Treating your employees better is good business, but…

One of the positive results of the increased focus on ESG by investors is that businesses are increasingly held to account for the way they treat their employees. And that is a good thing because too many businesses have exploited low paid workers and exposed them to unsafe working conditions. The situation might be different in poorer countries, but in the rich countries of Europe and North America, it is unfathomable to me how workers can be paid so little that they have to take on several jobs just to make ends meet and have to endure unsafe working condition in the name of “removing unnecessary regulation”. But every action has unintended consequences.

Take for instance the current push towards higher minimum wages. That is a good thing, particularly in the United States, where minimum wages are ridiculously low. But with an increase in the minimum wage comes not only higher costs for businesses, but also a bigger bargaining power for employees. A study of the introduction of the minimum wage in Germany in 2015 in comparison to strikes by the most powerful union, the IG Metall shows that they both have the same effect on labour market: they increase wages for a while, but the higher wages are immediately and almost completely passed through to customers in the form of higher prices. The result is that every time the union successfully negotiated higher wages real hourly wages (top right hand chart below) and nominal wages (bottom right hand chart) increased. But after two years, the increase was gone since the price level increased as well (top left hand chart).

Impact of wage increases on the German economy

Source: Budrys et al. (2021)

Note that economic growth declined for about a year and then recovered back to normal as businesses adjusted while unemployment increased permanently due to the wage shock. In the end, German businesses reacted to higher wages with increased mechanisation and outsourcing. The result was that the people who had a job had higher wages (though only for a while), but fewer people had a job.

Older readers may shrug their shoulders and say that this is just what one would expect. Well, not quite, because the consensus amongst economists has shifted over the last twenty years. Today the majority of economists are convinced that a higher minimum wage does not lead to lower economic growth or higher unemployment.  

So why do the results in Germany contradict the current consensus amongst economists? In my view, it is a question of how high minimum wages are today and what share of profits goes to the labour force vs. the employers. Take a look at the labour share of national income in France, the UK and the United States below. Note how the labour share of income has declined significantly since the 1980s in the United States, while in France, it has remained roughly constant. The UK is somewhere in between. In the United States, workers have been ripped off by employers for decades after the power of the unions was broken in the early 1980s. The result is that workers there now have such terrible wages that they need government help in the form of minimum wage laws. In France, meanwhile, the power of the unions never really declined so wages kept up with national income.

Labour share of national income

Source: OECD

And this means that the starting level of wages is very different in France vs. the United States. In the US, minimum wages can in my view easily increase without causing much damage to the economy, or the labour market. In countries like Germany or France, not so much. There, wages are already so high that increasing them now would lead to higher inflation and higher unemployment as businesses are forced to look for ways to reduce costs elsewhere.

So, while it is great to emphasise the S in ESG, too much of a good thing can be bad. And one has to be clear that pushing for higher wages, either through minimum wage laws or public pressure in media and by investors, can be harmful to the very workers these measures are supposed to help.