Sometimes everything comes together in unintended ways. That has happened to me this week. I…
There was an interesting Working Paper issued by the ILO – Is aggregate demand wage-led or profit-led? – last year, which finally received some coverage in the mainstream economics press this week. The Financial Times article (October 13, 2013) – Capital gobbles labour’s share, but victory is empty – considered the ILO research in some detail. That lag is interesting in itself given that it was obvious many years ago that the trends reported in the ILO paper and the FT article were part of the larger story – that is, the preconditions – for the global financial crisis. If you look back through the Modern Monetary Theory (MMT) literature, dating back to the 1990s, you will see regular reference to the dangers in allowing real wages to lag behind productivity growth. It seems that the mainstream financial press is only now starting to understand the implications of one of the characteristic neo-liberal trends, which was engendered by a ruthless attack on trade unions by co-opted governments, persistent mass unemployment and underemployment, and increased opportunities by firms to off-shore production to low-wage nations. Better late than never I guess.
Here is the labour share in factor income for Australia from the September-quarter 1959 to the June-quarter 2013. The downward trend since the 1980s is representative of similar trends in many advanced nations.
The ILO presented the following graphs (first two panels of Figure 1, Page 5), which I reproduce to put the Australian data in context. As an aside, for an official document, the formatting inconsistencies of the ILO graphs is somewhat poor. At least the vertical scales are comparable.
Their graphs are indexed at 100 at 1960 to make them comparable across jurisdictions.
The authors note that:
There has been a significant decline in the wage share in both the developed and developing world along with neoliberal policy reforms following the 1980s. The promise of these reforms was to stimulate private investment and exports, which in turn was expected to generate higher growth, more jobs and trickle down effects.
The question is whether these growth dividends have been sufficient to repay the workers for the sacrifice they have made in terms of wage share.
I have considered this topic in these blogs – There is a class warfare and the workers are not winning and Massive real wage cuts will not improve growth prospects and The origins of the economic crisis.
Another recent ILO Report written by Englebert Stockhammer – Why have wage shares fallen? A panel analysis of the determinants of functional income distribution – is also worth reading for its analysis of trends in the advanced OECD nations.
[Reference: Stockhammer, E. (2013) Why have wage shares fallen? A panel analysis of the determinants of functional income distribution, International Labour Office, Geneva]
There are two broad facts that are agreed by most analysts in this area/ First, up until the early 1980s, real wages and labour productivity typically moved together. As the attacks on the capacity of workers to secure wage increases intensified, a gap between the two opened and widened.
The widening gap between real wages and productivity growth manifested as the rising profit share and the wage share in national income has fallen significantly over the last 35 years in most nations.
Second, in the Anglo nations, “a sharp polarisation of personal income distribution has occurred” (Stockhammer, 2013: 2), with the top percentile and decile of the personal income distribution substantially increasing their total shares. The munificence gained at the expense of lower-income workers manifested, in part, as the excessive executive pay that emerged in this period.
To fix ideas some revision is necessary. Regular readers will know all this so you can skip to somewhere below.
The real wage is the purchasing power equivalent on the nominal wage that workers get paid each period. To compute the real wage we need to consider two variables: (a) the nominal wage (W) and the aggregate price level (P).
The nominal wage (W) – that is paid by employers to workers is determined in the labour market – by the contract of employment between the worker and the employer. The price level (P) is determined in the goods market – by the interaction of total supply of output and aggregate demand for that output although there are complex models of firm price setting that use cost-plus mark-up formulas with demand just determining volume sold.
The real wage (w) tells us what volume of real goods and services the nominal wage (W) will be able to command. For a given W, the lower is P the greater the purchasing power of the nominal wage and so the higher is the real wage (w).
We write the real wage (w) as W/P. So if W = 10 and P = 1, then the real wage (w) = 10 meaning that the current wage will buy 10 units of real output. If P rose to 2 then w = 5, meaning the real wage was now cut by one-half.
The relationship between the real wage and labour productivity relates to movements in the unit costs, real unit labour costs and the wage and profit shares in national income.
The wage share in nominal GDP is expressed as the total wage bill as a percentage of nominal GDP. Economists differentiate between nominal GDP ($GDP), which is total output produced at market prices and real GDP (GDP), which is the actual physical equivalent of the nominal GDP.
To compute the wage share we need to consider total labour costs in production and the flow of production ($GDP) each period.
Employment (L) is a stock and is measured in persons (averaged over some period like a month or a quarter or a year.
The wage bill is a flow and is the product of total employment (L) and the average wage (w) prevailing at any point in time. Stocks (L) become flows if it is multiplied by a flow variable (W). So the wage bill is the total labour costs in production per period – that is W.L
The wage share is just the total labour costs expressed as a proportion of $GDP, that is:
This is usually expressed as a percentage (as in the graph above although note the graph is about GDP at factor cost – a complication we will ignore here).
We can break this down further, by noting that labour productivity (LP) equals the units of real GDP per person employed per period. Using the symbols already defined this can be written as:
LP = GDP/L
Nominal GDP ($GDP) – that is, at market value or current prices can be written as P.GDP, where the P values the real physical output. This is different to real GDP which nets out the effects of price level changes on our measure of economic activity.
By substituting the expression for Nominal GDP into the wage share measure we get:
Wage share = (W.L)/P.GDP
We can write this in equivalent terms as:
Wage share – (W/P).(L/GDP)
Now if you note that (L/GDP) is the inverse (reciprocal) of the labour productivity term (GDP/L).
So an equivalent but more convenient measure of the wage share is:
Wage share = (W/P)/(GDP/L) – that is, the real wage (W/P) divided by labour productivity (GDP/L).
The point of all this torture is that it produces a very easy to understand formula for the wage share.
It becomes obvious that if the nominal wage (W) and the price level (P) are growing at the pace the real wage is constant. And if the real wage is growing at the same rate as labour productivity, then both terms in the wage share ratio are equal and so the wage share is constant.
The wage share was constant for a long time during the Post Second World period and this constancy was so marked that Kaldor (the Cambridge economist) termed it one of the great “stylised” facts. So real wages grew in line with productivity growth which was the source of increasing living standards for workers.
The productivity growth provided the “room” in the distribution system for workers to enjoy a greater command over real production and thus higher living standards without threatening inflation.
Since the mid-1980s, the neo-liberal assault on workers’ rights (trade union attacks; deregulation; privatisation; persistently high unemployment) has seen this nexus between real wages and labour productivity growth broken. So while real wages have been stagnant or growing modestly, this growth has been dwarfed by labour productivity growth.
As a result, the wage shares in most nations have been falling. Where has the real income gone? To the profit share, silly!
The ILO Working Paper noted in the introduction adds to this sort of analysis because it “estimates the effects of a change in the wage share on growth in the G20 countries using a post-Keynesian/post-Kaleckian model” and attempts to calculate “the global multiplier effects of a simultaneous decline in the wage share”.
So what that does mean?
The ILO paper notes that there are two competing views about what drives economic growth:
Mainstream macroeconomic models emphasize the supply side rather than the demand side of the economy; and assume that demand will follow supply. Most importantly for the purpose of this paper, they treat wages merely as a component of cost, and neglect their role as a source of demand. On the contrary, post-Keynesian/post- Kaleckian models … reflect the dual role of wages affecting both costs and demand, and while they accept the direct positive effects of higher profits on investment and net exports emphasized in mainstream models, they contrast these positive effects with the negative effects on consumption.
This sort of division among economists goes back to the debates in the C19th between Marx, who understood that if you cut wages you would not only cut costs but also income and the likely effect would be to undermine total spending, and the conservatives of the day (Ricardo, Mill, Say etc) who considered that wage cuts would increase supply and demand would follow.
The debates saw a more modern form during the 1930s when Keynes attacked the conservative Treasury view by emphasising the duality of wages – a cost and an income. The Treasury View dominated in the early days of the Great Depression and inspired wage cuts, which only made the unemployment higher.
The ILO Paper notes that if the wage share falls then we would expect to see a decline in total consumption because “the marginal propensity to consume out of capital income is lower than that out of wage income”.
Interestingly, the FT article begins with an amusing anecdote. It says:
In 1958, Walter Reuther, a powerful US union leader was taken on a tour of a newly automated Ford Motor plant. “Aren’t you worried about how you’re going to collect union dues from all these machines?” he was asked by a (no doubt smug) company manager.
“The thought that occurred to me,” Mr Reuther replied, “was how are you going to sell cars to these machines?”
So where will growth come from in this context? The ILO paper says that a lower wage share may stimulate investment because profitability is higher and firms typically use internal fans to finance investment expenditure.
It is also possible that a lower wage share will be associated with increased external competitiveness which may stimulate net exports.
In other words:
… the total effect of the decrease in the wage share on aggregate demand depends on the relative size of the reactions of consumption, investment and net exports to changes in income distribution. If the total effect is negative, the demand regime is called wage-led; otherwise the regime is profit-led. Whether the negative effect of lower wages on consumption or the positive effect on investment and net exports is larger in absolute value essentially becomes an empirical question.
So that is an interesting research programme.
I won’t go into the statistical techniques that the ILO paper uses but clearly you can read about them yourselves if you are interested. Their work focuses “on the sixteen major developed and developing countries, which are members of G20: European Union, Germany, France, Italy, UK, US, Japan, Canada, Australia, Turkey, Mexico, South Korea (henceforth Korea), Argentina, China, India, and South Africa.”
The principal findings are:
1. “a rise in the profit share leads to a decline in consumption” because larger “consumption propensities” out of wage income are “confirmed in all countries”.
2. “The US is the only developed country where the profit share has no significant effect on investment”.
3. “In most developing countries the profit share has no statistically significant effect on private investments”.
4. “The effect of the profit share on private investment in China is also insignificant …”
5. “Even in the East Asian countries like Korea and China that have high investment rates, private investment is not driven by high profits but the business environment created by industrial policy and public investment, which explains the lack of statistically significant correlation between private investment and profits.”
6. “In all countries, GDP has a strong and significant effect on private investment, providing evidence for the significance of an investment-growth nexus” – in other words, economies that are growing strongly provide a fertile environment for private investment. Austerity-ridden economies undermine private investment. Economies where consumption is falling due to real wage suppression also do not provide a buoyant investment climate.
7. “… in three developing countries (Korea, India, and China) public investment has a significant positive effect on private investment”.
8. “The negative effect of the increase in the profit share on private consumption is substantially larger than the positive effect on investment in absolute value in all countries. Thus demand in the domestic sector of the economies is clearly wage led; however, the foreign sector then has a crucial role in determining whether the economy is profit-led”.
9. “Overall demand in the Euro area (12 countries) is significantly wage-led … +Germany, France, and Italy as individual large members of the Euro area are also wage led … The UK, US, and Japan are also wage-led … Canada and Australia are profit-led; as small open economies the net export effects are high; the investment effects are also among the highest in the developed world in these two countries, and the differences in the marginal propensity to consume out of profits and wages are among the lowest.’
These results (Point 9) would suggest that there are no growth implications in Australia for the redistribution of income away from wages towards profits.
However, every study has its weakness and in this case there are severe limitations of the analysis as far as Australia is concerned. The same limitations apply for all nations but I’ll just briefly discuss Australia in this case.
The sample period chosen for the study includes the atypical period where household debt skyrocketed from X percent 2X percent of disposable income in a matter of 10 or 12 years.
Data from the RBA statistics archive – Household Finances – Selected Ratios – B21 shows that in March 1977 the Household Debt to Disposable Income ratio was 33.5 per cent.
As the financial system opened (floating of AUD, deregulation of mortgage interest rates, and relaxing capital controls), the ratio rose to 42.9 per cent 10 years later (March 1987).
Then the gap between real wages and productivity started to rise as the wage share was suppressed.
By March 1997, the household debt ratio was 73 per cent and the financial planners were coming out to play exploiting the slack rules about product disclosure and the fact that the capacity of households to maintain consumption growth out of real wages growth was declining.
The credit boom that followed saw the Household debt ratio peak at 153.3 per cent in September 2006 as the warning bells of the impending financial crisis were starting to toll. By then the interest payments out of disposable income had risen from 5.3 per cent to 11.1 per cent, squeezing the capacity of the households to purchase other goods and services.
The limitation of the ILO analysis in this regard is that the observed results they gain for the so-called “profit-led” economies ignore the fact that consumption was being propped up beyond what it might otherwise be because of the rapid and unsustainable credit growth.
So not only was the differences in the consumption propensities (how much out of each extra dollar is consumed) between wage income and profit income not as magnified in Australia as elsewhere but the real rate of GDP growth was stronger than otherwise, which also led to a more favourable investment response.
But as is clear now, the credit binge produced unsustainable household balance sheets and is now over. the household saving ratio is now back around 10% and rising after being negative in the years leading up to the financial crisis.
Whether it gets back to its prior’s steady average of around 16 per cent remains to be seen and the continued suppression of real wages growth and the mass labour underutilisation rates may prevent that.
But the point is that the growth environment is significantly different now than it was when households were piling up the debt. I suspect that the ILO results will be different if the researchers revisit the project in a few years time when the post-credit binge data sample is longer.
Further, in the case of Australia we had a massive depreciation in the exchange rate in the latter part of the 1990s, which provided for a favourable net export environment.
The FT article quotes a financial market economist as musing:
… whether Marx was right all along, and that capitalism ultimately sows the seeds of its own destruction, “when there is no consumer demand and it all falls over”.
The declining wage share and the resulting credit binge in many nations were clearly causal in creating the global financial crisis. The mainstream economists believed that the markets were efficient and that there would be no problems with placing an increasing proportion of real income into the hands of the Casino economy.
They were wrong but then just this week we have learned that one of the leading contributors to the “efficient markets” literature, who is also one of the most vocal proponents of the free market myth, was just awarded a Nobel Prize in Economics (Fama).
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.