Asymmetrical Information - Megan McArdle

02.15.13

So What About Indexing the Minimum Wage for Inflation?

Would it raise unemployment during recessions?

The other part of President Obama's minimum wage policy, which I didn't really mention yesterday, was the proposal to index it for inflation.  I didn't mention it because as far as I can tell, this is dead letter--Democrats like being able to bring up the issue every few years, and Republicans aren't fan of anything that automatically increases the minimum.  

Nonetheless, I think it's interesting to ponder.  And what I want to ponder is this:  what does indexing do to the effectiveness of monetary policy?  

One of the main benefits of inflation (a little bit of inflation, anyway) is that it eases the burden of "sticky wages".  Which is to say that people don't like their wages to go down.  In theory, if productivity drops, employers can lower wages to match the new reality.  In practice, they apparently can't, so they fire people instead.  

Inflation allows you to lower the real value of peoples' wages by just not giving them a raise, while not triggering the complex emotion response that a pay cut engenders.  

So what happens if you make the minimum wage rise in line with inflation?  

Well, you've taken away a key adjustment mechanism.  Now productivity losses have to be experienced as either shrinking profits, or unemployment.  But while corporate profits are up in general, fast food franchise owners are not generally sitting at home watching the checks roll in.  Margins for most franchise owners aren't that great, though I believe that McDonalds franchises are still a license to print money . . . if one could print money by spending hours every day personally ensuring that the toilets are spotless and the rest dealing with misplaced purchase orders and sullen teenagers.

And this effect would probably percolate up the food chain somewhat.  Companies near the minimum wage may want to maintain the gap between their employees' wages and the legal minimum, in order to ensure that they get better workers.  So as those wages increase, near-minimum wages will also have to.  

Would we see a sharp spike in the unemployment rate?  Unlikely.  Even if 10% of minimum wage workers were laid off, that would be a fraction of 1% of the overall job market.  

But I would expect to see higher unemployment among young and low-skilled workers during recessions, when employers are facing a lot of pressure on their margins.  If your sales fall by 30%, so does the output of each worker.  So that overall, monetary policy would become at least slightly less effective at managing the employment declines during recession.