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Higher minimum wages are like mainstream monetary policy

Wednesday, February 10th, 2016

By Paul Joubert, Senior Researcher: Solidarity Research Institute

A political process for the introduction of a compulsory national minimum wage is currently under way in South Africa. There are those who contend that a high minimum wage, in the order of about R5 000 per month, will be conducive to economic growth and employment, or at least that it will be conducive to economic growth without any negative impact on employment.

The first question to be asked in this regard is: If a minimum wage of R5 000 per month would not be detrimental, why not introduce a minimum wage of R10 000 or R20 000? Why not simply a million rand per month? By suggesting any specific level, one admits that there are trade-offs between the cost of labour and other factors such as the level of employment.

Why not?

Be that as it may, the half-baked theory suggested by proponents of a substantially higher minimum wage to support their point of view is something like the following: If workers are paid more, the economy will be stimulated because the workers will spend the additional money, which will create a bigger market for employers to sell products and services. Because of the bigger market, these higher sales will increase the employers’ income and will enable them to afford the higher minimum wages. So it continues in a virtuous cycle of higher wages and a growing economy!

This sounds like it is too good to be true, and indeed it is. The abovementioned idea ignores an important part of the picture. The higher remuneration paid to the workers will have to be sourced from somewhere. Possible sources are:

  1. from the wages of other workers;
  2. from the employer’s budget for maintenance and/or expansion;
  3. from the pocket of the shareholder; or
  4. from the pocket of the consumer of the product via higher prices.

If the higher remuneration is recovered from the wages of other workers, and because it is very difficult to lower existing wages, it will mean that some workers will have to be dismissed so that other workers can be paid more. Even companies that do not dismiss any workers will scale down any plans for future expansion of employment – a company that planned to hire 20 new workers would now employ only 10 new workers. However it happens, total spending does not rise; it is merely shifted from one group of workers to another, smaller group.

If the higher remuneration is recovered from a company’s budget for maintenance and/or expansion, it will weaken the capital structure of the economy, quickly resulting in decreased or less suitable production. Lower production leads to lower supply, which, with higher demand leading to higher prices, cancels out the possibility of a better standard of living for those receiving the higher minimum wage. Similarly, even if production does not decrease, the weakened capital structure will lead to lower quality or suitability of products and services, which will also lead to a lower standard of living than would otherwise have been the case.

If the money for the higher minimum wage is recovered from the pocket of the shareholder, it will obviously result in a shrinking demand for goods and services by the shareholder, or a decrease in the amount which the shareholder would have reinvested otherwise. This will cancel out any increase in demand for goods and services by the workers.

Lastly, if the money is taken from the pocket of the consumer via higher prices, it will negate the possible improvement in living standards of employees, because the employees’ higher wages will be neutralised by the higher prices.

For the above reasons, the argument that higher minimum wages will result in a virtuous cycle of rising wages and a growing economy and still higher wages, is completely devoid of truth.

Mirage of a virtuous cycle

However, there is another mechanism that could create the impression that something like this could indeed happen. If minimum wages are increased significantly without workers being dismissed (at least initially), spending on numerous kinds of goods and services will indeed increase. Suppliers of these goods and services would probably think they should expand their businesses to meet this growing demand. In such a situation, expansion of factories and other companies will indeed take place and a number of new companies will be started – to maintain or gain market share. What will go unnoticed initially, however, is the decrease in demand from shareholders, who will consume less of another set of goods and services because of their lower income. The companies who provide goods and services to the shareholders will not decrease their production or close their doors immediately – they will keep producing for some time and try to push through the hard times (lower demand and higher wage costs!).

Initially, therefore, the only visible effect is the results of the increased spending by the workers who now have higher wages to spend. The economic party is in full swing and everybody (apart from the shareholders, but they are ignored) is happy and expands to meet the needs of the workers with their pockets full of money. This carries on until those companies who have started to struggle because of lower spending by the shareholders begin to downscale or close down one by one, with their workers being unemployed and their spending dwindling. In due course, slowly at first and then ever quicker, it becomes clear that the expanded and newly established companies who wanted to meet the increased needs of the workers spent capital unwisely. They also start struggling to make money and start closing down as well. The house of cards created by the illusion of “more money in the economy” collapses and people shake their heads and blame the recession on “external factors” and “greedy capitalists”.

Just like monetary policy

This danger of increased spending which is eventually exposed for the illusion that it really is only after costly investment mistakes have been made, is indeed recognised by most mainstream economists. It is ironic, however, that these same economists often do not have a problem with the monetary policy commonly followed by most central banks (government banks). This monetary policy entails the creation of money out of thin air, which is then pumped into the economy, creating a similar illusion of higher spending. This also results in costly investment mistakes being made because initially it appears as if the growing spending on goods and services comes without any trade-offs. Only at a later stage everybody realises that the growing money supply has destroyed – through inflation – the savings of those who have saved. By the time this effect becomes obvious, the unsuitable factories and companies have been created but the demand for their products and services has dried up.

It is tragic that most economists realise that it is not true that minimum wages can be increased for everlasting economic progress, but they cannot arrive at the same conclusion with regard to modern monetary policy.

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