The perverse effects of declining wages and declining wage shares

1. The perverse effects of declining wages and declining wage shares Marc Lavoie Department of Economics University of Ottawa

2. Two issues that need to be conceptually distinguished • What if wages and prices fall together, without any change in real wages (assuming a constant level of labour productivity)? • What if real wages relative to productivity fall, that is, what if the wage share falls? • These issues need to be tackled at the macroeconomic level. If we only look at these questions at the micro level, we are likely to be subjected to the fallacy of composition.

3. The impact of lower prices and lower wages

4. The standard view • Lower prices with lower wages have a positive impact on real aggregate demand because: • The real wealth of households becomes higher (V/P). They feel richer. Positive effect on consumption. • The economy will become more competitive on international markets. Positive effect on net exports.

5. Potential GDP S 0 S 1 D E F S D 0 S 1 The standard view (Patinkin wealth effects):A reduction in wages has favourable effects Lower wages Price Level 100 90 5,000 6,000 Real GDP

6. A critique of the standard view • Nominal wealth is unlikely to remain constant when prices fall. The value of real estate will fall and stock market prices will fall. • What about real debt (D/P) ? Households still need to pay their mortgages, their credit card balances, their car loans, etc. All of these remain unchanged in nominal terms, thereby leading to a rise of debt burden in real terms. • Firms still need to make interest payments on their bank loans, on the bonds they issued in the past, etc. Their real debt also rises. • In a global financial crisis, where prices or inflation rates are falling in all countries, the export channel is non-existent.

7. The alternative view • Lower or falling wages and prices have a negative effect on real aggregate demand because debt is usually in nominal terms: • The burden of fixed debt is larger for households; they may also wait for further price decreases. Negative effect on consumption. • The burden of fixed debt is larger for firms, so profitability gets reduced; they may also wait for further cost reductions. Negative effect on investment.

8. Potential GDP S 0 S 1 D S D 0 S 1 The alternative view (Fisher debt effect): A reduction in wages has perverse effects Lower wages E Price Level 100 90 F 5,700 5,000 Real GDP

9. The alternative view is now endorsed by many central banks • Central bankers now fear wage and price deflation because: • Monetary policy is conducted through changes in the real interest rate (nominal rate minus the expected inflation rate) • Nominal interest rates cannot fall below zero. • With wage and price deflation, real interest rates cannot be pushed down to zero or into the negative range. Therefore expansionary monetary policies become impossible. • Japan (1994-2004) is a good empirical illustration of monetary policy impotence under wage deflation. The non-conventional monetary policies now suggested, such as raising bank reserves, were also totally useless.

10. Lawrence H. Summers (and Delong) on the Great Depression, AER 1986

11. The impact of lower real wages and lower wage shares

12. Macroeconomic impact of real wages • Aggregate demand is made up of four components: Y = C + I + NX + G • Increases in real wages relative to labour productivity (or in the wage share) will have an impact on the first three of these components. • A direct positive impact on consumption because the propensity to consume out of wages is higher than the propensity to consume out of profits (by about 0.30). • A direct negative impact on investment, because profitability at given rates of capacity utilization gets reduced (with however a possible indirect positive impact through the accelerator, with higher real wages raising rates of capacity utilization). • An uncertain, but usually negative impact on net exports.

13. Wage-led or profit-led ? • An economy is said to be wage-led when increases in real wages relative to labour productivity or in the wage share lead to faster growth of economic activity. • An economy is said to be profit-led when increases in real wages and wage shares lead to slower growth of economic activity.

14. Empirical studies on growth regimes • There has been a large number of recent empirical studies (Hein, Stockhammer, Naastepad, and their co-authors) on various OECD countries, based mainly on 1960-2005 data. • As is often the case of macro studies, the results are somewhat ambiguous (the same author may obtain contradicting results in two different studies). Some countries seem to be wage-led, others profit-led. • However, some generalizations can be drawn.

15. Generalizing the empirical results • Most countries appear to be wage-led, including Korea. • Some countries seem to be profit-led, including China, (because the saving rates of households are high). • However, profit-led countries are mainly driven by the positive impact of reduced real wages on net exports. • In other words, the positive effect of higher wage shares on consumption is generally bigger than, or equal to, the negative effect on investment • But once again we face a fallacy of composition: not all countries can simultaneously increase net exports by reducing real wages. • In other words, taking into account only the consumption and investment effects, we conclude from these studies that the world economy is wage-led.

16. Conclusions

17. Fallacies of composition • It is in the best interest of each firm and each country taken individually to reduce nominal and real wages when others don’t. • However if all firms and all countries act in such a way, the overall profits of firms and overall growth will be reduced by spreading competitive deflationary pressures. • Governments must take actions to prevent wages and real wages from falling.

18. Means to stop wages from falling • Governments must stop asking for concessions from labour unions when firms go bankrupt (GM, Chrysler). • Upkeep or increase minimum wages. • Improve unemployment benefits, to improve the bargaining power of workers. • Change laws so as tomake it easier for labour unions to become accredited. • Let the government act as an employer of last resort, offering meaningful work to whoever asks for it, so that this labour force will be ready to enter the private employment market when needed, with no loss in human capital. • If adopting work sharing, hourly wages must be increased at least in proportion with expected hourly productivity gains, otherwise there will be hardly any favourable impact on employment.