The Destructive Minimum Wage

If you ask anyone what happens to demand for a good or service if price increases, they will logically tell you that demand decreases. Yet when it comes to the minimum wage (MW), proponents claim there is little to no effect on employment. Could it be? In every other market, higher prices results in less demand, yet in the labour market, government imposed higher wages have little effect?

Fast food workers in the US go on strike demanding a $15 minimum wage

In this post I will explain why most academic studies in economics are unreliable, how the service sector will be impacted by higher labour costs and other problems with the pro-MW argument.

Why academic studies are flawed

The mainstream economic profession believes that they can measure and predict the economic effects of policy change. They usually create regression models to test the effect of independent variables on dependent variables. In the real world, the economy is a dynamic environment with numerous forces acting on prices (inflation, interest rates, fiscal policy, consumer preferences, trade, weather and seasonality etc.). It is almost impossible to accurately model the behaviour of an economy comprising of millions of individual people and transactions. Yet the illusion continues because the mainstream economists see their field as a science like physics. Therefore, they embrace mathematical models to the detriment of dull archaic theory or praxeology.

Take this example of Andrew Leigh’s (now an Australian Federal Labor Party MP) study of Western Australia’s MW increases on employment. He concludes “After each if these increases, the employment to population ratio in Western Australia fell, relative to the Rest of Australia. Aggregating these six changes, the elasticity of labour demand with respect to the Western Australian statutory minimum wage is estimated to be -0.13. The employment impact is most substantial among younger employees, with the elasticity of labour demand for workers aged 15-24 estimated at -0.39.”

I do not want to dismiss the attempt at measuring the effect of an increase in the MW but we all know what the effect was going to be, this study was aimed at measuring the magnitude of the change.

Empiricism is useful to an extent; however I would always place praxeological theory above empirical or model driven evidence.  If the empirical results showed that increases in the MW actually increases employment, I guarantee there would be economists rejecting the law of demand and supply in the labour market. Unfortunately, these economists harm the integrity of economics by supporting preposterous claims to support a socialist political bias. I have always applied the common sense rule to economics which is just logic combined with fundamental principles such as higher prices results in less demand. Complicating issues just causes more spurious results and false policy prescriptions.

The service sector is not immune from higher labour costs 

The MW will affect industry sectors differently. For example, manufacturing workers are competing globally with foreign workers and capital. Any government mandated increase in wages will result in a loss of competitiveness ceteris paribus. However, the service sector is somewhat protected from competition because many services cannot be imported or exported. The classic example is haircuts because even though China has low labour costs it cannot export haircuts. Once again the free-market will always find a way to undermine government interference. We are seeing an increase in what is known as Labour-Capital Substitution, which is basically people being replaced by automated machines.

I went into Australia Post (AusPost) today and saw a newly installed self-serve machine. Yes even a government owned business is finally making the switch! I say this because the same self-serve machines have been in major supermarkets for a few years now. We saw this first in retail banking when bank tellers were being replaced by ATMs. Eventually banks are going to be entirely self-serve with a few staff on hand to handle more complex services. Going back a few decades, petrol stations had attendants who would fill your tank. Now that wages are too high, it has become self-serve which is a reduction in the quality of the service.

Behold the Postmaster9000

New Australia Post self-service machines

I would have used the self-service machines if it required no AusPost employee to finalise the lodgement. The first time I tried to send a parcel via registered post, it told me to wait for an Australia Post employee. It actually took me longer to use self-serve than just go to the counter and lodge it the old-fashion way.

Coincidentally, while I was standing in line one of the AusPost employees asked the elderly lady behind me if she would like to use the self-serve machines and this is what she said, "I don't want to put anyone out of a job". I felt like turning around and explaining to her the benefits of labour saving devices, the benefits of increased productivity and the fact that in a free-market economy there is always demand for labour... I decided to bite my tongue.

This display of economic ignorance by Luddites is pervasive throughout society. Never mind that despite centuries of technological advancement and machines replacing labour, we continue to prosper and that adoption of labour savings devices have not led to mass unemployment. This is the challenge that faces economists in explaining these matters to people who see the intended consequences and are blind to the unintended consequences. Of course it is not the fault of the economic ignorant, but it does epitomise the reason why economically destructive policies like the MW remain popular.

Early adoption of self-serve is slow to say the least

Clearly unskilled and low-skilled work will be under constant threat by machines that do not require sick leave, annual leave and will not ask for higher wages to work on weekends. The service sector is undergoing this paradigm shift and it will be Australia leading the implementation of machines and robots given the exorbitant cost of labour. This will be appreciated by consumers enjoying lower prices.

A different perspective

MW supporters always look at the policy from the workers perspective with phrases such as a “living wage” and “a fair day’s wage for a fair day’s work” tossed into the debate like a moral trump card. One just has to think of it from an employer’s perspective which is what most economists and other pundits who are pro-MW fail to do. When faced with a government mandated increase in labour costs, the business making slim profits has few options:

• The employer reduces costs by cutting the most unproductive staff and works existing staff harder
• The employer reduces staff and outsources/offshores the operation, or employs machines instead of labour
• The business becomes unprofitable and shuts down. The end result being less output (thus higher prices) and unemployed people
• In rare cases, the employer maintains profit margins by passing on the higher labour costs through higher prices, causing a lower quantity demanded. However, the industries that tend to employ unskilled workers usually have products which are very price sensitive or which have a high price elasticity

In all options either unemployment occurs or prices increase. I purposely looked at a business that is marginally profitable because more profitable business can absorb the cost. Cost absorption is negative because a less profitable business will find it more difficult to attract investment capital in the future and lower profits means the value of the business also declines.

One size fits all

The other problem with the MW is the one size fits all approach. For example, average wages in the Northern Territory or Tasmania are lower than average wages in New South Wales or Victoria given the higher cost of living in the latter states, yet they all have the same minimum wage. Clearly the minimum wage in Sydney is less of a burden than the same minimum wage in rural Tasmania. This is just one example of how a top-down approach or centrally planned economy causes inefficiencies to arise.

Neo-Marxist prejudice

The worst rebuttal I have heard is that without a MW, the unskilled will be paid $1/hr or a pittance as the greedy capitalist drives down the price of labour. This is a slippery slope argument, which will not occur. If the MW was removed, wages may fall but just like in any market, the price of labour will be supported by demand for that labour. Therefore, falling wages will increase demand and the market will find an equilibrium point at which all those who want a job can get one. It is possible that unskilled labour wages could drop to $1/hr but this is impossible in Australia due to the high levels of capital accumulation in the Australian economy.

To illustrate how capital accumulation benefits wages, imagine a hole needs to be dug and an employee has to use his hands to dig. It may take the employee an hour to dig the hole with his bare hands. Now imagine another employee who possesses a shovel and can dig the same hole in 6 mins. They produce the same result (a hole in the ground) and therefore they should get paid the same. However one earns the same payment 10 times faster because they have the shovel (capital). In this example the employee equipped with a shovel will earn 10 times the unequipped employee per hour.

The problems associated with the MW are numerous and are usually ignored by MW advocates. The effect of the MW is downplayed by academic studies employing econometric models. While economic models can estimate effects, they cannot be used to counter fundamental principles in economics. Even if industries face less competition, businesses will find a way to reduce costs to satisfy their customer’s preference for low priced goods and services. Finally, it is only a free-market naturally promoting capital accumulation that raises the purchasing power of wages.

I will conclude with this video which is a simple and easy to understand animation of how the minimum wage affects the economy:

How a Currency Dies

India is a prime example of a broken country and squandered potential. Years of mismanagement and interference has mutilated an economy which is now disintegrating before our eyes.

The fires of inflation destroy purchasing power

The volatility over the last year in Indian financial markets resulted from years of government monetary intervention and bureaucracy choking productive activity. In this post I want to explore the causes of dramatic currency depreciation and possible remedies.

Burning Down the House

Firstly, we have to look at how this happened. India was part of the infamous BRIC nations. Supposedly, India was a new engine of global economic growth that would unleash millions of middle-class consumers demanding more goods and services from the rest of the world. China was the poster child and India was its little brother waiting for its chance to live up to the high expectations set by its sibling. But as any free market or Austrian economist will tell you, economic growth can only occur when there is less government involvement in the economy.

Fundamentally, India has not escaped its historical communist influences. The government is strangling the private sector with a byzantine regulatory system, numerous taxes and a corrupt bureaucracy. The political actions of recent weeks epitomise the intrusive and destructive handling of the economy. By placing restrictions on gold imports and then banning currency derivatives resulted in greater capital flight and a greater loss of confidence. This then leads to a vicious cycle of more regulations and more capital flight until the government and society capitulate to reality.

A depreciating currency is always caused by loose monetary policy. Interest rates are kept too low, resulting in excess credit creation and eventually rising prices. Unless interest rates are raised to quash rising prices, the currency loses its integrity as a store of value. People quickly convert the depreciating currency into commodities (e.g. precious metals), hard assets and alternative currencies to avoid the loss of purchasing power. At some point, the government is forced to act correctly as social tension rises amidst a financial and economic crisis. If the government denies its prior economic mistakes and maintains loose monetary policy, hyperinflation and a complete loss of confidence is the inevitable conclusion followed by transition to a new currency. We have seen this throughout history and thus none of this is a revelation; it is the certain truth.

Eye-Watering Results

To give you an idea of the extent to which the Rupee has lost purchasing power, we will look at a staple of the Indian diet, onions. As seen in the chart below, onion output and productivity has dramatically increased and is a testament to India’s agricultural industry harnessing better farming techniques and utilising capital.

In a free market economy, such a large increase in onion production would result in lower prices but guess what prices have done:

This is exactly why Indians have an insatiable appetite for gold. Gold has always been a part of Indian culture and has become more sought after due to the realisation that gold is a better store of value than the Rupee.

Behind the Curve

When exactly did the Reserve Bank of India (RBI) commit the crime of inflating the money supply? At the same time most central banks did, in the aftermath of the global financial crisis of 2008/2009. Below is a graph showing the changes in the consumer price index which measures the average prices (dashed red line) in the economy compared to the interest rate set by the RBI (solid black line).

Before 2009, the CPI was slightly below the interest rate which means the cost of borrowing was very low. After 2009, the RBI slashed interest rates but made the fatal mistake of raising rates too slowly. During 2010, the CPI was increasing at 8-10% p.a. while interest rates were below 6% and slowly rising. Real interest rates were negative, which meant credit had no cost and resulted in a booming property and stock market. This attracted foreign capital as interest rates around the developed world were at or close to zero. There was a huge yield differential that could be exploited via borrowing in the US at a low rate and then investing in India at a higher rate. This caused upward pressure on the Indian Rupee as portfolio flows flooded Indian capital markets (bonds and stocks). Portfolio flows (equities, bonds etc.) were favoured over foreign direct investment (building factories, buying entire businesses etc.) because of India’s hostile business environment which made it easy and less risky to buy equity and debt in companies.

India is just the worst case out of all emerging markets. A few years ago, emerging markets joined the currency war. They were complaining about QE because it was causing all this hot money to flow into their economies. But instead of allowing their currencies to rise which would have ended the inflows. They bought USDs and US treasuries and sold their domestic currency to stop it appreciating. Now that USDs are being repatriated from emerging markets, their domestic currency has come flooding back.

Similarly in India’s case, what goes up must come down. The Fed’s rhetoric changed in late May with hints that asset purchases will taper. This sent a shockwave around the world as US treasury yields rose, narrowing the yield differential between the US and economies with higher interest rates. The Australian dollar was one currency that depreciated as the RBA cut interest rates. Likewise, other Asian and emerging market economies saw their currencies tumble. As the situation unfolded, the market became aware of the precarious position India was in and panic took over. But what can India do to stop the Rupee depreciation?

Do It! Do It Now!!!

Things India can do to turn the tide:

• Sell all foreign currency reserves (US$275bn) and gold (US$25bn) to buy rupees. Then destroy the purchased Rupees. The effect is a reduction in the Rupee money supply which will have an immediate impact on the exchange rate. It also sends a message to the market that the government is serious about a strong Rupee
•  Raise interest rates to squash inflation. There’s no balance between growth and inflation. The only way to get India growing again is to liquidate bad investments and rebuild after the recession has reset the economy. This is what Regan and Thatcher did in the 1980s.
• Fully deregulate the domestic economy. This will encourage long-term foreign direct investment instead of portfolio capital which can leave the country quickly
•  Reduce government spending to balance the budget. A good place to start is defence with India being the largest arms buyer in the world. By reducing the deficit, the government borrows less money from the private sector and therefore the private sector has more capital to invest in productive investments. A submarine is not a productive investment!

However, Indian elections are around the corner and reform measures are not popular. This is what happens if no reforms take place:

•  Rupee continues to plunge, which results in lower confidence and capital flight. Could result in a vicious cycle till the government is forced to act
• Import prices sky-rocket. Oil is already 50% more expensive in recent months
•  Long-term stigma and sovereign risk due to the perception of a dysfunctional economy

The only way India can seize its potential is by deregulating the entire economy and restoring faith in its fiat currency as a store of value. Both these actions are difficult given their political implications, which is why I am doubtful they will be done voluntarily. It will be the market who makes an offer they can’t refuse, and will be the driving factor behind change. Unfortunately, this episode has proven once again that the actions of the few in government torture the many living under India’s rule.

How To Make Housing More Affordable

It never made sense to me how a country of Australia’s geographic size can have some of the highest property prices in the world. Australian cities are on par with population dense cities like Hong Kong, Singapore, Tokyo and high profile cities like NYC, Paris and London. This raises questions like why haven’t we developed inland Australia? Sure it’s a hot desert with arid land but that hasn’t stopped middle-eastern cities developing or even one of my favourite cities Las Vegas springing up.

There are actually a number of issues explain why property prices are unusually high in Australian and with most economic issues that sees costs rise consistently or quality deteriorate; government has some involvement in the issue.

The following notes have been sourced from the policy monograph released by the Centre for Independent Studies entitled: Price Drivers: Five Case Studies in HowGovernment is Making Australia Unaffordable by Oliver Marc Hartwich and Rebecca Gill (December 2011) ISBN: 978 1 86432 133 3.

Main reasons that make housing less affordable include:

•          Land supply
•          Tax incentives for property investors (negative gearing)
•          Subsidies for owner-occupiers (first home owner grants)
•          Stamp duties
•          Infrastructure levies

Land supply

The population is concentrated in the metropolitan capital cities.

Canberra has a lot of land, and yet its house prices are nearly as high as prices in Sydney and Melbourne.

Housing prices have risen far more than construction costs. One can then conclude that land scarcity has been the main driver of property price rises.

Negative gearing

Property investors whose capital costs exceed their rental income, can offset their net losses against their income tax liability. This incentivises investment in property using debt with the prospect of capital gains. Hence, highly leveraged property investors increase the demand for housing which results in higher prices.

First home owner grants

Unfortunately these grants increase demand since buyers in this segment of the market all have access to the grant and will bid up entry level property prices.

Stamp duties

There is no economic rationale for stamp duty and is set from state to state at an arbitrary level. An interesting fact is that taxes on financial and capital transactions in Australia, which includes stamp duties, are twice the average of OECD countries. The effect of stamp duties is just to make housing less affordable.

Infrastructure levies

Local councils have been increasingly resorting to using levies to pay for infrastructure investment. These levies are borne by property developers, who pass them on to their customers.

Housing is one of the most distorted markets in Australia. All these interventions have made housing unaffordable because the market supply is restrained. Governments respond by perversely boosting demand and making housing less affordable.

Key recommendations:

•          Increase supply by encouraging councils to take on more residents through local government finance reforms
•          Abolish both negative gearing and the first-time buyers grants
•          Abolish stamp duty
•          Abolish infrastructure levies and permit the private sector to own and operate infrastructure

Debt-fuelled buying and a slowing economy

The other issue that tends to appear in most inflated markets is debt fuelled buying. Australian banks have made billions over the years lending to property buyers and investors. In the period during the GFC, prices fell dramatically as the entire economy deleveraged. The Rudd government stimulated the economy and the RBA slashed interest rates to 50 year lows. This resulted in a property market recovery with prices rising from the bottom by 20%! Clearly, movements in interest rates affect property prices since higher rates increase the debt burden and vice-versa for lower interest rates. In the last few years, rates have been steady but have declined in 2012 and are expected to decline further as China appears to be slowing. However, the entire interest rate cut has not been passed on by banks because they claim that their cost of funding has increased. This is somewhat true but we have also seen profits rise at all the banks, which suggests the banks are price makers and not price takers. The market concentration among the big four banks is high and the slow shift from offshore funding to onshore funding over the years should give the banks the ability to pass on more of interest rate cuts than we have seen in the past.

Despite the interest rate cuts we have seen over the past year, property prices continue a slow grind lower. With the economy expected to slow further, the current trend of lower property prices should persist until the government or the RBA decides to stimulate the economy through increased borrowing or lower interest rates.

Going forward

The government imposed distortions are unlikely to be reduced at any time in the near future since there is no political debate whatsoever around the housing market. Should the economy continue to slow, it is even less likely that these barriers are removed since they generate taxation revenue and would be negative for the state budgets. However, a slowing economy will also see property prices decline until the politicians decide it’s time to be Keynesians and stimulate the economy.