Minimum Sense

Hans-Werner Sinn
The Wall Street Journal Europe, 30.04.2007, S. 15

While the German economy is finally booming again and employment rising rapidly, the situation of the low-skilled and long-term unemployed remains difficult. Their wages, if they can find a job at all, have come under increased pressure in recent years due to the extensive outsourcing and offshoring activities of German firms. They are the obvious victims of globalization. As the ex-Communist countries and India, accounting together for no less than 45% of mankind, decided to participate in the market game, equilibrium wages for ordinary labor in the industrialized world, including Germany, have fallen.

Berlin is considering introducing minimum wages to fix this problem. This is at least what the Social Democratic Party and its labor minister, Franz Muntefering, demand. Chancellor Angela Merkel's Christian Democratic Party, the coalition leader, is still reluctant to endorse this proposal. But its opposition is eroding in view of the public support minimum wages enjoy.

Left-wing politicians and journalists dominate the debate. Minimum wages, they say, are necessary to maintain the living standards of the poor. They argue that minimum wages pose no problem for the economy: After all, most other European countries have them already.

They fail to acknowledge, however, the negative experience these countries had with minimum wages. The vast majority of empirical studies show they tend to cost jobs. In France, for example, a 1% increase in the real minimum wage reduces the employment probability of a young man by 2.5%. If the minimum wage is sufficiently low, as is the case in the U.K. and the U.S., where only about 1% of the work force earn it, it poses no major problem for the labor market. However, if it is as high as in France, where 15% of the work force earn minimum wages, it contributes to chronic unemployment by pricing the low-skilled out of the market. The French youth riots that shocked the world two autumns in a row can be attributed to the high unemployment among the young, which in turn is partly caused by the high minimum wage.

What the left further overlooks is that Germany already has an implicit minimum wage resulting from its extensive welfare system. An unemployed couple with two children typically receives a monthly net income of 1,600 euros -- and that doesn't even count free health insurance, worth another 600 euros per month, and free pension and old-age nursing insurance. As this income is paid under the condition that people do not work and is cut to the extent that they do, it defines a minimum wage that the private sector would have to exceed in order to be able to attract workers.

If Germany now were to introduce an official minimum wage alongside the implicit one, there would be no additional harm for the labor market provided the former remains below the latter. In this trivial sense the left-wing politicians may well be right when they argue that a legal minimum wage would not result in job losses. However, given the mechanics of the German political system, it is all but inevitable that the legal minimum wage, once introduced, will be increased from one election to the next. Germany's new far-left party, fittingly called "The Left" and led by former Social Democrat Party head Oskar Lafontaine, will surely set the tone by calling for higher wages. The Social Democrats, worried about the new competition from the left, would not dare staying far below that, and the Christian Democrats, struggling with an image of social coldness, would be forced to follow. Thus, either a formal minimum wage would soon exceed the implicit one, or the implicit minimum wage would, for the sake of justice, also be forced upward. In either case a further increase in unemployment among the low-skilled is likely once the current economic boom is over.

The basic problem for the army of low-skilled is that no entrepreneur will employ a person who adds less value than the wage he must be paid. At the same time, hardly any unemployed person will take a job whose net wage is not sufficiently above welfare payments. In light of this, the German government should consider another strategy for helping the low-skilled.

Such a strategy would convert welfare payments into wage subsidies, a bit like the U.S. Earned Income Tax Credit. Basically, welfare recipients would be required to work in exchange for the money they receive from the state. This kind of "Activating Social Aid" system would involve a two-tier aid system. The state would subsidize low incomes while those unemployed who cannot find a job in the private sector would be required to do public work. Such a system would abolish the implicit minimum wage and create jobs for the low-skilled while preserving their living standards. A legal minimum wage, while sounding fair and just, would do the opposite.

Mr. Sinn is president of the Ifo Institute for Economic Research.