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December 13, 2012 / Sian Moore

Planet Earth is Wage-Led: Prof Özlem Onaran on declining wage shares and growth

In this post, Prof Onaran discusses her research for the International Labour Office into wages, consumer demand, and growth.  She has also discussed this research on the Real News Network.

The dramatic decline in the share of wages in GDP in both the developed and developing world during the neoliberal era since the 1980s has accompanied lower growth rates at the global level as well as in many individual countries. Ignoring the lessons of the past, mainstream economics continues to guide policy towards further wage moderation and austerity as the main response to the Great Recession, particularly in Europe. 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 in wages. The key problem is that wages have a dual role and affect not just costs but also demand.

Mainstream economists and policymakers 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 incorporates this dual role, and thereby negative as well as positive effects of a fall in the share of wages relative to profits. 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 (sixteen large developed and developing countries where wage share data is available).

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 (a lower wage share) 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. Thus, 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 to changes in income distribution. 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 as the unit of analysis and develop a global model to calculate the effects of a simultaneous decline in the wage share in all these countries. Thus 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 the table below.

Three main 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, if countries, which have strong trade relations with each other (like the Euro area with a low trade volume with countries outside Europe), are considered as an aggregate economic area, the private demand regime is wage-led.

Finally, even if there are some countries that are profit-led, the Planet Earth as a whole is wage-led. This makes intuitive sense: Planet Earth is a closed economy (as long as we are not yet trading with Mars). Thus, a simultaneous wage cut in a highly integrated global economy leaves most countries with only 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. Thus beggar thy neighbor policies cancel out the competitiveness advantages in each country and are counter-productive.

(For a clearer view, please click the table.)

onarantable

In conclusion, the ILO has drawn on these findings to argue that “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” (2012: 60)

References

ILO, 2012. Global Wage Report-2012/13.  Geneva: International Labour Office.

 

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, Geneva: International Labour Office.

 

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