Thoughts on minimum wage

As more and more cities push to increase the minimum wage, I wonder how it will affect the type of labor in those cities compared to places that have left the minimum wage at or near the federal level. My first thought was simply that inequality will increase because low-productivity or low-skilled labor will be shut out entirely from the (visible) labor market. This might take a while, but I think in the long run this is true.

Imagine a business owner, let's call her Stella, who relies heavily on low-skilled labor (and remember, unskilled or low-skilled labor doesn't necessarily mean the work is easy, just that it doesn't require extensive training or education). We'll say this person runs a local grocery store in Seattle. The new minimum wage law is passed, but the full increase in minimum wage is spread out over a multiyear phase-in period. Stella essentially has an extended audition for her employees to see who is worth $15/hr. Low-skilled labor has a higher rate of turnover than higher-skilled labor, so Stella will likely turnover the majority of her workforce over the next three years. As the cost of a new employee increases, Stella is likely to increase her requirements and become more selective with each new hire. As anybody who has had to hire for low-skilled positions can tell you, the selection process is extremely inefficient. Before, Stella might have been able to hire riskier employees, ones with spotty work histories or poor educational performance, at a price that reflected that person's level of perceived skill. Maybe Stella offered a starting wage of $8/hr for this type of employee compared to a starting wage of $10/hr for someone who looks much stronger on paper. Now, Stella needs to select high productivity employees at a much higher rate because labor is so much more expensive - she no longer has the option of offering $8/hr to the riskier hire. And surely Stella is investing anything she can into capital improvements that will reduce her reliance on expensive labor wherever it makes sense. By the time the $15/hr minimum wage is in effect, she might only need 6 people on staff instead of 10.

So who gets left out? The people that were already at the bottom will now find it even harder to make ends meet. And even if they would like to improve their lot, they will find a much less receptive audience among hiring managers. Why hire someone at $15/hr if they struggled to show they were worth $9/hr? An argument might be that $9/hr is simply not enough to survive, so we need to lift the floor on wages to make sure every job provides a "livable" income. Certainly a job paying $9/hr, which would equate to a full-time annual salary of $18,720, doesn't sound appealing. I'm sympathetic to the idea that we don't want people who work 40+ hours each week to live in squalor. But by raising the wage floor, you are essentially raising the productivity floor as well. Waving a magical government wand does not suddenly make mopping a floor worth $15/hr.

Another thought I had is that maybe by raising minimum wage, you are effectively forcing labor providers to increase their skill level. I can imagine many of the workers who currently get by working 50-60 hours each week at $9-10/hr going through some sort of job training or going to school. The problem, of course, is that education costs money. For someone making around $20k annually, that likely means debt and possibly leaving the workforce for some number of years. It will be interesting to see if cities with higher minimum wages essentially sort the country geographically according to income. Areas with $15/hr minimum wages have only high productivity, high wage labor with lots of capital and technology replacing human labor wherever possible, and areas with $8/hr minimum wages become the only places where low-skilled labor can find work. The minimum wage acts as a signal - unless you are highly educated and skilled, you are not welcome in our city.

Are financial markets built on informational asymmetry?

In a post on Bloomberg View, Noah Smith has some interesting comments about asymmetrical information in financial markets. From the article:

For most products, there are things you can do to resolve the information gap -- if you don’t trust a used car salesman about the quality of a car, you can have it checked out by a mechanic. In most markets, reputation is also important.

In finance, however, these tools have often proven to be less reliable than for cars, houses or other products. Taking complicated credit products to a “mechanic” didn’t work in the run-up to the 2008 financial crisis -- the more opaque the product, the more willing the credit rating agencies were to sign off on it. As for reputations, these often simply added to the crisis -- people were probably too willing to enter into contracts with risky banks like Lehman Brothers and Bear Stearns, precisely because of these companies’ sterling reputations.

First - the comparison with the mechanic would make more sense if you took the car you were about to buy to the mechanic that works for the dealer. Banks hire rating agencies to sign off on products as part of the marketing for that product. For many institutional buyers, any investment without an investment grade rating isn't going to even get a sniff. There is an inherent conflict of interest here. The bank needs a highly rated product, and the rating agency needs clients. While the products that were sold with supposedly AAA credit turned out to be extremely risky, I doubt the rating agencies fully understood the product and should have said as much. If you take a Tesla to a diesel mechanic, you would hope the diesel mechanic would tell you that he can't help you rather than tell you that everything looks fine.

Noah continues:

Why is asymmetric information so crucial to an understanding of financial markets? It’s probably related to the reason people want financial assets in the first place. People want cars and bananas and microwave ovens because those things are immediately useful. But most people who buy and sell financial assets have no intrinsic desire for the asset itself -- they only care about how its value to other people will change in the future. That means that while information is important for many products, when it comes to financial markets, information is the product....

...Suppose you come to me offering to sell me a stock for $100 a share. Why are you offering to sell it to me for $100? Maybe you’re selling stocks because you’re shifting into bonds, or ready to retire, or need to pay a sudden medical expense. But chances are, you think the stock is worth less than $100, and you’re trying to unload it. That should make me wary about taking you up on your offer. But on the other hand, if I jump at the offer, that should tell you that I have reason to believe the stock is worth more than $100 … and that should make you wary.

I may be misreading this, but Noah seems to think of financial markets as a sort of hot potato where everybody makes money except the person left with the potato when the music stops. If I sell an asset, it is because I believe that asset will no longer continue going up. I'm holding that potato as long as possible, with the hopes of dumping it off to somebody else right before the last note. And if I am the one with the most information, I have the best guess as to when that music is going to stop. So why should anybody buy anything in the financial markets if the game is to make every buyer the bigger fool? The only things for sale would be things I wouldn't want to buy.

Of course, markets don't work that way. The volume in stock and bond markets far exceed what you would expect if most trades are just to offload a soon-to-be dead asset. So why are these markets so active? If markets are efficient and react quickly on all publicly available knowledge, once any material information is released, prices will reflect that new information. Suppose you have a stock that was worth $10 yesterday, but something happened today makes you think it is now worth $5. You might decide to sell it, but how much can you get? If you are the only person that has this bit of new information, maybe $10. If the information is public, then much less. Someone might think that new piece of information is not as awful as you do, and maybe offers you $6. Happy to get rid of something at what you now see as a 20% premium, you make the trade.

Did anybody get screwed in this transaction? If the seller made the trade based on non-public information, then the buyer probably did. That is the purpose of insider trading laws. If market participants aren't comfortable making trades out of fear that counter parties have material non-public information, the market will dry up. But if both parties have the same information, but that information leads to different assessments of an asset's value, transactions can occur. The same principles apply in business acquisitions. Wanda's Farm Supply might be doing just fine today. But Wanda might think the future is a little bleak so she takes bids to buy out her business. Maybe Rupert's Feed Store has been looking at opening a farm supply store and decides that buying Wanda's shop would provide a much higher return on his investment than starting from scratch. Rupert pores over Wanda's financial statements, customer lists, etc, and decides the business is a good buy. Rupert pays Wanda what he thinks is a fair price, Wanda is happy to get paid on what she thinks is a declining business, both parties are happy. The stock market is the same - people are buying and selling businesses based on current profits and projected growth.

Unfortunately, the stock market has become Wall Street's version of Caesar's Palace as speculators throw money at things they don't understand. If I want to buy a car but don't understand how a car works, I should find my own mechanic to take a look at it - and a mechanic that understands the type of car I want to buy. If I want to buy a stock but don't understand balance sheets or income statements, I should find my own financial professional to take a look at it that has expertise in the type of stock I want to buy. If I play the market like a slot machine, I should expect the house to win.

Noah says that asymmetrical information "is at the core of finance. It's key to the way traders, including high-frequency traders, make their profits." If asymmetrical information was so key, I would expect more traders to have higher risk-adjusted returns than their respective benchmarks. The fact is, they don't. The reason is that, for all the information that traders might hoard, they are still guessing on what will happen in the future, just like everybody else. While they might have some very smart guesses that turn out to be profitable, they also might wildly miss on others. Noah says traders are more informed because they "know something about the asset's fundamental value," but unless they have (illegal) insider knowledge, they have the same set of information that others have. The more information, and the more complex that information is, the wider variation in "fundamental value" among traders.

Labor Mobility in the US

I've been staying very busy with my actual work as well as side projects lately, but Prakash Loungani has a post on his blog linking to a new paper about labor mobility. I've only skimmed through the paper so far, but it seems to show that people are not moving for better prospects as much as they used to.

The result doesn't particularly surprise me. As some anecdotal evidence, I live in Indianapolis, which is not exactly a hotbed for financial professionals. Yet, I have remained here in spite of the restricted career opportunities due to family ties. At the start of my career, I even worked in accounting as it was the only offer I had, and I hate accounting (and really, hate is probably not strong enough). But, the job would pay the bills and keep me in Indiana. I wonder if there have been some significant cultural changes that cause people to take worse economic opportunities in favor of better social opportunities. I grew up in a military family and attended five different school districts by the time I graduated high school. As a parent, my goal is to avoid that kind of nomadic life for my own children.