Planet Earth Is Wage-Led!

OZLEM ONARANA simultaneous increase in the profit share by 1% point in the major developed and developing countries, leads to a 0.36% decline in global GDP.

The dramatic decline in the share of wages in GDP in both the developed and developing world during the neoliberal era of the post-1980s has accompanied lower growth rates at the global level as well as in many countries. 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 for the International Labour Office (Onaran and Galanis, 2012), 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. We work with a post-Keynesian/post-Kaleckian model, which allows this dual role.

A fall in the wage share has both negative and positive effects

We estimate the effect of a change in income distribution on aggregate demand (i.e. on consumption, investment, and net exports) in the G20 countries. Consumption is a function of wage and profit income, and is expected to decrease when the wage share decreases, since the marginal propensity to consume out of capital income is lower than that out of wage income. Investment is estimated as a function of the profit share as well as demand, and a higher profitability is expected to stimulate investment for a given level of aggregate demand. Finally, exports and imports are estimated as functions of relative prices, which in turn are functions of nominal unit labor costs, which are by definition closely related to the wage share. 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. If the total effect is negative, the demand regime is called wage-led; otherwise the regime is profit-led. Mainstream economic policy assumes that economies are always profit-led, whereas in the post-Keynesian models the relationship between the wage share and demand is an empirical matter, and depends on the structural characteristics of the economy.

Next, we go beyond the nation state and develop a global model to calculate the effects of a simultaneous decline in the wage share in all these countries. We calculate the responses of each country to changes not only in domestic income distribution but also to trade partners’ wage share; this in turn affects the import prices and foreign demand for each country. The results are summarized in Table 1.

Table 1: Summary of the effects of a 1%-point increase in the profit share (a decline in the wage share) at the national and global level

table 1 Özlem Onaran edit

Three important findings emerge: First, domestic private demand (i.e. the sum of consumption and investment in Columns A and B in Table 1) is wage-led in all countries, because consumption is much more sensitive to an increase in the profit share than is investment. 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 (Column C) do not suffice to offset the negative effects on domestic demand. Similarly, in the Euro area as a whole, consisting of countries with strong trade relations with each other and a low trade volume with countries outside Europe, the private demand regime is wage-led. Finally, even if there are some countries, which are profit-led, the planet earth as a whole is wage-led. This makes intuitively sense; because what we find is that planet earth is a closed economy as long as we are not trading with Mars, not just yet! 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 some profit-led countries contract when they decrease their wage-share, if a similar strategy is implemented also by their trading partners. Beggar thy neighbor policies cancel out the competitiveness advantages in each country and are counter-productive. ILO (2012:60) in the recent Global Wage Report-2012/13 writes “The world economy as a whole is a closed economy. If competitive wage cuts or wage moderation policies are pursued simultaneously in a large number of countries, competitive gains will cancel out and the regressive effect of global wage cuts on consumption could lead to a worldwide depression of aggregate demand.”

At the national level, the US, Japan, the UK, the Euro area, Germany, France, Italy, Turkey and Korea  are wage-led. Canada and Australia are the only developed countries that are profit-led; in these small open economies, distribution has a large effect on net exports (see Column D and E). Argentina, Mexico, China, India, and South Africa are also profit-led. In particular China is very strongly profit-led due to high effects on exports and imports. 

Race to the bottom leads to lower global growth

At the global level, the race to the bottom in the wage share, i.e. simultaneous increase in the profit share by 1%-point in the major developed and developing countries, leads to a 0.36% decline in global GDP. The Euro area, the UK, and Japan contract by 0.18-0.25% and the US contracts by 0.92% as a result of a simultaneous decline in the wage share (see Column G in Table 1). Most interestingly, some profit-led countries, specifically Canada, India, Argentina, and Mexico also contract as an outcome of this race to the bottom. The expansionary effects of a pro-capital redistribution of income 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 wage-led economies contract more strongly in the case of a race to the bottom. Australia, South Africa, and China are the only three countries that can continue to grow despite a simultaneous decline in the wage share; however the growth rates in these countries are also reduced. 

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

First, at the national level in a wage-led economy, a higher profit share leads to lower demand and growth; thus even though a higher profit share at the firm level seems to be beneficial to individual capitalists, at the macroeconomic level a generalized fall in the wage share generates a problem of realization of profits due to deficient demand. Second, even if increasing profit share seems to be promoting growth at the national level in the profit-led countries, at the global level a simultaneous fall in the wage share leads to global demand deficiency and lower growth. What seems to be rational at the level of an individual firm or a country turns out to be contractionary at the macro or global level.

Policy implications

At the 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 hurting the growth potential of the economies.

For the large wage-led economic areas with a 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.

Addressing the problem of income inequality is even more important today with 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 share 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’s 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 in the epicentre of the Euro-crisis.

A global wage-led recovery, to put an end to both the unsustainable debt-led consumption and export-led beggar thy neighbor models, as a way out of the global recession is economically feasible. Growth and an improvement in equality are consistent. This is true not only for the wage-led countries but also for those that are profit-led, although in the latter the room for improving the wage share is more limited unless the structural parameters of the countries change. 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% (Onaran and Galanis, 2012).

The austerity policies with further detrimental effects on the wage shares since 2010 will only bring further stagnation. Growth in China and a few developing countries alone cannot be the locomotive of global growth.

A global wage-led recovery can also create space for domestic demand-led and egalitarian growth strategies rather than export orientation based on low wages in the developing countries. Second, even if some important developing countries are profit-led, like China and South Africa, south-south cooperation can create a large economic area, where destructive wage competition policies are avoided.

Rebalancing growth via increasing domestic demand in the major developing countries, in particular China would also be helpful in addressing global imbalances. However, this rebalancing can only take place in an international environment where the developed countries not only leave space for developmentalist policies, support technology transfer, but also create an expansionary global environment by avoiding a race to the bottom.

Given the profit-led structures in some developing countries, the solution to the coordination problem requires a step forward by some large developed economies in terms of radically reversing the pro-capital distribution policies. Strengthening the bargaining power of labor unions via an improvement in union legislation, increasing the coverage of collective bargaining, increasing the social wage via public goods and social security, establishing sufficiently high minimum wages, and leveling the global playground through international labor standards are the key elements in creating the balance of power relations in favor of a wage-led global recovery.

References:

ILO, 2012. Global Wage Report-2012/13, http://www.ilo.org/wcmsp5/groups/public/—dgreports/—dcomm/documents/publication/wcms_194843.pdf

Onaran, Ö. and Galanis, G. 2012. “Is aggregate demand wage-led or profit-led? National and global effects,” Conditions of Work and Employment Series No. 40 , International Labour Office, http://www.ilo.org/wcmsp5/groups/public/—ed_protect/—protrav/—travail/documents/publication/wcms_192121.pdf

Originally posted at the Global Labour Column of the Global Labour University

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  • Steven Frans

    In my opinion there isn’t any guarantee that in a time of rising inventories, excess production facilities and cash hoarding by the capitalists, increasing the wage share will lead to a new cycle of investment and thus growth. It might relax the overproduction of capital but at the same time eat profitability and thus not yield any guarantee for a new round of mass investment.

  • http://twitter.com @Little_Cossack

    Then lower taxes in one form or another whether on consumer goods or payroll or credits. Those who argue against this cite the Bush tax cuts. Fact is once the internet bubble burst, 9-11 had greater impact than any statistical data can measure. That coupled with the bubble burst, then hurricane Katrina in the bastion of capitalism (i.e. USA), which provides more foreign aid than the next 3 combined, naturally the world entered a significant slow down. Consumerism (even among the poor who have satellite dishes, flat screen tv & mobile phones) is still relatively high. Standard of living even for poor is high in USA. Union bosses wealth has grown. Why don’t you look inside your premise & apply it to your conclusion. Take a critical view, exercise your conscience, be intellectially honest, impirical. Examine trends within unions. Union workers struggle while union bosses get fat & use union dues unethically to affect elections ,,, totally Bolshevistic.