In his State of the Union address, President Obama called for raising the minimum wage. Whenever someone talks about this issue, you immediately get some heated reaction about how that's a terrible idea because it makes workers more expensive for firms, which means they won't be able to hire as many people -- and that, therefore, fewer jobs will be created.
This analysis is both flawed and extremely unsophisticated.
Raising the income of workers raises their ability to consume more. That should be obvious. It should also be obvious that the ability to consume more means an increase, as well, in the demand for the goods and services that firms produce. So, while the cost to produce those goods might rise (all else being equal), the volume of sales increases -- and that means a climb in firms' net income as well.
It's important to understand that national product equals national income by definition. The total value of everything produced in our economy equals the total income paid to produce it. Increasing people's incomes increases the size of the economy. Furthermore, while some of that income "leaks out" in the form of imports, most of it stays within the economy. That which does leak out, in the form of our current account deficit, comes right back as our capital account surplus -- so it's really all contained here.
Cutting wages does the opposite. It doesn't create more jobs by making labor cheaper. It reduces national income, so it reduces the size of the economy. If you take the example to its logical extreme, you see very quickly what happens. If workers were paid nothing, very few people would have the money to buy the goods and services that firms produced. That means firms would have lower profit to invest in creating those goods and services, and our standard of living would plummet. We'd all be poor. That's why "rich" countries generally don't display low per-capita income.
The whole argument against raising the minimum wage is, therefore, backwards. The fact is, if you raise incomes you raise demand, and that leads to more investment, more product and a larger economy. More wealth is created. Cutting wages creates poverty, and you can't grow by engineering poverty.
This is why the U.S. economy is struggling today. Since the crisis we have seen a very meager rise in wages and salaries, and this has weighed heavily on aggregate demand, since wages and salaries comprise the largest slice of national income. It's also why banks are hesitant to lend. What bank would risk lending to a person who doesn't have sufficient income to make the payments on that loan?
The people who work at minimum wage also have the highest propensity to consume. They tend to spend every penny of what they earn. They have to. That's because merely the basics -- like food, clothing, rent, utilities and so on -- will, in most cases, require everything they have. It's their spending that drives most sales in the economy. If they earn more, they can spend more -- and not just on nondiscretionary items like the things I mentioned, but on some discretionary things as well. That's the dynamic that creates jobs, not the cutting of someone's pay.
On the other hand, someone with a multimillion-dollar salary has all his or her basics covered and then some. In fact, much of that person's income just piles up in bank accounts as savings, and savings constitute a leakage to demand.
How high, then, should the minimum wage be? Studies have shown that a proper minimum wage should be around $22 per hour, but there's an easy way to find out what the right level is. Raise the wage until the economy is at full employment. Full employment defines the level at which our output is maximized without generating any inflation. That's where you want to be.