Who is afraid of high wages?
Aug 2021
Who is afraid of high wages?
A higher wage bill can always be beneficial for an economy if it becomes a spur for more productivity and innovation. A commentary by Joachim Voth.
This article was originally published in the newspaper «Finanz und Wirtschaft» on 6 April 2021. Translated and edited for layout purposes by the UBS Center.
A high salary - great! Who wouldn't like to be generously compensated for their work? The higher the income, the sooner you can fulfill your desire of a new car, the nicer apartment, the fancy dinner. But wait - who actually pays for it? One person's wages are another person's expenses; employees' salaries are the expenses of the company, whose profits are now lower as a result. A widespread view therefore says: always take it easy, you can also overdo it with the high wages. At the very latest, when corporate profits come under so much pressure that investments no longer pay off, the beautiful windfall threatens to cast a heavy shadow - after all, fewer investments mean less growth, perhaps even job losses if production is moved to other, cheaper locations. Therefore, the fun and games should end relatively soon and wage restraint be demanded from the employees.
A whole slew of recent research findings calls precisely this logic into question. What can be quickly deduced in theoretical models - high wages lead to low employment, for example - does not seem to be quite accurate in reality. As early as twenty years ago, American labor market economists used the staggered introduction of minimum wages in various states to show that increases almost always have no effect. They looked primarily at industries with particularly large numbers of minimum-wage workers, such as fast-food restaurants. When you go to the border of two states and compare cities on opposite sides of that border, there is virtually no differential effect in the change in the volume of employment after the minimum wage is increased on one side. In any case, there is no rapid decline in employment where wages had been raised by regulation.
A higher wage bill can always be beneficial for an economy if it becomes a spur for more productivity and innovation. A commentary by Joachim Voth.
This article was originally published in the newspaper «Finanz und Wirtschaft» on 6 April 2021. Translated and edited for layout purposes by the UBS Center.
A high salary - great! Who wouldn't like to be generously compensated for their work? The higher the income, the sooner you can fulfill your desire of a new car, the nicer apartment, the fancy dinner. But wait - who actually pays for it? One person's wages are another person's expenses; employees' salaries are the expenses of the company, whose profits are now lower as a result. A widespread view therefore says: always take it easy, you can also overdo it with the high wages. At the very latest, when corporate profits come under so much pressure that investments no longer pay off, the beautiful windfall threatens to cast a heavy shadow - after all, fewer investments mean less growth, perhaps even job losses if production is moved to other, cheaper locations. Therefore, the fun and games should end relatively soon and wage restraint be demanded from the employees.
Joachim Voth, UBS Foundation Professor of Macroeconomics and Financial Markets
Companies often have market power
Former President Ronald Reagan once joked that an economist is someone who sees how something works in practice and then asks whether it can work in theory. Why are the labor market consequences less devastating than originally assumed? In most economists' models, competition among companies is fierce; there is hardly any margin to speak of. But in reality, many companies have at least a good amount of "market power" - they don't sell their products at cost plus a mini-margin for the capital providers, but with a good amount of profit on top. This profit is reduced by higher wages, but not so much that investment would suffer. Thus, the empirical evidence contradicts the overly simplistic insights of chalk economics. However, there are natural limits to the process. At some point, the predicted consequences will occur, just not as quickly as feared; raising the minimum wage in the U.S. to $100 per hour would almost certainly be fatal.
There is a second, much more interesting reason why modern economies should fear higher wages less. Where workers are scarce and labor is correspondingly expensive, there is more innovation and more investment in labor-saving equipment. If wages are too low, for example, it is not worthwhile to introduce an automated parking control system in parking garages; instead, employees sit behind the glass, take paper tickets and breathe in car exhaust fumes. If wages are sufficiently high, these jobs disappear.
The economic historian Robert C. Allen argues, for example, that, at the time, England was the first to industrialize because wages were particularly high there - it was only there that new inventions such as automated looms and cotton mills could be used profitably. A study with North American data systematically shows this connection. Since immigration (mostly illegal) into the U.S. from Central America increased in the 1970s, wages have begun to stagnate. This was particularly the case in those States that attracted especially large numbers of immigrants. To rule out demand-side effects, researchers looked at changes in the immigrant population that could be predicted by family ties that existed before 1970. Wherever more immigrants joined the labor market (for reasons unrelated to labor demand), labor-saving investment in industry was lower. Accordingly, productivity growth was weaker.
Two channels were responsible for this. Firstly, less was invested in each industrial sector in order to save labor. Secondly, the "wrong" sectors grew; instead of fully streamlined factories in which workers earned high wages, employment grew in relatively non-productive sectors such as catering and gardening. The same picture emerges elsewhere: when, for example, many agricultural workers fled Louisiana after a devastating flood, massive investments were subsequently made in new tractors. In the Sweden of the 19th century, more horses were purchased in agriculture wherever particularly large numbers of people had migrated overseas.
Former President Ronald Reagan once joked that an economist is someone who sees how something works in practice and then asks whether it can work in theory. Why are the labor market consequences less devastating than originally assumed? In most economists' models, competition among companies is fierce; there is hardly any margin to speak of. But in reality, many companies have at least a good amount of "market power" - they don't sell their products at cost plus a mini-margin for the capital providers, but with a good amount of profit on top. This profit is reduced by higher wages, but not so much that investment would suffer. Thus, the empirical evidence contradicts the overly simplistic insights of chalk economics. However, there are natural limits to the process. At some point, the predicted consequences will occur, just not as quickly as feared; raising the minimum wage in the U.S. to $100 per hour would almost certainly be fatal.
There is a second, much more interesting reason why modern economies should fear higher wages less. Where workers are scarce and labor is correspondingly expensive, there is more innovation and more investment in labor-saving equipment. If wages are too low, for example, it is not worthwhile to introduce an automated parking control system in parking garages; instead, employees sit behind the glass, take paper tickets and breathe in car exhaust fumes. If wages are sufficiently high, these jobs disappear.
Higher wages create incentives
But the unexpected blessing of high wages extends beyond the streamlining of factories and the acquisition of new machinery: It affects the very heart of the capitalist economic system - innovation. Where a productivity factor is expensive, a particularly large amount of creative energy is directed toward the question of how to handle the scarce commodity more cautiously, more wisely and more sparingly, and this is also true of the labor factor. When the U.S. ended a guest worker program for Mexican harvest workers in the 1960s, the wage for labor in agriculture quickly skyrocketed. At the same time, the rate of granting patents for new machines and processes designed to save labor in agriculture accelerated rapidly. But this means that higher wages also expedite the innovation process because they provide incentives for the purchase of new machinery, and the more it is used, the better it tends to become.
High wages have long had a bad reputation among economists. Along with "practitioners" such as owners and managers, the mantra " moderation, otherwise economic damage is inevitable" has long applied. German economist Knut Borchardt even argued that the downfall of the Weimar Republic in the interwar period was partly due to excessive wages. The empirical evidence that has accumulated over the past two decades, however, points in the opposite direction. As much as individual employers may resent the short-term consequences for profits, a higher wage bill can be beneficial for the economy whenever it becomes a spur to increased productivity and innovation.
But the unexpected blessing of high wages extends beyond the streamlining of factories and the acquisition of new machinery: It affects the very heart of the capitalist economic system - innovation. Where a productivity factor is expensive, a particularly large amount of creative energy is directed toward the question of how to handle the scarce commodity more cautiously, more wisely and more sparingly, and this is also true of the labor factor. When the U.S. ended a guest worker program for Mexican harvest workers in the 1960s, the wage for labor in agriculture quickly skyrocketed. At the same time, the rate of granting patents for new machines and processes designed to save labor in agriculture accelerated rapidly. But this means that higher wages also expedite the innovation process because they provide incentives for the purchase of new machinery, and the more it is used, the better it tends to become.
High wages have long had a bad reputation among economists. Along with "practitioners" such as owners and managers, the mantra " moderation, otherwise economic damage is inevitable" has long applied. German economist Knut Borchardt even argued that the downfall of the Weimar Republic in the interwar period was partly due to excessive wages. The empirical evidence that has accumulated over the past two decades, however, points in the opposite direction. As much as individual employers may resent the short-term consequences for profits, a higher wage bill can be beneficial for the economy whenever it becomes a spur to increased productivity and innovation.
Quote
If pay is too low, it's not worth implementing an automated parking control system in parking garages; instead, employees sit behind the glass, take paper tickets and breathe exhaust fumes.
Joachim Voth
Contact
UBS Foundation Professor of Macroeconomics and Financial Markets
Joachim Voth received his PhD from Oxford in 1996. He works on financial crises, long-run growth, as well as on the origins of political extremism. He has examined public debt dynamics and bank lending to the first serial defaulter in history, analysed risk-taking behaviour by lenders as a result of personal shocks, and the investor performance during speculative bubbles. Joachim has also examined the deep historical roots of anti-Semitism, showing that the same cities where pogroms occurred in the Middle Age also persecuted Jews more in the 1930s; he has analyzed the extent to which schooling can create radical racial stereotypes over the long run, and how dense social networks (“social capital”) facilitated the spread of the Nazi party. In his work on long-run growth, he has investigated the effects of fertility restriction, the role of warfare, and the importance of state capacity. Joachim has published more than 80 academic articles and 3 academic books, 5 trade books and more than 50 newspaper columns, op-eds and book reviews. His research has been highlighted in The Economist, the Financial Times, the Wall Street Journal, the Guardian, El Pais, Vanguardia, La Repubblica, the Frankfurter Allgemeine, NZZ, der Standard, der Spiegel, CNN, RTN, Swiss and German TV and radio.
UBS Foundation Professor of Macroeconomics and Financial Markets
Joachim Voth received his PhD from Oxford in 1996. He works on financial crises, long-run growth, as well as on the origins of political extremism. He has examined public debt dynamics and bank lending to the first serial defaulter in history, analysed risk-taking behaviour by lenders as a result of personal shocks, and the investor performance during speculative bubbles. Joachim has also examined the deep historical roots of anti-Semitism, showing that the same cities where pogroms occurred in the Middle Age also persecuted Jews more in the 1930s; he has analyzed the extent to which schooling can create radical racial stereotypes over the long run, and how dense social networks (“social capital”) facilitated the spread of the Nazi party. In his work on long-run growth, he has investigated the effects of fertility restriction, the role of warfare, and the importance of state capacity. Joachim has published more than 80 academic articles and 3 academic books, 5 trade books and more than 50 newspaper columns, op-eds and book reviews. His research has been highlighted in The Economist, the Financial Times, the Wall Street Journal, the Guardian, El Pais, Vanguardia, La Repubblica, the Frankfurter Allgemeine, NZZ, der Standard, der Spiegel, CNN, RTN, Swiss and German TV and radio.