Pre-distribution and monetary policy: stabilizing employment and growth

Employment & Income,Inclusive Economy22 Jul 2014Thomas Aubrey

In an increasingly globalized world which places downward pressure on nominal wages, monetary policy should permit the rewards of productivity growth to be passed on to workers in the form of falling prices. Targeting nominal income growth to equal the growth rate of total factor productivity would allow prices to fall in proportion to productivity growth, allowing the broader workforce to benefit from its productive activity.

The benefits of productivity are no longer flowing through to workers. Median nominal wage growth remains depressed due to globalization, with the rise of China and India dramatically increasing competition. As workers in developed markets are displaced by this process they tend to gain new employment at lower wage levels. This has been exacerbated by the falling cost of investment goods leading firms to employ more capital instead of labour, particularly in sectors such as mining, transport and manufacturing.

As growth in real wages is determined by nominal income and the general price level, monetary policy has been redistributing the rewards of productivity growth from labour to capital with significant implications for growth and employment. Depressed median real wages leads to falling total demand for goods and services and potentially a lower rate of job creation as low to middle income households have a higher propensity to consume.

Policy therefore should be oriented towards how falling prices might stimulate real wage growth, given that slowing the rate of globalization and technical progress is not a desirable option. This can be achieved by central banks targeting nominal income growth to equal the growth rate of total factor productivity allowing prices to fall in proportion to productivity growth.

Deflation is not always bad

The debate on falling prices has been overshadowed by central banks failing to distinguish between good and bad deflation. Bad deflation arises when a slump in aggregate demand results in rising unemployment and lower investment. Good deflation occurs when rising productivity growth leads to falling prices, which is exactly what has been happening in the technology sector over the last 30 years.

Falling prices do not necessarily mean falling wages

Many economists dislike falling prices, arguing that it will drive down nominal wages leaving everyone worse off. But wages tend to be sticky, with employers reluctant to reduce nominal wages. Moreover, there have been numerous periods in history where the general price level has fallen with rising real wages, including Britain between 1873 -1896 and the United States in the 1920s.

Benefits of marginally higher real interest rates

Once the European economy has emerged from its slump in total demand, there are numerous economic benefits from marginally higher real interest rates. Firstly, it would permit productivity rewards to be passed on to workers in the form of falling prices, driving up real wages, total demand and the rate of job creation. Secondly, it would help prevent large-scale financial crises by limiting excessive credit binges as real interest rates rise to offset increasing productivity growth. Finally, slightly higher real interest rates would force companies to focus on productivity growth as a source of profits, given that firms would not be able to benefit from ultra-cheap financing and relatively lower exchange rates.