Minimum wage, maximum delusion

The idea that it would always cost jobs must be ditched. Employment could actually rise, says Yvette Cooper

Mary Walz is still waiting to find out if she's won the jackpot. A cool half a million will be hers if an industrial tribunal decides she is entitled to the bonus she was offered before Barings - her employer - collapsed.

Her case has hit the headlines, not least because she has the gumption to go to court, and because she was one of Nick Leeson's bosses. But many of the other Barings employees also demanded their bonuses when the Dutch bank ING bought up the collapsed bank. And their bonuses were duly paid.

Astonishing isn't it? Those people were working for a bank that went bust. It is bizarre to think of them having earned huge sums regardless.

Economics is offered to us as the justification. Had the bonuses not been paid, we are told, those Barings staff would have left and got equally well-paid jobs elsewhere. ING decided it was worth paying the bonuses to keep the employees on.

But do we believe this? People working in the City are not really operating in a competitive market. Were they to offer their skills in any other sector of the economy, these Barings employees would not be offered this kind of "performance-related pay".

The truth is that City firms cream off huge profits, and the people that work for them get their cut, regardless of their real contribution to the firm or the economy.

Of course to some extent competitive wage pressures operate. It would have cost ING to recruit new staff if the old ones had left, and certainly if wages fell relative to other City firms, the best and brightest would have found jobs with other high-paying companies. But pay is affected by institutions, by the culture that operates in the City, by the excess profits made by the company and how it chooses to cut them, and countless other factors.

Nevertheless the myth of the perfectly competitive labour market lives on. At the top end of the scale, it is used to justify immense bonuses. At the bottom end of the pay scale, it lies behind the claim that minimum wages cost jobs.

The theory goes as follows. The higher the pay, the more people are keen to do the job; the lower the pay, the harder it is to recruit. Firms look at how many people they can recruit at different wages then choose the combination of pay and employment levels that make them most profits. If wages are pushed artificially higher than the perfectly competitive labour market demands, firms will employ fewer people.

The trouble is that the evidence does not match the theory - at least at the kinds of levels of minimum wage in place in Europe and America. The US research on levels of employment in fast-food joints has been well rehearsed: studies discovered that a rise in the minimum wage in one state did not reduce employment relative to a neighbouring state. In fact, the fast-food joints concerned actually took on staff.

A group of academics has taken a detailed look at minimum wages in Europe and has come up with a similar story. Writing in the latest edition of Economic Policy, Juan Dolado, Francis Kramarz, Stephen Machin, Alan Manning, David Margolis and Coen Teulings analysed the effects of minimum wages in France, the Netherlands, Spain and the UK. In our own case it is the old wages councils, which used to set minimum standards in several industries, that they examine.

They conclude that the effects of minimum wages are exaggerated. In some circumstances they find that the minimum wage does cost jobs - notably among young workers in France, although even here the evidence is mixed and controversial. In others, a minimum wage does not cost jobs at all. The abolition of the wages councils in Britain did not lead to a big boost in employment in the sectors covered.

Economists are now starting to offer suggestions as to why the low-wage labour market does not operate as our intuitions suggest. Basically, like the City, it is not perfectly competitive.

Here is a possible account of how it might work. Imagine a security firm that is breaking even. It has 50 employees paid pounds 3.50 an hour. It decides to try to cut costs to make profits. Wages are pushed down to pounds 3 an hour. According to the perfectly competitive model, all 50 employees will immediately walk out and find jobs paying more elsewhere.

In practice, of course, we know that this is not the way things work. It is far more likely that some of those security guards will stick with it because they cannot find anything else, and others will leave when they can. New workers will take the jobs, but people will not stick around long. The firm will face rapid turnover and continually have to recruit and train new staff. Finally it finds that some of the cash saved on wages is spent on recruitment instead.

It does not matter much to the owners of the security firm whether they are breaking even at pounds 3.50 an hour with low turnover, or at pounds 3 an hour with high turnover. But it matters an awful lot to the workers who are earning less, and the taxpayer who pays them more benefits.

More importantly, even if the firms are making lots of profits at such low wages, they cannot expand when demand grows for security services because they cannot recruit. If wages were forced up by the minimum wage, the firms might lose some of those excess profits, but it would be worth their while expanding and taking on new employees. So long as the minimum wage was not set far too high (so that the costs of employing more people became too heavy) employment could rise.

As Dolado et al point out, theory on its own cannot calculate the effects of a minimum wage. Whether it costs jobs depends on the level at which it is set, and the way that part of the labour market works. Pay and employment are not set in perfectly competitive markets. The mantra that minimum wages always cost jobs - and the insistence on a particular model of pay and employment that lies behind it - should be rejected once and for all.

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