Productivity and wages: flagging trends and possible solutions

Productivity and wage growth are flagging across the world, particularly in many rich countries such as the US and UK. Trends in output per worker hour (a common measure of productivity) have generally become weaker since the beginning of the Global Financial Crisis (GFC). An interesting article in this week’s Economist magazine discusses several academic papers which try to pinpoint the reasons for this. Given the strong link between productivity and wages, this issue is vital for policymakers trying to improve national prosperity.

The authors cited in the article suggest fairly mainstream solutions such as deregulation or boosting support for research. But one paper offers evidence that, rather than the commonly understood direction of causation running from productivity growth to wage rises, that the reverse process has been in operation: low wages have led to low productivity. For example, if firms can hire workers at a low wage, they may do so rather than install labour-saving technology, which would have been more likely if wage levels had been higher. In other words, a key policy plank of free market economics, that of ‘flexible labour markets’, might create employment, but it may also undermine productivity growth. Flexible labour markets thus end up stimulating the creation of lots of low paid, low productivity jobs.

The Economist writes as if the low wage-low productivity idea is something new. And to the economics mainstream, maybe it is, apart from ideas such as the efficiency wage, which remain important in the New Keynesian literature. However, such ideas have been put forward by heterodox economists for years.

Those working in the post-Keynesian tradition have been highly critical of labour market deregulation, since it seems to have contributed to rising inequality even if it has led to the creation of employment. These economists also maintain that it is the growth of effective demand that determines the level of employment, rather than wage flexibility. In fact, falling wages, if they are widespread in an economy, can reduce demand and prevent a recovery in employment. This will happen if economies are ‘wage-led’. If they are ‘profit-led’, then falling wages could stimulate employment through the incentives given by rising profits to increasing investment. Neither theory requires flexible labour markets in its reasoning.

Some heterodox economists also support the idea, mentioned above, that labour market regulations which improve wages and working conditions will encourage both managers and workers themselves to become more productive in the face of higher labour costs. Indeed the UK is often cited as having a pretty flexible labour market, alongside the US. Job-creation in the UK since the GFC has been quite strong, but many of these jobs offer low pay and poor working conditions and are not very productive.

Germany also has a fairly low unemployment rate, and its economy has been successfully creating jobs in the last decade or so. However, much of this has been due to partial deregulation which has created a dual labour market. Many new jobs offer low pay and little regulation of conditions, while those who have kept their jobs in the country’s industrial sector tend to have higher pay and better conditions. This trend has led to a rapid increase in inequality as wages at the bottom of the scale have stagnated, and may well have reduced overall productivity growth in the economy.

The Economist article cited above suggests a greater priority should be given among policy-makers to achieving full employment in their economies. It is true that a tighter labour market tends to exert upward pressure on wages, and the theory goes that this would change the incentives facing firms: with scarcer labour and rising wages, they would have the incentive to increase productivity through higher investment in new technology and worker training. However, experience suggests that tight labour markets, though potentially offering such economic benefits, can lead to higher price inflation.

Back in 1943, the Polish economist Michal Kalecki wrote an article in which he outlined the differences between capitalist economies getting to full employment and the policy of maintaining it. The latter situation, he argued, would lead to power shifting from managers to workers. Without a more cooperative approach to wage bargaining and the operation of the workplace, business leaders, faced with a potential loss of authority, would declare the system to be ‘unsound’ and press the government to abandon the goal of full employment. This proved to be an astonishingly accurate prediction of what happened across Western economies in the 1970s and 80s. Thus even if fuller employment were possible, it may not be sustainable.

With this in mind, achieving full employment with low inflation, as well as raising productivity performance, may be a tall order given the current ideological consensus in rich countries. But the debate on productivity shows that labour market ‘flexibility’ may not be such a panacea for the ills of capitalist economies. Also missing from the argument are the role of industrial and technology policies, substantially increased investment in public infrastructure, and improved education and training, particularly for the more marginalised groups in society. There are potential solutions a-plenty, but do politicians have the vision to enact them?

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