Ifo Viewpoint No. 90: Christmas Fear: Angela and Minimum Wages

Hans-Werner Sinn
Munich, 26 November 2007

As Christmas approaches pressure mounts to resolve the minimum wage issue in Germany. The conservatives weaken and agree to a comprehensive minimum wage of €7.50 an hour. This scenario is my Christmas fear.

Well-meant is not well done. Comprehensive minimum wages at the amounts being discussed will lead to mass unemployment. The alternative to minimum wages is not heartless neo-liberalism but a policy that ensures a minimum income via wage subsidies. If Hartz IV is reformed according to the proposal of the Ifo Institute, the German Council of Economic Experts, the Academic Advisory Council at the Federal Ministry of Economics and the Institute for the Study of Labor (IZA), there will be no one who can work, who is willing to work and who will fall below the Hartz-IV benefit level. And Germany will find its way back to full employment.

Minimum wages are of course harmless if they are low enough. If they are lower than the wage that is paid today for simple work, they have no effect on employment. Germany already has a minimum wage in the form of Unemployment Payment II (the former social welfare), since hardly anybody works for less than what the state pays for doing nothing. If the new minimum wage is under this level, it cannot destroy once more the jobs that have already been destroyed by the welfare state.

But such a low minimum wage is not what is under discussion today. If a minimum wage is introduced, the parties will debate how high it should be before every election. The left will make the highest bid, the social democrats will bid somewhat less and the conservatives will be constantly accused of heartlessness. Chancellor Merkel may succeed in closing the subject by making concessions. But this would mean that her successors would be confronted with this issue before every election. “Lost Leader”, as Newsweek called her, would be a fair evaluation.

That minimum wages that bind the market lead to major job losses is clear from international comparisons. In the United States, where only 4 euros is paid, the minimum wage is no problem because it is so low. Only about one percent of wage earners are affected. Similarly low (1.9 percent) is the share of wage earners in Great Britain that work to the minimum wage. Here too, the wage does not bind the market. It is very different with the high French minimum wage, which 15 percent of wage earners receive. It has ruined the labour market as much as the implicit minimum wage that the German wage replacement system creates. The burning French school busses have their origin in the minimum wage.

We also know about the job losses from the relevant studies for Germany. The Federal Statistical Office has calculated that one ninth of employees in the private sector in western Germany and a quarter of employees in eastern Germany earn less than €7.50 an hour. Thum and Ragnitz of Ifo Dresden and the Halle Institute for Economic Research (IWH) have used the official data to calculate how many jobs would be lost from the forced wage increases. Using the lowest empirically based coefficient for the percentage reaction of employment after a wage increase of one percent (-0.5), they reach the conclusion that in the medium term in western Germany 800,000 jobs would disappear and 300,000 in the east. These calculations are reliable, cautious and understandable for anyone.

And now there is also a study by Marion König and Joachim Möller, the new head of the Institute for Employment Research (IAB) in Nuremberg, which qualitatively says exactly the same thing (despite surprisingly defensive formulations, which have led to misinterpretation). The authors examined the effect of coverage extension of wage agreements in construction that was introduced in 1997. Since they could not examine the hours worked, they developed an estimation method that takes the resulting imprecision into consideration. While they found no significant effects for western Germany, they were able to show that the coverage extension led to a considerable loss of jobs in eastern Germany.

That the data for western Germany was insufficient for clarifying the issue is not surprising. Since the degree of unionisation was relatively high, the introduction of coverage extension did not lead to many more workers being bound by the wage agreement. And where nominally a few more were included, the coverage extension could easily be circumvented by an unobserved extension of working hours. This makes the results for eastern Germany all the more important. Since many employers left the employers associations – signers of the wage contracts – the effect of the coverage extension of binding wage agreements was greater and the drop in employment correspondingly higher.

This has clear implications for western Germany, since the other institutional features of the labour market are the same as in the east. The wage increase forced by the state was a unique, large-scale experiment on the effect wages have on employment under the German legal conditions. The result of this experiment shows that without union wages, employment would also be higher in the west.

If Chancellor Merkel is not only interested in spreading Christmas cheer but also wants to do something truly positive, she should not agree to a minimum-wage compromise. Not Santa Claus but the devil is the instigator of minimum wages.

Hans-Werner Sinn
Professor of Economics and Finance, University of Munich
President of the Ifo Institute

Revised version. Earlier published as "Christmas Fear". Published as "Weihnachtsangst", WirtschaftsWoche, no. 48, November 26, 2007, p. 230.