It's Wages, Stupid
By focusing on supply, economists and policymakers have lost sight of the fact that driving down wages destroys demand.
For a few decades now, American economic policy has focused on keeping inflation low, assuming that the natural rate of unemployment is fairly high. In general, that has led to stagnating wages. Family income today is at 1990s levels. Adjusted for inflation, hourly wages are at levels they last reached in the 1960s. The wage share has been falling.
Some economists claim inequality is the bigger issue due to runaway income at the top. My own view is that a better way to understand America’s dilemma to focus on stagnation for the broad middle and bottom. As I note in my latest piece for the New York Review of Books, the incomes at the top, which account for most of the inequality, are made in finance — much of which is a game Wall Street plays with itself. For this brief piece, I will put that issue aside.
It is time to talk about the importance of high wages to sustainable growth in America and Europe — indeed, in most countries around the world. The precarious circumstances in the eurozone today are widely understood, as was the U.S. financial crisis, as a problem of fiscal and financial discipline. In fact, I’d argue they were mostly a product of economic models based on low wages that were not sustainable. Both Germany and China had models that depended on low wages.
I’d also argue that the U.S. had a low wage policy to fight inflation, which had become public enemy number one in the minds of even the most sophisticated economists since the 1970s. These economists persistently over-estimated the so-called natural rate of unemployment, which gave the Federal Reserve justification to keep rates up to suppress inflation. In practical fact, the Fed under Alan Greenspan was mostly appeasing bond markets, which Greenspan watched very closely as the signal of inflationary expectations.
We can now focus our attention on wage deficiency. You might be surprised to think Europe or even American financial distress is a wage problem, not a financial discipline problem. But it is time to think this through clearly. We are told too often that disciplined Germany must bail out undisciplined Greece, that America is angry at China’s currency manipulation and China at America’s profligate government deficits. We might almost believe this is the heart of the matter.
But at the center of the issue are low wage shares and inequality. And one reason the world’s policymakers, technocrats, and economists don’t think about it clearly enough is that they focus too much on “supply” as the principal source of economic growth — of machinery, ideas, technology, resources, and human capital quality labor. They focus far too little on “demand” as a source of economic growth.
So here is the brief version of this case. To simplify, aggregate demand must be strong enough to utilize the full productive capacity of a nation in order to optimize growth and keep unemployment down. Demand is largely consumption, which in turn is mostly a product of salaries and wages. In other words, wages must be high enough to support demand for goods and services.
Already we start with an over-simplification. Higher demand, for example, can itself increase productive capacity by promoting investment. On the other hand, higher wages can undermine profits and dampen growth. New School professor Lance Taylor tells us America’s economy is profit-led rather than demand-led. I am a little skeptical of this argument, but Taylor readily admits conditions may change. Servaas Storm, the Dutch economist, who has models similar to Taylor’s, believes that is exactly what is happening.
If wages are too low, then, there won’t be enough demand to support growth. Similarly, if inequality is too high, demand will be insufficient because high-end consumers usually save far more than the rest — there will be a dearth of consumption. The International Labor Organization is now arguing along these lines.
There are basically two ways to increase demand, and they are at the center of the current financial crises. One is to export much more than one imports. Germany and China are the classic examples of this. Wages are relatively low in Germany and very low on a world basis in China, however hard China is trying to raise them. Low wages and low currency values keep their exports competitive. The other model is to borrow to pay for consumption. The U.S., where wages are also low as we noted earlier, is the classic example of this.
The main point is that neither of these economic models of growth is sustainable. There is no longer any doubt about the American debt-led model. It collapsed dramatically in 2008 with damaging implications for the U.S. and the rest of the world.
But many seem to believe that the export model can last forever. Indeed, Germany is cited as a model of rectitude for its moderate wages and discipline. It is now called on to bail out the profligate Greeks, and maybe the Italians, the Spaniards, and the Portuguese. There is a moralistic and sometimes I think ethnically prejudiced subtext for this simple diagnosis — a diagnosis the media repeats carelessly.
The export model, however, is not sustainable because Germany and China are increasingly dependent on borrowing nations (or relatively high-wage but less export-competitive nations) to buy all those goods. If Germany suddenly left the eurozone, for example, a new deutsch mark would likely rise sharply in value and put its exports at a disadvantage. Then what? One wonders how carefully some of the anti-bailout German economists have thought this through.
In fact, Germany and China are as dependent on those who buy their goods as those who now over-borrowed may be dependent on Germany and China to bail them out. As suppliers of careless debt, their institutions also bear heavy responsibility for their debtors. Thus, both Germany and China have moral obligations to support a bailout.
I’d like to say that we should not ascribe blame. But some shifting of blame back to Germany and China is necessary if only to balance responsibility for corrective action now. The euro is priced too low for Germany, giving it a great advantage, and China manipulates its currency downward.
The world requires rebalancing. The answer is to raise wages and wage share and reduce inequality. America would then need to borrow less, and China and Germany would need to export less. Current account balances — big surpluses for Germany and China and big deficits for the U.S. and much of the rest of the Eurozone — would move closer to balance.
One way to start would be immediate coordinated fiscal stimulus. If all provide stimulus, the leak from deficit nations due to the high propensity to import would be mitigated. Similarly, looser monetary policies in the rich nations are required, even as America addresses its so-called zero bound problem. Germany should lead a stimulative fiscal charge in Europe.
Nations, however, are generally doing just the opposite. Germany is mildly stimulative, but austerity economics is tragically in vogue in countries like France. Those within the eurozone, because they cannot cut the value of their currencies, see lower wages as the only recourse to make their exports competitive and generate growth. On the contrary, it will of course bring on slow growth or recession. This has become a vicious circle.
While I don’t advocate ending the euro, the single currency makes it difficult for those within the eurozone to adjust currencies. But ideally, China’s currency should rise, which has of course been widely discussed in the U.S. and Congress. (Keep in mind, this may provide more advantage to China’s even lower-wage rivals, like India, Bangladesh, and Indonesia, than the U.S. and some economists currently consider.) There should be continuing pressure to make this happen.
China needs a strong domestic market to make growth sustainable, but it is not clear that Germany fully understands that it does as well. The European Central Bank has also been especially destructive. Its obsession with low inflation has damaged Europe for a couple of decades. Now, it’s narrow view that it should not be a lender of last resort could do the euro in. One wonders whether these technocrats are any better than first year doctorate students who believe all the rudimentary theory they are taught.
Aggressive short-term, medium-term, and long-term strategies are also needed to raise wages in the U.S. On an after-tax basis, policies are a little easier to coordinate. In the U.S., where the top one percent of earners make almost 20 percent of the income, higher taxes should be levied on the wealthy and then distributed as transfers to the rest — or used to reduce deficits to keep the deficit hawks quiet.
But the more significant task for the U.S., and the more difficult one, would be to fix the broken jobs machine in America and generally raise wages before taxes. Jobs growth was very slow before the Great Recession, as was wage growth. Such policies could include direct hiring by the federal government, persistent large infrastructure and energy investment programs, a living wage policy, and a higher minimum wage.
In sum, there seems to be a deep and potentially tragic misunderstanding of the sources of today’s problems. Internationally, as I note, we should stress how important it is that wages rise in China. Germany must also learn as a nation that its low-wage, export oriented policies are beggar-thy-neighbor policies that cannot last forever, and that it played a part in the financial distress in peripheral eurozone nations.
And the U.S. should get over its own obsession with low inflation, born with the general acceptance of a natural rate of unemployment in the 1970s that no one could forecast but many pretended they could. Keeping wage growth suppressed was a direct outcome of this inflation focus. Compounding the problem is cultural acceptance of low wages and the powerful and widespread influence of Wall Street, which rewards CEOs with stock options that are only valuable with high short-term profits, encouraging them to lay off workers and keep labor costs down.
I plan to write a longer and more nuanced take on this argument, but in light of widespread misinterpretations and possibly calamitous developments in Europe, I thought it important to make this point clear: ”It’s wages, stupid.”
The Roosevelt Institute is a non-profit organization devoted to carrying forward the legacy and values of Franklin and Eleanor Roosevelt.