Acton Commentary

Schumpeter's Paradox: Wages, Wealth, Incentives


America's federal minimum wage has begun its legally-mandated long march from $5.15 an hour to what will be $7.25 in 2009: a 40 percent increase. This was the result of considerable lobbying of America's Congress by unions, activists, and churches - all of whom claim to be promoting social justice. But whether this measure will help low-income workers in the long-term is more questionable.

The basic economics of supply and demand suggest that legally enforcing a wage-price above the natural market wage is likely to cause unemployment among low-income and entry-level workers: that is, those who most need steady employment and those trying to break into the labor market to begin their working life.

Still, strong reservations about the wisdom of legally-mandated minimum wages have never stopped governments pursuing such policies. Eighteen of the European Union's 27 member states have national minimum wages. Likewise, many Latin American nations also have minimum wage laws, most of which were implemented in the 1960s through the Alliance for Progress.

Curiously, but perhaps not coincidentally, America's minimum wage-increase parallels growing and intense discussion of executive pay across the world.

In Britain, the salaries and bonuses of private equity and hedge fund managers have been stridently criticized – again, by activists, politicians, churches, and unions – partly because of the low tax rates often paid by such individuals.

Even Switzerland's rather relaxed attitudes about such matters were disturbed lately by Mr. Thomas Minder, the head of Trybol, a successful Swiss cosmetics company. He has been loudly declaiming what he regards as excessive managerial compensation, especially that not endorsed by shareholders.

Across the Atlantic, the U.S. House of Representatives passed a bill to strengthen shareholder-oversight of senior executive compensation in May 2007. Almost immediately, a similar bill was introduced into the Senate by none-other-than aspiring presidential candidate, Senator Barack Obama.

Certainly the question of executive compensation is morally and economically complex. Transparency and clearly linking compensation to performance are the tools most likely to resolve this issue. Unfortunately discussions about executive earnings tend to become heated when linked with questions about minimum wages and low-income workers' well-being.

In this regard, participants in these debates would do well to consult an article published exactly 80 years ago by one of the twentieth century's most famous economists, Joseph Schumpeter.

Perhaps best known for his posthumously published History of Economic Analysis (1954), Schumpeter wrote an article in 1927, titled "The Function of Entrepreneurs and the Interest of the Worker." Published in a magazine for industrial workers, the article's central thesis was that high incentives for entrepreneurs and executives are tremendously beneficial in the long-term for everyone, including non-entrepreneurs and non-executive workers.

Schumpeter's argument was that while entrepreneurs and executives receive more of the rewards of economic growth than lower-level workers, this is really beside the point. For Schumpeter, the engine of the economic growth that raises everyone's living standards was entrepreneurship. But entrepreneurship – be it of start-up type or of the strategic variety characteristic of successful senior executives – simply will not occur, Schumpeter wrote, unless people are sufficiently incentivized to risk their own capital and that loaned by others.

Nor will people invest their time, energy, and talents into new, potentially wealth-creating enterprises unless they are reasonably sure that – assuming, of course, the business succeeds – it will be financially worthwhile.

In short, without sufficient incentives such as high compensation, these entrepreneurial instincts are likely to remain dormant. The cost is not only economic stagnation and declining living standards, but also a corresponding reduction in new jobs.

None of this, Schumpeter believed, was meant to suggest that any effort at redistribution was unthinkable or intrinsically immoral. In the same article, however, Schumpeter calculated that even if all the resources of the wealthy in Britain were redistributed to everyone else in the UK, living standards would be barely altered. One suspects the same analysis would hold true today, even on a global scale.

Which brings us back to the minimum wage: This is unquestionably an exercise in redistribution. Note, however, that the redistribution barely affects the materially wealthy.

Instead legally mandated minimum wages tend to have a higher negative economic impact upon (1) middle-class shareholders whose dividends are consequently reduced; (2) thousands of small-business owners with tight margins; and (3) millions of consumers to whom the costs of paying non-market wages will undoubtedly be passed on.

Whatever else this might be, it's hardly justice – social or otherwise.