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The minimum wage should not be linked to inflation. here’s why

Cost of living pressures have increased, but this is a global problem. The US consumer price index (CPI) hit an all-time high of 288.66 points in April. In Australia, the CPI rose 2.1% in the March quarter of 2022 and 5.1% annually – the largest quarterly and annual rise since the introduction of the Goods and Services Tax (GST). ). The Australian Bureau of Statistics (ABS) attributed the increase to rising housing construction costs and fuel prices.

Why is this increase a significant issue? First, a higher CPI indicates rising inflation: if there is inflation, that is, when goods and services cost more, the CPI will rise. When inflation increases, the value of a currency decreases over time. Thus, people on fixed salaries and with cash savings will be penalized by inflation.

Second, this inflation caused PLA leader Anthony Albanese to say he would support the minimum wage (currently $20.33 an hour) rising 5.1% to match inflation. However, business groups have decried such a push. Similarly, the Reserve Bank of Australia (RBA) has warned against pegging wages to inflation.

Labor’s comments raised concerns about a wage-price spiral, in which wages drive up inflation, pushing wages up in a vicious cycle.

But the situation is complex. Many employers have tried to underpay employees for an extended period. Many employers have consistently kept wage growth well below inflation, failed to increase wages with seniority, or cut wages even in good times. This sparked resentment, which boils over in times of high inflation. This is understandable and needs to be addressed.

This raises the question: should wages be linked to inflation? And if not, why?

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Raising wages to inflation will not necessarily improve living standards

A wage-price spiral can occur when wage increases trigger inflation. And, then, that inflation further triggers increases in wages and prices. And it happens in a (hypothetically) endless cycle.

This happens for the following reason. Suppose a person’s income increases by $1. Let’s think about the impacts:

  1. The person now has $1 more to spend on goods, invest or save. At least a portion of that $1 will go toward additional demand. Since supply and demand largely determine prices, this increase in demand will cause prices to rise, keeping supply constant. Moreover, even when the person repays their debt, the lender can now free up this capital to lend elsewhere, thus “easing” the financial conditions. The president of the San Francisco Fed indicated that this could be inflationary.
  2. The person’s employer must now pay him an additional $1. This increases costs for the employer. Thus, the employer will pass the costs on to the customers whenever possible. Some companies may pass on the full amount. Some companies cannot, given the dynamics of the market. The only way around this is a price cap. But it would simply reduce the amount of goods companies are willing to supply, creating shortages.

The Fair Work Commission is an independent body that sets the national minimum wage, which as of July 1, 2021 is $20.33 per hour or $772.60 per week. Photo: Shutterstock

Now suppose we are in a simple idealized world. In this simplistic world, people might say, “What if bread goes up 10% if my income has also gone up 10%?” But the world is not that simple.

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To explore negative impacts, we need to dig deeper. So far we see more inflation: people can pay more for goods because they have more money, so demand increases. But companies have higher input costs, so they charge more. The above two steps will continue for some time. This creates a cycle of inflation. But eventually, this cycle will go off the rails, and here are the long-term effects on flow:

  1. Imports will become more expensive and the standard of living will fall. They will do this because the value of $ decreases in relative terms. Thus, imports become more expensive. This reduces productivity and lowers people’s standard of living. In the long term, exports could increase due to the weaker currency and central banks could raise rates to control inflation. These might counteract this effect after some time. But the possibility of a long-term equilibrium would do little to resolve the fear that imported foods could become unaffordable now. This logic applies mutatis mutandis (the necessary modifications having been made) to the entire economy. Failure to reduce inflation can trigger hyper-inflationary catastrophes.
  2. Central banks will try to reduce inflation. But, if wages are now linked to inflation, the central bank will have to raise interest rates still further: it will no longer be able to count on the stabilization or fall in wages to reduce inflation. On the contrary, the central bank will need a destruction of demand, operationalized by unemployment. Ultimately, it’s not good for the employees.
  3. Some companies cannot pass on price increases. These businesses become less profitable. They hire fewer people or risk going bankrupt. This hurts employees and increases unemployment. Ironically, this could, in the long term, reduce wage pressure and put downward pressure on wages if they are not mechanically linked to inflation.
  4. Following the bankruptcy of certain companies, markets may become more concentrated. This would be a long-term “tail event” type risk. However, if we are looking at a situation where wages are mechanically pegged to inflation, as Anthony Albanese seems to want, then that is the ultimate outcome.

Thus, the overall result of linking wages to inflation is negative. But that does not solve the problem: real incomes have fallen.

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So what can be done to improve the standard of living?

Several solutions can help mitigate inflation-related wage demands and needs.

1. Prevention is better than cure. Employers can seriously attack employee wages. In a period of “stable” inflation, wages would evolve roughly in line with equilibrium inflation. It is important that employers do not tax loyal employees who stay with excessively low wage growth. Employers would also do well to invest in productivity gains, whether through mechanization, automation or upgrading of their workforce. Such an increase in competence must not simply add hours to the work of the employee – as is too often the case with workload plans – but must actually allow this employee to gain in efficiency.

Failure to invest in this way will simply cause employees to impose “shrinkflation” on the company. Whereas a loyal or productive employee might have been ready to “go beyond” before, in high inflation environments they will simply work to rule and engage in side hustle. It is therefore essential that employers pay employees at market value. Otherwise, these employees will simply leave.

2. Employers should recognize cost of living pressures. Employers should explain to employees the issues with wage-price spirals and whether price increases are affordable. Explaining these issues to employees and treating them like adults will likely reduce (but not eliminate) worry.

3. Inflation must come down. Central banks should tackle inflation. The root cause of wage claim inflation is high inflation. Reduce inflation, and inflation expectations are essential. Employees are less likely to push for aggressive pay increases if they think inflation will come down. This involves credible signage. Both the RBA and the Federal Reserve have signaled that future rate hikes are on the table.

4. Help employees develop. There is no single answer. The fact that wages may normalize over the next few years does not necessarily help current cost of living pressures. Whenever possible, upgrading is the best approach. This creates more demand for your workforce in both a strong labor market and a weak market. Warren Buffett specifically advised us to “be exceptionally good at something”. When people want to hire you, you can demand more money or change jobs.

It is always important to have an ex-ante buffer. A side hustle can work for an efficient office worker who decides to work to rule. This may not be as viable for a worker whose income is tied to hours earned. Nonetheless, focusing on effective shift management (i.e. penalty rates, less desirable hours) can increase revenue with progressively less pain.

Changing jobs is an important mechanism. Often, employers impose a “loyalty tax” on employees who remain. Currently, unemployment is 4% in Australia. It is less than 4% in the United States. There are a myriad of jobs for a myriad of different skills. If you’re willing to leave, you can often get a higher salary.

What does this mean for politics? Cost of living pressures are real. And so, central banks have to control inflation so that the standard of living does not fall in the long term. Above all, central banks have shown that they are ready to do so.

Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals and his research interests include corporate finance, venture capital and law. For more information, please contact A/Prof. Humphery-Jenner directly.

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