Planet earth is wage-led!

Inclusive Economy17 Jun 2013Özlem Onaran

Economic growth should go hand in hand with an improvement in wage share and vice versa. However, current policy put no end to both the unsustainable debt-led consumption and export-led beggar thy neighbour economic models.

The dramatic decline in the share of labour compensation in GDP in both the developed and developing world during the neoliberal era of the post-1980s has accompanied lower growth rates at global level as well as in many countries. Addressing the problem of income inequality is even more important today against the background of the crisis. Debt-led consumption, enabled by financial deregulation and housing bubbles seemed to offer a short-term solution to aggregate demand deficiency caused by falling wage shares in countries like the US, UK, Spain, or Ireland until the crisis. The current account deficits and debt in these countries were matched by an export-led model and current account surpluses of countries like Germany or Japan, where exports had to compensate for the decline in domestic demand due to the fall in labour share.

However this model also proved to be unsustainable as it could only co-exist with imbalances in the other European countries – an issue, which is now at the epicentre of the euro crisis. A further rise in inequality is the outcome. A truly inclusive solution to the crisis and European imbalances should focus on rising inequality in both functional and personal income distribution.

However, mainstream economics continue to guide policy towards further wage moderation along with austerity as one of the major responses to the Great Recession. In our recent report “Is aggregate demand wage-led or profit-led? National and global effects” for the International Labour Office, we show the vicious cycle generated by this decades’ long race to the bottom. The main caveat of this common wisdom is to treat wages merely as a cost item. However, in reality, wages have a dual role affecting not just costs but also demand.

In this report we work with a post-Keynesian/post-Kaleckian model, which allows this dual role, and estimate the effect of a change in income distribution on aggregate demand (i.e. on consumption, investment, and net exports) in the G20 countries. With regard to the effects of distribution on demand, consumption is expected to decrease as the wage share decreases, since the marginal propensity to consume out-of-capital income is lower than that out of wage income. A higher profit share is expected to stimulate investment. Finally, net exports will be negatively dependent on unit labour costs, which are closely related to the wage share. The total effect of the decrease in the wage share on demand and growth therefore depends on the relative size of the effects on consumption, investment and net exports. If the total effect is negative, the demand regime is called wage-led. Otherwise the regime is profit-led.

Three important findings emerge: First, the sum of the effects of a fall in the wage share on consumption and investment, i.e., domestic private demand, is negative because consumption is much more sensitive to an increase in the profit share than investment is. Second, foreign trade forms only a small part of aggregate demand in large countries, and therefore the positive effects of a decline in the wage share on net exports do not suffice to offset the negative effects on domestic demand. Similarly, in the euro area as a whole, which consists of countries with strong trade relations with each other and has a low volume of trade with countries outside Europe, the private demand regime is wage-led.

Finally, even if there are some countries which are profit-led, planet earth as a whole is wage-led. A decrease in the wage share in isolation leads to lower growth in the euro area, Germany, France, Italy, UK, US, Japan, Turkey, and Korea, whereas it stimulates growth in Canada, Australia, Argentina, Mexico, China, India, and South Africa. However, a simultaneous decline in the wage share in all these countries leads to a decline in global growth. Furthermore, Canada, Argentina, Mexico, and India also experience negative effects on growth when they decrease their wage-share along with their trading partners. At global level the race to the bottom as regards wage share, e.g. a simultaneous decrease in the wage share by 1% as a ratio to GDP in the major developed and developing countries, leads to a 0.36% decline in global GDP. This intuitively makes sense because what we are finding is that planet earth is a closed economy as long as we are not trading with Mars, and that is not yet the case – at least not for the time being! A simultaneous wage cut in a highly integrated global economy leaves most countries with only the negative domestic demand effects and the global economy contracts. Furthermore it is, in theory, possible for a profit-led country to increase growth by squeezing wages. However, a decrease in their wage share can lead to lower GDP if a similar strategy is implemented also by their trading partners. Beggar thy neighbour policies cancel out the competitiveness advantages in each country and are counter-productive.

At national level, the US, Japan, the UK, the euro area, Germany, France, Italy, Turkey and Korea are wage-led. Canada, Australia, Argentina, Mexico, China, India, and South Africa are profit-led. However, Canada, India, Argentina, and Mexico also contract as an outcome of a race to the bottom. The expansionary effects of a redistribution in favour of profits and at the expense of wages in these countries are reversed when relative competitiveness effects are reduced as all countries implement a similar low wage competition strategy. This consequently leads to a fall in the GDP of the rest of the world as well as import prices.

The microeconomic rationale of pro-capital redistribution conflicts with the macroeconomic outcomes.

At national level, if a country is wage-led, pro-capital redistribution of income is detrimental to growth. There is room for policies to decrease income inequality without this hurting the growth potential of the economies.

For the large wage-led economic areas with high intra-regional trade and low extra-regional trade, like the euro area, macroeconomic and wage policy coordination can improve growth and employment. The wage moderation policy of the euro area is not conducive to growth.

A global wage-led recovery, to put an end to both the unsustainable debt-led consumption and export-led beggar thy neighbour models, as a way out of the global recession is economically feasible. Growth and an improvement in equality are consistent. We present a scenario where all countries can grow along with an improvement in the wage share, and the global GDP would increase by 3.05%.

The austerity policies with their further detrimental effects on the wage shares since 2010 will only bring further stagnation.

Strengthening the bargaining power of labour unions via an improvement in union legislation, increasing the coverage of collective bargaining and the social wage via public goods and social security, establishing sufficiently high minimum wages and levelling the global playground through international labour standards are the key elements in creating the balance of power relations in favour of a wage-led global recovery. However, for this to happen, we need to overcome the coordination problem among the countries. The solution to the coordination problem requires the initiative of some large wage-led developed economies towards wage and macroeconomic policy coordination. A global wage-led recovery can create space for domestic demand-led growth strategies in the developing countries.