The minimum wage and monetary misperceptions theories

by on July 22, 2010 at 4:36 pm in Economics | Permalink

I have never heard a market-oriented economist argue that a rise in the minimum wage boosts the demand for labor.  You might try this argument: "The government is certifying that these workers are worth this much.  The government is defining the market price.  Entrepreneurs will believe that price and hire workers in the expectation of finding an equivalent or even superior marginal product.  The government said that was the right price." 

No go.  Market-oriented economists instead claim that entrepreneurs "see through" to the real marginal products of these laborers.  The demand for labor, rather than rising, would fall and unemployment would result.

So what happens when the Fed "sets" short-term interest rates or influences other prices?  What is postulated by monetary misperceptions theories, including Austrian business cycle theory?  Entrepreneurs no longer see through to the fundamentals.  Instead, entrepreneurs are taken to believe this Fed-influenced rate is the correct price and they make their plans accordingly.

What is the difference between these two cases?  I believe we need a better theory of when people take price signals as informative and when not.  Too often people just assume that the inferential abilities, or lack thereof, go the way they want them to.

1 Cthorm July 22, 2010 at 4:47 pm

It seems to me that the response from entrepreneurs would be highly tied to the prevailing economic climate. Maybe early in the decade or in the 1990s entrepreneurs put more wait on the Fed funds rate. Today lower fed funds rates seem to have little effect on market interest rates (specifically Libor). Or, maybe this represents a paradigm shift in the public’s perception of Fed independence in light of the financial crisis.

2 Jordan July 22, 2010 at 4:57 pm

I don’t think it can be correct that “entrepreneurs are taken to believe this Fed-influenced rate is the correct price and they make their plans accordingly.” If it were truly “correct” then the entire yield curve would have to shift at the same time, and nobody would change their behavior. So you have to posit there are other interest rates (or rates of return) which are somewhat untied to the Fed’s rate, which is what causes people on the margin to switch more money into/out of the bank.

3 Jim July 22, 2010 at 5:02 pm

The difference is whether the policy maker is in control of the price or the quantity. A minimum wage law directly sets a price, without changing the quantity of labor available. It creates a disconnect between price and quantity. Fed interest rate targeting only occurs indirectly, through open market operations that directly control the quantity of money. This does not create a similar disconnect. In both cases, entrepreneurs do see through to the fundamentals, it just that in the case of monetary policy its one of the fundamentals that is itself being manipulated.

4 long time listener July 22, 2010 at 5:08 pm

Jim is right, the Fed can print money and print bonds, but the Govt cannot “print workers”. The Fed policy rate is implemented through the channels of supply and demand for financial assets. Minimum wages are just price floors.
The minimum wage alternative to open market operations is perhaps to offer every worker a job at the minimum wage, then, a few simplifying assumptions later, the private sector would be forced to pay at least the minimum wage for workers. I hope this policy is never pursued.

5 John V July 22, 2010 at 5:09 pm

I think a big difference is that lower rates to profit from are attractive. Higher wages to pay out are not. Lower rates induce more borrowing and consumption….especially among the more short-sighted in residential consumer area.

People who are able to take advantage of lower rates are not interested in whether it’s a “real rate” or artificially low rate.

That being said, I don’t think lower short term rates will do too much with commercial borrowing besides refinancing to lower debt repayments. It’s not going to help much when businesses are wary of expanding business in contractionary times.

6 baconisgood July 22, 2010 at 5:13 pm

One main difference in your example is direction. The minimum wage is a floor for wages while the fed funds rate can be changed in either direction, would you expect more money to be borrowed if the fed set rates at 18% based on the idea that the government was saying that capital should be returning 18%+ in this environment?

By lowering interest rates the effect in the Austrian’s view is similar to that of setting a maximum wage instead of a minimum wage. If the maximum wage was set at $8 an hour what would one expect? Businesses would be falling over themselves to hire as many workers as they could sine many workers have marginal production rates well above that level (in the US at least).

7 perko July 22, 2010 at 5:41 pm

The answer probably comes from repeated games:

Any strategy profile that gives all players a better pay-off than the Nash equilibrium of the stage game can be supported as an SPNE when players are sufficiently patient. We can achieve this with grim trigger, where if players use our preferred strategy profile, they continue to do so, and if anyone deviates, they all revert to the Nash profile.

Now, the Fed’s credibility relies on the fact that they are better informed and pursuing a particular strategy that is beneficial to all players, and players’ responses are adapted to that strategy, and if the Fed ever started behaving in a way that undermined the expectation of responsible monetary authority, they’d be punished by a loss of trust.

Gov’t regulators could, in principle, do this with the minimum wage. However, they aren’t better informed, and manipulation of firms through a min wage would likely hurt the firms. Where does the “better payoffs than stage Nash” part of government participation come from?

8 Dan H. July 22, 2010 at 5:55 pm

“Is not the difference due to the interest rate being effectively guaranteed by the government where the marginal product of labor is not?”

I think this is the best answer. If the government fixes the interest rate at a low level, you get a direct and obvious benefit when making a short-term loan.

If the government tells you that a worker must be paid $8/hr and that his productivity is worth at least that much, you have no such guarantee. So you’re going to evaluate his marginal productivity on your own terms.

The worker price is a promise from an untrustworthy source. The interest rate is a guarantee.

A more interesting question is whether short-term rate manipulation affects long-term planning.

I think lowering the rate during a normal economic period may stimulate production because business takes it as a sign of the fed’s estimate of the general state of the economy and where interest rates ‘should’ be, so they have confidence that the lower rate means conditions for longer term investment are good.

On the other hand, lowering the rate as an explicit stimulus of a sick economy may not have that effect, because businesses cannot use the rate as a signal of the health of the future economy.

And if business believes the rate of interest is being held artificially low, it may make their uncertainty even worse as they expect negative ramifications of this policy in the future, and could cause anything but short-term borrowing to actually slow down. Now you’re closer to the case of the promise of laborer’s marginal value.

9 Andrew July 22, 2010 at 6:13 pm

I was going to ask if low interest rates could cause a shortage of credit.

10 Doc Merlin July 22, 2010 at 6:21 pm

The truth is that people aren’t “fooled” by too low rates, so they short money and go long non-nominal assets. This is a debt fueled bubble.

11 Dan Karreman July 22, 2010 at 6:40 pm

Why are you asking MR readers this, and not entrepreneurs? Seems to me that the overlap is rather small, at least judging from commenters.

12 steve July 22, 2010 at 7:15 pm

Tyler, your argument makes no sense. The equivalent of a minimum wage would be a usury law, where a maximum interest rate is set by decree.

When the central bank reduces the policy interest rate, it buys a bunch of bonds to increase their price. That is analogous to subsidizing labor to increase its wage.

You’re comparing a decree to a subsidy and bemoaning the fact that standard micro theory suggests the two would have different results.

13 steve from virginia July 22, 2010 at 8:53 pm

The labor side of this pop- quiz question was actually solved in real time and place;

http://papers.ssrn.com/sol3/Delivery.cfm/98091403.pdf?abstractid=126428&mirid=1

The outcome (since everyone has forgotten already) was not what most would consider.

The money side of this question is being solved in real time now, all over the place. ZIRP has no traction with either entrereneurs or end users. Neither has – nor does – QE. This means the ‘money- pricing’ arguments are hollow.

This is unlike increasing labor earnings which puts real customers in stores with (valuable) cash in their hands. Neither central bank flim- flam nor Austrian- style throat- cutting accomplishes anything other than the perpetuation of robber politics and robber economics.

Not surprising the Austrians’ knickers are in a twist since the hypocrisy is impossible to avoid. Good on ya, Tyler.

14 Harkins July 22, 2010 at 9:09 pm

Interest rates are information, the role of the Fed is to add noise to the signal.

15 Doc Merlin July 22, 2010 at 9:36 pm

I suggest you read Steve’s response at Jul 22, 2010 7:31:08 PM.
It is right on the money.

16 Ben Daniels July 22, 2010 at 10:14 pm

Why should we believe that entrepreneurs “believe” the fundamentals of either the interest rate or the minimum wage? The fact in both cases is, the price is what it is. The market has no choice but to hire workers at the minimum wage, and no choice but to lend at the rate set by the Fed.

17 E. Barandiaran July 23, 2010 at 1:21 am

Tyler, in the last paragraph you ask “What is the difference between these two cases? ” Although the difference is too obvious to most economists, let me twist your question to ask: what is the difference between Solow’s 7/20 testimony and Bernanke’s 7/21 testimony to Congress? Emeritus Professor Solow had an opportunity to advise Congress on what to do to overcome the current crisis but ended up showing that the emperor had no clothes –he used his time to criticize a theory! Fed Chairman Bernanke was asked how the Fed could save the world and replied that he would save it if necessary –he used his time mainly to explain what the Fed had done in the past two years. No market player paid attention to what Solow said because he didn’t have the power to force the players to listen his critique of DSGE (you can bet that if he had had it, he would have used it). All market players paid close attention to what Bernanke had to say and decided to take a break to figure out what his noise (or if you prefer nonmarket signal) was about.

18 AC July 23, 2010 at 2:27 am

I think there is still an interesting issue as to how entrepreneurs respond to Fed-induced interest rate changes, but comparing it to the minimum wage seems to be creating a puzzle where there is none.

19 Manto July 23, 2010 at 7:25 am

The gov says my workers are worth $10/hr, but I know they’re worth $8/hr; I reject their kind suggestion.

The fed says they’ll lend to me at 5%, but I know my MPK is 10%; I accept their kind offer.

Simple. As. Pie. Maybe simpler.

20 Andrew July 23, 2010 at 8:56 am

Also, this reminds me with regards to the instant fiat price adjustment argument which I don’t know the name of. If The Fed thought the price adjustment was instantaneous, they’d close up shop, wouldn’t they?

Cash used to pay gold sellers should go into the economy, but maybe things aren’t equivalent. Maybe gold sellers are more likely to save and slower to spend than others. That doesn’t make them wrong.

21 Alex Salter July 23, 2010 at 2:06 pm

Estimating the profitability of the marginal unskilled worker at the going minimum wage rate is much easier than estimating what the “true† rate of interest should be and where it is in relation to the rates the Fed influences. Businesses and financiers could spend time and other real resources trying to second-guess the Fed but interest rates are such a complex phenomenon that I’m not sure trying to beat the central bank at its own game is even remotely feasible. For entrepreneurs, the dominant strategy is “business as usual† – focusing on producing goods and services rather than playing chicken with the Fed.

22 Andrew July 23, 2010 at 2:40 pm

What do you think of the stress tests?

I thought the point was not to fail anyone, but did the Europeans have to fail some to give credibility to their seal of approval?

23 DG Lesvic July 24, 2010 at 5:49 am

Even if the gov could fool employers into believing that workers were worth what it said they were, it couldn’t fool them into having more money for paying them than they actually had.

Since it is the market’s valuation of their products that determines how much money they will have for paying their workers, and it is the value judgments of the market and not of the employers that will ultimately prevail, the gov cannot accomplish its goal simply by fooling employers. It must fool the market. It must convince the market that had placed a higher value on A than on B that B was really worth more than A. So it cannot simply set the prices of workers but must set the prices of A and B and of all other goods. It cannot simply intervene in the market economy but must replace it with all around socialism.

24 DG Lesvic July 24, 2010 at 6:47 am

My statement above, that the gov cannot simply intervene in the market economy but must replace it with all around socialism, is right out of Mises.

“The government†¦fixes the price of milk at a lower rate than that prevailing on the free market. The result is that the marginal producers†¦now incur losses†¦stop producing†¦milk†¦use their cows and†¦skill for other more profitable purposes. They†¦produce butter, cheese or meat. There will be less milk available for the consumers, not more†¦Now, the government†¦must add to the first decree concerning only the price of milk a second decree fixing the prices of the factors of production†¦of milk at such a low rate that the marginal producers of milk will no longer suffer losses and will therefore abstain from restricting output. But then the same story repeats itself on a remoter plane. The supply of the factors of production required for the production of milk drops, and again the government†¦must push further and fix the prices of those factors of production which are needed for the production of the factors necessary for the production of milk. Thus the government is forced to go further and further, fixing step by step the prices of all consumer goods and of all factors of production†¦†

Middle-of-the-Road Policy Leads to Socialism, Pp 11, 12

25 Andrew July 25, 2010 at 5:35 am

I have another theory. It’s a variation on the tragedy of the commons.

I don’t really think that everyone is rational, I just believe on average, in the absence of behavioral economics, errors fall around a mean and the mean is close to the correct answer.

A rational entrepreneur could see that the interest rates are not correct, just as he could see that there is a real-estate bubble. But that doesn’t stop his competitors from gaining market share and booking profits if he doesn’t join the musical chairs game.

I think (some) Keynesians well understand this. They know full well that their objective is a transfer of wealth from entrepreneurs to labor.

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