Any economists in the house? Arm me with counter-arguments to neoclassical orthodoxy!

November 10, 2006 1:03 PM

Is there a counter-argument to the idea that indexing wages to inflation encourages inflation?

I'm currently taking a class in macroeconomics, taught by your standard neoclassic economist. She recently mentioned off-hand in a class discussion about inflation and consumer confidence that indexing the minimum wage to inflation can encourage inflation. I'd only ever heard Republicans say this, so I was skeptical.

I did some research, and the only place I can find this assertion is either on conservatie think tank websites, or in my textbook, which is well-written but co-authored by a former member of Bush's Council of Economic Advisors.

It concerns me that my professor might be causally tossing around partisan arguments in an othrwise great class, and I would like to press the professor on this. I'm prepared to admit that she may be right, but I'd like there to at least be a debate about it.

So, anyone got any good counter-arguments for me to try out?

posted by lunasol to law & government (17 comments total)

Are you talking about indexing all wages to inflation or just the wages that minimum wage positions pay?

Most (lots?) of people get raises that are greater than inflation every year, bumping a fast-food worker's wages by 1-2% every year will have a minimum effect on the wages of workers in higher-paying jobs.
posted by bshort at 1:15 PM on November 10, 2006

Well, she's right, in a limited sense. Indexing puts more money in the pockets of people with fixed incomes, or government salaries, or whatever. If they have more money to spend, there's inflationary pressure on the economy. The question is how big this influence is. It may be negligible, depending on how many people are having their incomes indexed. Or even if there's some effect, it may well be worth it to see that seniors living on government pensions aren't reduced to eating cat food within a few years of retirement.
posted by Dasein at 1:17 PM on November 10, 2006

(Why not ask your professor what the counterarguments are? You're paying big bucks to get access to an expert — you may as well get your money's worth.

Most academics will happily explain their opponents' ideas — if only so they can argue against them more clearly — and most good academics want to give their students a broad and balanced picture of the field. At worst, you'll get a quick explanation of why the other side's wrong; at best, you'll get a fascinating conversation, more respect and maybe even a higher grade.)
posted by nebulawindphone at 1:19 PM on November 10, 2006

Rather than 'trying out' a counterargument , why not raise your hand and ask the professor if there are any opposing economic theories out there on the subject?

Her mentioning that the theory exists, or that it "can encourage inflation" is hardly partisan advocacy.

To answer the question more directly: As far as I know, there is no good counterargument to the assertion that increasing wages can encourage inflation. Of course it can encourage it.

But that's not political or partisan -- the politics comes in when you ask the questions of how much and how soon it will encourage inflation and whether or not that uncertain effect outweighs the assumed short-term socio-economic benefits of increasing the minimum wage enough to guide policy. You also have to ask what the assumed constants are (ceteris paribus) and what the real world impact will be of the nonexistence of that massive assumption.
posted by JekPorkins at 1:21 PM on November 10, 2006

On the textbook point:

my textbook [is] co-authored by a former member of Bush's Council of Economic Advisors.

You are, presumably, referring to Gregory Mankiw. Mankiw's textbooks are a very mainstream introduction to modern macroeconomics — a neoclassical long run with a bit of Keynesian short run. From an economic perspective, I don't think his textbooks contain much in the way of partisan bias.

It's true that he was on Bush's CEA, but that doesn't mean he wholeheartedly agrees with Republican economic policy. For example, he said outsourcing is "probably a plus for the economy in the long run", a sentiment shared by a huge majority of modern economists, but not one that would find favour with most Republicans in power.

Furthermore, membership of something like the CEA more-or-less requires public obedience to the government's policy; private agreement is entirely separate. For example, you wouldn't say that because Joseph Stiglitz was Chief Economist at the World Bank, Stiglitz's views are in line with traditional World bank policy.
posted by matthewr at 1:22 PM on November 10, 2006

"If they have more money to spend, there's inflationary pressure on the economy."

worth noting too is that the price of goods is a function of the cost to produce them - added to the profit margin. If the price to produce goes up (payroll cost), manufacturers aren't going to shrink the profit margin to maintains the same price to consumers. So you've got both ends causing inflation, not just increased buying power.

as was said earlier, the idea that hiking min. wage increases inflation isn't partisan. Its pretty simple economics. The debate should be is it worth it? cost/benefit analysis etc.
posted by Tryptophan-5ht at 2:21 PM on November 10, 2006

You might want to read this PDF, which discusses some of the problems with introductory economics courses.

Blog discussion here or here.

Nutshell: introductory economics is so oversimplified that when you try to apply your knowledge to the real world, as you are trying to do, you end up believing entirely untrue things.
posted by jellicle at 3:22 PM on November 10, 2006 [1 favorite]

I think the basic theory is that if wages are pegged to inflation, you've hardwired a positive feedback loop: prices go up, so wages go up, so expenses for manufacture go up, which causes manufacturers to raise prices, which leads to more inflation. Round and round and round you go.

The counter-argument is that the loop can be broken either by manufacturers cutting their profit margin, or by increases in productivity. The latter one in particular is the best argument against it: wages go up, but workers produce more, so the manufacturer can continue to sell at the old price because his increased expenses are paid for through increased sales volume at the old price.

Of course, sometimes there is no increase in productivity, and sometimes the manufacturer isn't willing to cut his profit margin (or may not be able to because he's already at the bare minimum needed to make his business viable) and in that case you'd expect to get that positive feedback loop.
posted by Steven C. Den Beste at 3:33 PM on November 10, 2006

++ Tryptophan-5ht

Too often policy arguements are held with both sides arguing that their proposal will help the economy. It is possible for a policy proposal to be one which would hurt the economy and still be the right thing.

I say this as someone with pretty traditional economic views, by the way. Economists (I'm not one) get annoyed when plainly economically damaging things, like tarrifs, are framed as being a help to the economy. Just say that the health of the steel industry or whatever you're protecting is more important than the economy as a whole. Or that socialized medicine is worth the greater equality even though the average quality of care would go down. I could buy into that. I can't buy into economic arguments that go against all reason and evidence.

As far as introductory economics goes, I think the marginal utility of money is a pretty good argument against some oversimplified neoclassical-ish ideas. Poor people value the same amount of money more than rich people. Your last dollar is worth much much more to you than your billion and first. Since wealth is measured not by dollars and cents but by value (which is why each freely-entered-into and well-informed market transaction, say a dollar for a candy bar, increases the amount of wealth in the world), it is possible to create value and therefore wealth through some kinds of redistribution. If Bill Gates were to give me one million dollars, the amount of wealth in the country would go up because I would value that million dollars more than he would. There are naturally some limitations to this approach.
posted by yesno at 3:38 PM on November 10, 2006

2 important things that 1st year economics students often forget:

1. Ceteris Paribus -- this is the biggest assumption in the world, and is the whole point behind economic theory. In this instance, Ceteris Paribus means that you assume that there is no increase in productivity that is kicked in along with the increased minimum wage, for example.

2. "Economics" doesn't mean "money." It means everything that people or society value, including money. "The Economy" is not what Economics is focused on. Economics can be useful in determining how to help or hurt the economy. But "the Economy" (as in the U.S. or some other country's money/financial system) is not what Economics is about.
posted by JekPorkins at 4:04 PM on November 10, 2006

If inflation already existed, and inflation is worse in the least developed countries, it doesn't make too much sense to say that linking the lowest paid jobs to inflation is inflationary. It would seem that something which forces producers to pause in raising prices can't be an incentive either. I found an interesting statement by Dan Blatt:

PRICE INCREASES ARE OBVIOUSLY DEFLATIONARY - NOT INFLATIONARY.
Price increases powerfully induce increases in supply and decreases in demand - which tend to diminish and even throw into reverse the forces pushing prices up.

So, if more money in the hands of immediate spenders causes a rise in demand and lowered supply, then this could theoretically reverse the process of inflation induced by the central bank.
posted by Brian B. at 5:41 PM on November 10, 2006

No doubt raising the minumum wage tends to increase inflation at least a little bit, I don't think you'll find any serious arguments against that proposition. But that doesn't mean the effect is so large as to be at all significant, or even measurable. Very likely, its degree of relevance depends in part on the ratio of the minimum wage to the average wage.
posted by sfenders at 7:41 PM on November 10, 2006

I was thinking of those very same blog posts (I saw earlier today) when I read the question also, Jellicle.

Lunasol, you could also search out (since I make the same assumption that matthewr does) Professor Mankiw's Blog, perhaps he discusses the issue and the arguments for-and-against somewhere in his archives?
posted by SenshiNeko at 8:50 PM on November 10, 2006

Thanks, everyone, for the very intelligent and helpful responses. Those of you who assumed Mankiw were correct - and I actually love his textbook (if it is possible for a non-econ person to love a macro textbook!). Certainly, my assumptions about him were based on my own partisan leanings.

It's a good point that introductory econ courses tend to - probably necessarily - be not enough to prepare one to apply in the real world. And my professors have been quite open about that. However, I'm at a top-tier public policy school and many of my classmates will be taking what they learn in this class and using this knowledge to shape policy, so it does seem a bit irresponsible to not address things like this.

I think I'll probably go talk to the professor and ask her what she thinks about this issue.
posted by lunasol at 9:14 PM on November 10, 2006

Indexing wages to inflation will not start some spiraling cycle of further inflation. The only cause of inflation is an increase in the money supply relative to the intrinsic value of all the 'goods' in the economy. If the government or certain companies or whatever are forced to pay a higher wage, that money doesn't just magically appear. They will either cut back on how many people they have to pay that wage to, lose some profits (taking a loan would probably fit here), or be more productive. Everything will stay balanced. The trouble comes when the government can't do these things (including covering the cost with taxes) and instead gets more money from the Federal Reserve which can print money from thin air. This extra money, which you could say is pretty much magically added to the economy, throws off the natural balance mentioned above, lowers the real value of everyone's money, and causes inflation.

So from this you can see that the only way that indexing wages could lead to inflation is when the government does it and then refuses to cover the cost (balance the budget) with increased taxes.
posted by Durin's Bane at 9:23 PM on November 10, 2006

"the only way that [anything] could lead to inflation is when the government does it"

Not really. Excessive government spending is one way to create inflation, but it is certainly not the only way to increase the money supply. For one thing, fractional reserve banking. Hmm, what are those reserve requirements at today?

Anyway, the nature of money has gotten a bit complicated lately. You might consider today's thoughts from Doug Noland on the subject of recent monetary developments:

No longer does the Federal Reserve even attempt to manage “money” and the Fed and banking system certainly no longer enjoy a monopoly on its creation. Greatly complicating the matter, the static monetary aggregates today have little relationship to the vagaries of marketable securities-based Credit “money.” The phenomenon of “Money” is perception-based, hence, non-quantifiable – which, by the way, creates one heck of a predicament for econometricians and contemporary (statistical models-based) economics generally.

I was greatly amused this week to ponder the absurdity of the question "Should Money Help to Guide Monetary Policy?"

Right. Well, having been reminded of what's currently going on in the magical realm of monetary policy, I think it's safe enough to say that whatever inflationary effect there would be from raising the minimum wage a bit closer to the minimum one might need to escape poverty, it's likely to be somewhat undetectable amidst all the other inflationary things going on at the moment.
posted by sfenders at 10:46 PM on November 10, 2006

Most of the best arguments against economic theory are drawn from empirical evidence.

Empirical evidence shows that COLAs aren't generally inflationary, in large because they generally just make automatic the result that workers and employers (or retirees and plan obligors -- pensions often have COLAs) would negotiate (explicilty or through market processes) on their own. Whatever value destruction occurs by a slight incremental pressure on prices is probably offset by the value creation of avoiding strikes and other frictional costs of negotiation.

However, empirical evidence shows that COLAs are dangerous insofar as they remove a very important brake on large discontinuous surges in inflation. If an important component in the CPI basket suddenly jumps up because of some extrinsic factor, one can argue that the economy "needs" consumers to pull back on spending on that component in order to restore equilibrium. COLAs can remove that impetus. (For example, if people had gotten a 5% wage increase due to the 50 cent increase in gas prices after Katrina, do you think that they would have cut back on consumption the way that they did?)

The potential of COLAs to exacerbate surges in inflation is why they are disfavored in some places which are broadly resistant to imposing neoclassical theory on policy, like much of Western Europe.
posted by MattD at 4:43 AM on November 11, 2006