocational and for-profit schools are ineffective alternatives for developing marketable skills.

The Motor City Needs a New Nickname

Detroit has been called the Motor City for almost a century, but that nickname no longer applies. In 1973 the Big Three automakers had a market share of over 80%, and more than one out of every four workers in the motor vehicle (and parts) manufacturing industry was employed in the Detroit metro area. Today, fewer than one in nine autoworkers are employed in Detroit, even after Federal assistance was provided to two domestic automakers.

The Obama Administration is proposing policies to help “insource” manufacturing jobs back to the US. The case of Detroit tells us that both new and existing manufacturing jobs are likely to re-locate in states with lower taxes and right-to-work laws.

The past 38 years has seen many changes in the auto industry, but the most striking change may be where vehicles are produced in the US. Auto industry employment declined by 70% since 1973 in Detroit, but increased in states outside of Michigan and Ohio.

Forty years ago economists might have argued that Michigan and Ohio had a comparative advantage in motor vehicle production. Factories in the upper Midwest were located close to suppliers of parts and raw materials and had access to the infrastructure that facilitates vehicle shipments. As the fortunes of the Big Three waned, foreign-owned firms had access to a pool of laid off workers with valuable skills and experience.

Nonetheless, in the past three decades new motor vehicle production facilities were built in cities and states that had none of the incumbent advantages of Detroit and Michigan. Foreign-owned firms were instead attracted by the lower taxes and more favorable labor laws in Southern states. I suspect that if manufacturing jobs are “insourced” back to the US in this economic recovery, Southern states will again be the beneficiaries.

We’re Too Old For This Recession

The outcome of the 2012 election may well depend on the unemployment rate in November.  President Reagan was re-elected in 1984 when the unemployment rate was 7.2%, but Presidents George H.W. Bush and Jimmy Carter were defeated when unemployment rates were 7.4% and 7.5% respectively.

It is misleading to compare today’s unemployment rate to the rate 30 years ago because today’s labor force is older and more experienced.  The unemployment rate was high during the early 1980s in part because many baby boomers were in their 20’s when unemployment rates tend to be high.  The declining unemployment rate in the late 1990’s and early 2000’s was aided by baby boomers entering their prime working ages.

Voter sentiment in November may depend on whether unemployment rates by age group are unusually high.  To make this comparison, I calculate an overall unemployment rate that holds constant each age group’s share of the labor force.  Using this method, I find that age adjustments increase last month’s 8.5% unemployment rate to 9.1%, while the “age-adjusted” unemployment rates when Carter, Reagan, and George H.W. Bush faced re-election were 6.8%, 6.8%, and 7.5% respectively.

Unemployment rates in the early 1980s were “inflated” by young baby boomers entering the labor force.  Although last month’s 8.5% unemployment rate is high by historical standards, it would be even higher if it weren’t for all the baby boomers now in their 50’s and 60’s (when unemployment rates tend to be low).  A worker today faces an unemployment rate that is 2.3% higher than someone the same age faced in November 1980.

This means that the recession of 2008 is even more severe than we first thought.  The unemployment rate has averaged 8.4% over the past four years which appears lower than the 8.6% average rate during the 1981 recession, but really isn’t.  In fact, the average “age-adjusted” unemployment rate over the past four years is 8.9%, which is much higher than the average 8.1% adjusted rate during the 1981 recession.

The following graph compares unemployment rates for five recent recessions and recoveries, after adjusting for workers’ ages.  It is clear that the 2008 recession has been the deepest and longest downturn in decades.  The “age-adjusted” unemployment rate exceeded 10% for 19 straight months in 2009-2011 and remains stubbornly high.

There is no doubt that the 2008 recession is more prolonged and severe than any economic downturn since the Great Depression.  The current 8.5% unemployment rate is high by historical standards, even if I don’t adjust for the graying of the labor force.  I find that the “natural” rate of unemployment for today’s relatively experienced labor force is about 1.2% lower than it was in 1980.  Therefore unless the unemployment rate in November 2012 is 6.3% or less, voters will face a higher unemployment rate this fall than voters the same age faced when Ronald Reagan defeated Jimmy Carter.

The IKEA Effect

The discussion in the news media about whether or not Bain Capital’s investments were beneficial to workers and consumers is confusing to me.  Venture capitalists allocate financial resources to enterprises where they expect a return on their investment.  Often these returns come from gains in efficiency and productivity.  Some productivity and efficiency gains result from new technologies.  Others are the result of management changes that allocate human resources, inventories and equipment in a more cost-effective way.  Efficiency gains allow a firm to compete more effectively in a world market and may cause product prices in the industry to fall, which benefits consumers.  Neither venture capitalists nor economists evaluate an investment by whether employment in the targeted firm/industry increased.  Many economically beneficial investments will cause labor-saving efficiencies and could conceivably reduce employment in the targeted firm or industry.

One of the great productivity success stories in the past twenty years has occurred in retail furniture stores in the U.S.  Output per worker hour in furniture stores has more than doubled in the past 24 years, while output per worker hour in grocery stores has barely changed.  The figure below shows that these large gains in labor productivity coincided with the entry of IKEA stores into U.S. markets.

IKEA stores attract customers because of lower prices.  One reason for the lower prices is that fewer workers are required to sell furniture and home furnishing products in an IKEA (and stores that followed its lead) compared to traditional furniture stores.  The primary result of this change is that consumers pay less for furniture.  It also means that total employment in furniture stores in the US is about the same today as it was twenty years ago.

The displacement of workers caused by increased efficiency is both a challenge and an opportunity in a free enterprise system.  Human capital that was previously employed in furniture stores can now be allocated to more valuable tasks in new ventures.   This is likely to occur only if entrepreneurs invest in start-ups and new technologies and dislocated workers acquire the skills necessary to take advantage of these new opportunities.