Last week on TV a reporter interviewed a journalist about the effects of raising the minimum wage. The journalist said, according to market theory if the wage were raised demand would lessen for the higher-priced labor and workers would lose their jobs. Next the reporter interviewed a professional economist who stated that numerous studies show that raising the minimum wage has little effect on employment.
This example shows the difference between economic theory and actual economic outcomes.
The origin of economic theory is usually attributed to Adam Smith who wrote “The Wealth of Nations” in 1776. He stated, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”
This idea of self-interest was combined with the idea of an invisible hand. In theory, an invisible hand leads those who pursue their own rational self-interest in the market, through competition, to also promote what is best for the general public.
Smith spelled out other conditions for a free market including that monopolies must be prevented because they distort the market and oppress the poor, government must regulate business to prevent abuses of power, and equal information is necessary for all involved in an economic transaction.
All financial traders need the same information about what they are trading. Therefore government has laws against using inside information on trades. Several traders have recently been convicted and sent to prison in the United States for insider trading.
A free market that actually maximizes economic benefits to society is of necessity not free. In order to have a free market some power must set the conditions necessary for the market and enforce them. Therefore a free market cannot be free of government law and regulation according to Smith.
Alan Greenspan erred by depending on free market theory when the Federal Reserve should have been researching and regulating derivative trading, credit default swaps and other causes of the financial crisis of 2008. In 2008, he told a House committee, “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, (was) such that they were best capable of protecting their own shareholders and their equity in their firms.” The theory of primacy of self-interest led to financial disaster.
On the other hand, economists David Card and Alan B. Krueger of Princeton University studied New Jersey’s actual 1992 minimum wage raise. They compared New Jersey counties to adjacent counties in another state that did not increase its minimum wage. The result was jobs were not lost, and in some cases, employment increased when wages were raised.
Card and Krueger were measuring and analyzing what actually happened in the real world when an economic change is made. The journalist on TV and Greenspan were depending on theory.
Theory can guide research but economic theory must be proven by real-life research to predict actual outcomes in order to guide economic activity.
Bill Dagnon, Baraboo