Can Circular Effects Justify a Wage Hike?
I couldn’t help but notice Ben Studebaker was doing one of his old saws about how circular effects can justify a minimum wage hike.
I know, I shouldn’t get sucked back into this. But I am. I have a new perspective I want to come at it with, and I was actually planning a similar post before Mr. Studebaker posted his. Down the rabbit hole we go!
I’m going to make a simple point in a very exacting way. The heart of my claim summarizes neatly: If the problem is a broken link between consumption and wages, you cannot fix the problem by trying to exploit that link.
I will first look at the underlying accounting model Mr. Studebaker employs. I’ve never been one to leave out explicit accounting equations when doing accounts, so I will develop it with a Social Accounting Matrix (SAM). This is nothing more than addition. I will show that it is impossible for the problem to be strictly a private sector model and still comport with the facts at hand.
I will then show that Mr. Studebaker’s analysis of the 1950s and 60s economies holds even when we include government accounts.
Next I will move onto an open economy model to establish the plausibility of other explanations. This, of course, only shows Mr. Studebaker is wrong to assume a tight consumption/compensation link and suggest alternatives. I will have to link this to his empirical considerations to evaluate which model we ought take.
I will then wrap together his empirical points as well as a few of my own to show that the problem rests very much in the Current Account. The money available for wages is very likely being sent abroad. I acknowledge this isn’t a perfect model, and I offer some other accounts to look for the difference in, but I think the case for it is compelling.
Finally, I’ll put the New Labor findings in a wider context so as to more fairly judge them. It is my position that both the statistical methods and conceptual explanations for those findings are flawed, as outlined above.
A Compensation-Consumption Model
Let me turn your attention to an early claim of Mr. Studebaker’s:
As productivity rises, the economy is able to supply more and more goods and services with the same number of workers. However, increases in the capacity of the economy to supply goods and services are not sufficient to grow the economy–to do this, consumers must be able to purchase those additional goods and services. Until the 1970′s, consumers were able to do this because their wages rose alongside productivity. Instead of firing workers or reducing their hours and salaries, businesses in the 1950′s and 1960′s increased wages and worker benefits, allowing workers to purchase the goods and services they were producing. As a result, the economy expanded quite rapidly during that period. Productivity and wages helped one another in a virtuous cycle.
Broadly I agree, but I’ll take exception to the bolded part when the time is ripe.
As a simple thought experiment, let’s imagine we resided in a closed libertarian economy. The macroeconomy is divided into three sectors—households, firms, and investment. Each pays the other. This is traditionally shown as a so-called Societal Accounting Matrix. As I’m presenting it, you read it as [row] pays [column] [entry].
For example, Households pay Firms Consumption, C. W stands for Total Compensation, I for investment, and S is Household Savings.
The beauty of the SAM is that rows must equal their corresponding columns. There is no great mystery to this; by accounting identities everything bought must be paid for. This is the essence of the argument Mr. Studebaker is making; supply must meet demand*. Firms obviously cannot claim any payment on things not bought; consumers cannot buy things with wages unpaid!
We find ourselves facing three identities:
Notice that from the first equation we can deduce that production (Y=C+I) is equal to compensation. Households drive the economy. Mr. Studebaker is unequivocally correct in a closed libertarian economy about consumers driving the economy.
The trouble is that productivity is locked into compensation! The break in compensation from productivity that he presents, as a matter of accounting, is impossible without other sectors of the economy! I will make the case for this in a moment.
But first, let’s tackle another of Mr. Studebaker’s claims:
The economy attempted to make up for the absent wage growth by making it much easier for consumers to borrow money. Instead of paying for goods and services with wages, consumers paid for these things with credit, which took the form of household debt:
Now, if we look back to our accounting identities, this is a conceivable argument. Borrowing for consumption must be credited to Consumption. (I mean, accounting tautology is a tautology.) In order to keep wages from rising proportionally, we must then debit savings. The trouble with this is that savings (investment) has increased empirically:
Granted, this data is not from a closed libertarian economy. Granted, Personal Savings—the account that better corresponds to the question Mr. Studebaker asked in a more open economy—has fallen with Compensation.
But that’s the point. We can also take this as a partial analysis model of an open economy with a government. We can assume these are the only accounts able to move, as Mr. Studebaker’s analysis implicitly does.
The logic Mr. Studebaker employs does not bear out either the claim that wages fall with falling productivity or that their fall necessitates more borrowing unless we include more accounts.
*The argument that supply creates demand is a stronger one. Instead of supply equaling demand, it says any increase in supply will be met with a increase in demand; we now know there are reasons to believe this is generally not true. Despite often claiming I fall back on Say’s Law, this is precisely what he is doing!
Adding in a Government
More complicated SAMs are, well, more complicated. As the number of sectors increases, the number of sub-accounts tends to increase faster, meaning that we have to make behavioral assumptions to make claims. This comes with the downside that behavioral assumptions lack the tautological umph! that comes with just being able to point to a simple accounting truth.
Still, we can still see some similar consequences from a 4×4 SAM with a government:
There are now 4 accounting identities:
Now, these equations more or less describe the state of affairs pre-1971 when the economy was much closer to closed*. Regardless, they offer a theoretical insight into how the state effects accounts without being muddied by international effects.
Mr. Studebaker’s proposal is that an increase in compensation suggests an increase in consumption is still plausible from the first two equations. I would like to point out the identities it does not necessitate it! An increase in wages could be balanced by any of the other accounts, including state ones.
However, the claim is borne out in the data he puts forward. I’m inclined to agree: prior to 1971, compensation increases meant consumption increases. The first paragraph I pulled above I believe is a fair analysis of that state of affairs.
*I will explore this in more detail in the next section. The barriers to trade in that era came down in 1971, offering an excellent natural experiment.
Yep, it’s time for a 5×5 SAM. We’ll add in an A account for Abroad.
This gives us 5 accounting equations:
This is where things start to get very interesting.
It remains a possibility that a consumption increase will end an increase in compensation. But Mr. Studebaker’s own evidence suggests this has not been the pattern of things since 1971.
In my first quote from his piece, I bolded the part about consumers. As it turns out, there is a whole host of possibilities. If compensation increases any of the following things must happen: an increase in consumption, household savings, household taxes, total investment, government subsidies to firms, or net exports by firms; or a decrease in government subsidies to households or on taxes on firms. (All of this is delightfully confounded by the fact that there is a lot of noise from other trends and policy changes.)
Let’s look at where we’re at. Neither a simple Compensation/Consumption model nor a more nuanced one involving the state is sufficient to explain the post-1971 trends. Further, there are a deluge of possible suspects present in an open economy model.
The Narrative in the Facts
Mr. Studebaker is very fond of the following graph:
For what it’s worth, I’m also very fond of this graph. I’ve written about it before—both independently of this ongoing discussion and in a previous response. It shows, quite clearly, that something happened in 1971 to cause the already drifting wage-productivity relationship to unhook. There’s no mystery to all of this!
That’s the year that Nixon ended Bretton Woods in favor of a more open regime. Prior to that, currency revaluations kept the Current Accounts of nations much closer to balanced. A look at the data shows that the Current Account wasn’t completely balanced pre-1971, but it was much closer to 0:
I want to draw your attention to a few similarities between this and the wage trend, but with a word of caution. Eyeballing time series data is doubly dangerous. Eyeballing any data opens you up for bias and false pattern spotting. Further, seeing lagged effects is more or less impossible. Still, both follow a pattern that I think merits some examination. Post-1971, both briefly rise and then fall together. (I’m not sure why the Current Account briefly went positive after the fall of Bretton Woods; it seems we were a significant lender to nations hit by the fallout?)
There’s also a period in the 90s where this hypothesis fails. I’ll print the graph momentarily, but this is not fully explanatory. Wages aren’t simply going abroad—which I’ll admit I’ve previously represented. While the R2 if calculated isn’t likely to be terribly impressive, the graph between wage share (vertical axis) and balance of trade as a fraction of GDP (horizontal axis) makes me think it’s part of a good model:
I’d be comfortable doing estimations on the fly with a rule of thumb along the lines of:
but I’d also clearly be missing something. Those clusters indicate some other variable is shifting around.
Again, without doing any formal statistical analysis, we can look at the Personal Savings account against the wage share. This is pretty weak, though I wouldn’t be surprised if it fit into a more complicated model robustly:
We find a much closer relationship—though, it’s hard to say how close without firing up R—between government subsidies to persons and wage share:
The point being, a lot of things are at work here, and they may well be working with and against each other.
How would I summarize these findings?
- The fall in the wage share cannot be a direct issue of the private, domestic market.
- Current account imbalances, including those driven by the deficit, are contributing to the wage shift. Because of the sharp change in the accounts following the demise of Bretton Woods, they are the single clearest explanation for wage decline, but they cannot be the whole story.
- Government subsidies and personal savings also have something to do with it, but teasing out causation is a bit harder. I’m inclined towards the argument that says that, at very least, government subsidies are helping keep wages low by keeping wage-earners from having to push for higher wages on the supply end and sending wages abroad on the demand end. I’m inclined to view the much weaker personal savings relationship as an obvious corollary of stagnated wages and rising debt, but I’m open to other ideas.
Wait, So What Happens if We Raise the Minimum Wage?
A full detailing of my thoughts on the state of the relevant empirical literature has been published, but it summarizes nicely enough. I don’t buy that it’s appropriate to control for being a state which raised the minimum wage and then report no correlation when the minimum wage is raised. Of course not—you implicitly controlled for it. This means I fall on the side that says there is a significant decrease in employment (in terms of wage-hours) following a minimum wage hike.
To be fair to Mr. Studebaker, those controls have a respectable acceptance among a minority of economists, but let’s not overstate his position. Most studies, including some which employ the New Labor methods, find that employment falls as the minimum wage rises. For a thorough, 150 page study detailing of the state of the literature, have this bit of light reading. The money quote starts at the bottom of page 114:
This wide range of estimates makes it difficult for us to draw broad generalizations about the implications of the new minimum wage research. Clearly, no consensus now exists about the overall effects on low-wage employment of an increase in the minimum wage. However, the oft-stated assertion that this recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. The studies surveyed in this paper lead to 91 entries in our summary tables (in some cases covering more than one paper). Of these, by our reckoning nearly two-thirds give a relatively consistent (although by no means always statistically significant) indication of negative employment effects of minimum wages—where we sometimes focus on results for the least-skilled—and fewer than 10 give a relatively consistent indication of positive employment effects. In addition, we have highlighted in the tables 20 studies that we view as providing more credible evidence, and 16 (80 percent) of these point to negative employment effects. Correspondingly, we have indicated in our narrative review that, in our view, many of the studies that find zero or positive effects suffer from various shortcomings.
To whit: the lit’s there for Mr. Studebaker, but it’s not a robust majority in any sense. And it goes on for several pages detailing specific trends that are very damning to any claim of New Labor ascendency. So, while for much of the preceding I’ve just assumed a compensation hike, it seems that may have been far too generous to Mr. Studebaker’s position.
And that follows from more careful accounting and the evidence he provided.
If the accounting doesn’t speak to you, let me pose it in a more essential way. Mr. Studebaker’s explicit position is that the wage-rate is not necessarily linked to either production or consumption, and presents evidence to this effect. But, he asserts that an increase in the wage-rate would, through this same broken link, increase both compensation and production as a whole.
It simply doesn’t follow.