The Krugman v. Sethi minimum wage argument – let’s all wade in.

There has been an argument over the last week or so between Paul Krugman, Rajiv Sethi and others on the question as to whether cutting minimum wages would boost employment.

Latest to join in is Stefan Karlsson who is definitely not at his best in this post. (S.Karlsson’s best is extremely good.)

Stefan’s first mistake (his 2nd para) is to claim that the idea that minimum wage cuts won’t raise employment is an idea adhered to by present day “leftist” economists. Not true. One of the big contributions to economics made by Keynes and others in the 1930s was to point out the flaws in the “wage cuts raise employment” argument. Nowadays there is widespread acceptance of these flaws.

In his 6th para (“Secondly, even if...”) Stefan seems to say, quite rightly, that wage bargaining is a “zero sum game” between employers and employees in that whatever employees lose by a reduced minimum wage, employers gain.

In his 7th para (“And since income...”) Stefan then claims that lower labour costs in the US will induce foreigners to buy more US produced stuff, hence the minimum wage cut WILL raise employment. But hang on – Stefan has just admitted that wage bargaining is a zero sum game: i.e. the TOTAL cost of producing a widget in the US is not influenced by the proportion of GDP going to employees as compared to that going to employers.

Moreover, even if the above increased demand from abroad DID occur, it STILL would not influence employment in the long run. Reason is that the US balance of payments must balance in the long run. To illustrate with a simple example, assume the US external trade position is exactly in balance immediately before the minimum wage cut. Then the cut takes place, and demand from abroad increases. At some point the US dollar will appreciate, to get the trade position back into balance. That will involve REDUCED demand from abroad for US products and/or reduced exports from the US to elsewhere.

Then in the second sentence of the same para (“And since income...”), Stefan claims that “That same substitution effect would increase demand for products made by American workers by American capitalists”. I.e. “capitalists” have more money to spend, thus they increase demand. But wait a minute – where did these “capitalists” get their extra money from? They got it from employees as part of the “zero sum game”.

Well if “capitalists” spend more because their income has increased, then employees are going to spend LESS because their income has declined, seems to me! Net effect: about zero.


Getting more technical.

Having said all that, there actually IS a mechanism via which a minimum wage cut WOULD raise employment. Very brief and crude exposition of this argument is thus.

Employers raise numbers they employ to the point where the output of the last or least productive person employed equals the minimum wage (or the union wage in a union dominated environment). And no, I’m not confusing micro with macro. Thus if the minimum wage is reduced, employers would expand the numbers they employ.

There is no automatic mechanism here for increasing aggregate demand. But if having reduced the minimum wage, demand WERE increased, then employment would rise.

This wheeze is NOT a cure for the current recession. The problem at the moment is sheer lack of demand. But if and when unemployment reverts to more normal levels, then the above minimum wage point starts to become relevant. That is, it could facilitate an increase in demand with less inflation than would otherwise be the case.

But there is a problem: the above involves people working for a wage that is regarded as unacceptably low on social grounds. Solution: in work benefits, or some form of employment subsidy.

Some ideas on how this might work here. But a better exposition is in the pipeline. Watch this space.

The “liquidity trap” is bunk, cr*p and drivel all rolled into one.

The New Palgrave Dictionary of Economics starts its definition of the liquidity trap as “A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective.”

Wikipidia’s definition is not much different. It starts thus. “The term liquidity trap is used in Keynesian economics to refer to a situation where the demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Therefore, if the economy enters a liquidity trap area -- and further increases in the money stock will fail to further lower interest rates -- monetary policy will be unable to stimulate the economy.”

This is all nonsense on stilts. It is clap trap. Do advocates of the liquidity trap seriously think that if every household in the country was given £10,000 in cash there’d be no effect? What do people do when they win a lottery? The average mentally retarded three year old knows the answer that: lottery winners SPEND their winnings (or a sizeable chunk of it). Bryan Caplan makes a similar point here.

So why are many economists incapable of solving a problem that the average mentally retarded three year old can solve? The answer is probably that economists have an interest in NOT solving economic problems. That is, solve an economic problem, and there will be fewer jobs for economists. At the very least, academic economists have an interest in exuding hot air, drivel and waffle: holding on to one’s job as a professional economist requires publishing a certain amount of material per year, even if one has nothing useful to say.

The theologians in the middle ages who argued about how many angels could dance on a pinhead (rather than solve the real problems facing the world they lived in) were similarly motivated. That is, for theologians in the middle ages, arguing about angels and pin heads kept them in food, wine, and shelter.

By way of keeping the debate on the liquidity trap going, economists often point to the fact that Japan greatly increased its money supply in the 1990s to little effect. Well of course there wasn’t much effect: this money supply increase was done via quantitative easing. That is Japan’s central bank gave people cash in exchange for the latter’s bonds. Well what’s the big difference between cash and bonds? Not much. They are both fairly liquid forms of saving. That’s why there was little effect.

Increasing the money supply and giving it all to people who are determined to put it on their compost heap and rot it down into compost will have no effect. But to argue from this that ALL money supply increases have no effect, is clearly nonsense. At least for mentally retarded three year olds, the nonsense is clear enough.

Finally, it should be said that some definitions of the liquidity trap consist of the idea that recessions can persist despite interest rates being zero – in which case fiscal policies are required. That is, some advocates of the liquidity trap are arguably well aware of the fact that printing enough money and dishing it out to households will solve the problem. But I suspect that many of the aforementioned advocates are not aware of this point.

Afterthought (25th Nov. 2010): Nice to see Scott Sumner agreeing.

Do Aggregate Demand - Aggregate Supply diagrams mean anything?

Krugman refers to a paper by Gauti Eggertsson. This itself is based on simple Aggregate Demand – Aggregate Supply diagrams: much the same as micro economic supply – demand diagrams for apples, etc.

These AD-AS diagrams appear in many text books but I regard them as meaningless. Will someone please please please explain what they mean?

For example Eggertson says (p.13) “A tax cut shifts down the AS curve. Why? Now people want to work more since they get more money in their pocket for each hour worked.”

This is bunk. First, people in low wage countries work much the same hours as people in wealthier countries, thus in the long run this tax cut will not influence hours people want to work (though there could be a short term temporary effect). Second, assuming the Eggertson exercise is budget neutral, government must make up for the tax cut somehow. For example it may increase indirect taxes. But this puts wage earners back where they started in real terms!

Alternatively the tax cut is NOT budget neutral: i.e. it represents a net increase in the deficit. Which in turn means the real effect comes from the increased deficit.

So what does the AD-AS diagram amount to in this case? NOTHING !!

Does anyone know of any instance in which AD-AS diagrams actually mean anything?

P.S. Thought my suspicious were well founded. See here.

P.P.S. (21st December) This argument is now turning into World War III.

Arnold Kling's brainwave.

Arnold Kling has produced a great idea for producing jobs, as follows.

“Cut the employer contribution to the payroll tax. In the short run, this will reduce labor costs and increase profits. This will lead firms to expand and to raise employment. In the long run, it will lead to higher wages. When recovery comes, you can either bring back the payroll tax or replace it with a less regressive tax.” And that’s it.

Why on earth would increased profits “raise employment”? It is obvious that IF increased profits result from increased orders (i.e. increased demand) then employment will rise. But in this case the increased employment results from the increased demand, not from the increased profits as such.

Put another way, anything with artificially increases profits (like a payroll tax reduction) will have no effect on employment whatever if it does not increase demand. Since Kling does not tell us whether his reduced payroll tax is budge neutral or not, it is entirely unclear as to whether his proposal WILL involve an increase in demand.

Does he understand macroeconomics?

Wall Street Journal’s strange choice of blogs.

WSJ staff have been hard at work – at least that’s what they’d like you to think. They probably also want the boss (Rupert Merdoch) to think likewise.

Apparently they have “sifted through the sea of economics blogs and determined the top 25”. Just one problem: the fellow responsible for the blog that comes third from top on their list (Brad Setser) announced his intention to cease blogging on 4th August 2009 (apart from one post on 22nd September). See here.

There is nothing wrong with Setzer's blog. But when you've read a blog and it's several months old, staring at a brick wall becomes relatively interesting by comparison.

Nonsense from the Heritage Foundation.

“What creates jobs? Entrepreneurs with ideas for new or better ways of doing things who successfully put their business plans into action.” At least this is what creates jobs according to James Sherk and Rea Henderman of the Heritage Foundation. You can almost hear the trumpets playing along with the latter answer to the above question, so as to give a general feeling of uplift and gung-ho.

Trouble is, this is all poppycock. To illustrate, we lay bricks nowadays in pretty much the same way as in Roman times 2,000 years ago. But amazingly there are hundreds of thousands of bricklayers employed in the US, and even more throughout the rest of the world: a complete mystery.

In more general terms, it is a moot point as to whether increased efficiency expands or contracts numbers employed in a particular industry. Obviously “better ways of doing things” cuts costs and hence prices. But whether this results in an expansion in numbers employed depends on the elasticity of demand for the product in question.

If demand is relatively inelastic, the decline in numbers employed because of the increased efficiency will outweigh any increase in demand resulting from reduced prices.

These two conservative plonkers also tell us that “As long as entrepreneurs remain reluctant to invest, job creation will lag.” Really? So the fact of investing creates jobs? Fascinating.

Why does the fact of investing in a new car plant increase demand for cars? Darned if I know.

To be fair, a lack of investment COULD be a constraint on economic growth in the US once employment levels get near the 2006-7 levels. This is because the US has slightly REDUCED its total stock of physical investments since that date. But just at the moment, there is any amount of idle plant, machinery, factory and office block ready and waiting to be used.

Billy' Blog's latest.

I cannot improve on this.