Real wages, monetary policy and innovation

In my drive into Oxford I pass a petrol station that offers a car wash service. Ten or twenty years ago you would have expected this to involve a large degree of automation. However in this particular case it involves a few workers with hoses, mops and buckets. Now anyone who has seen my own car will realise that I know very little about car cleaning technology. But with this caveat, it seems to me this garage offers a nice illustration of how labour productivity is a function of relative prices. If labour becomes expensive relative to capital, it is worth the garage investing in a car washing machine, but if the opposite happens, once the machine reaches the end of its life it goes back to the old labour based technology.

In technical terms what I describe above is just an example of factor substitution. This is one explanation of the UK’s productivity puzzle, investigated at the aggregate level by Joao Paulo Pessoa and John Van Reenen. They “argue that ‘capital shallowing’ (i.e. the fall in the capital-labour ratio) could be the main reason for [the productivity puzzle]”. Although initially the US did not see productivity fall, there are indications a milder form of this may be happening there too.

So why does this not happen in every recession? One answer, provided by Pessoa and Van Reenen, is that the behaviour of real wages in this recession has been very different. Real wages have been much more responsive to unemployment in this recession compared to the recessions of the 1980s or 1990s. Pessoa and Van Reenen suggest this could be the result of a combination of weaker union power and welfare reforms that keep effective labour supply high even when demand is low. You could also add greater availability of cheap labour from members of the EU where unemployment is high.

A counter argument might be that earlier recessions have been caused by tighter monetary policy, pushing up the cost of capital, whereas in the Great Recession interest rates have been at the zero lower bound. However there is evidence that the Great Recession has increased the cost of capital for large firms in the UK, and the impact on small firms will have been even greater. In addition a recession that involves a financial crisis is likely to leave firms feeling particularly reluctant to invest, because any borrowing will involve a long term financial commitment that leaves them more vulnerable. In the past they could have relied on their bank to see them over any temporary cash-flow problems, but now they are less sure. In these circumstances, labour intensive rather than capital intensive forms of production seem much less risky.

Indeed in a world of certainty the capital intensive form of production might actually be more efficient. In economic jargon, switching to people with buckets and hoses has actually reduced total factor productivity. But in a world where financial risk has increased, the firm may still choose the labour intensive form of production.

This process of factor substitution will also lead to a steady decline in survey measures of excess capacity. As the recession hits, the car wash business with a large machine will report excess capacity as people economise on car cleaning. However when the machine reaches the end of its useful life, it is replaced by people with buckets and hoses, and the firm reports no spare capacity.

What happens when demand begins to rise? Initially not much - the firm just hires more labour. Productivity does not increase. The situation becomes more interesting if labour becomes scarce. Does the firm start paying higher wages to attract more workers, or push up prices to choke off additional demand? Or does the firm now think that maybe it is time to invest in a car washing machine, which would in a more certain future allow the firm to reduce costs and prices (and lead to a reversal in the fall in productivity)?

Perhaps all of the above. But suppose that at the moment real wages or inflation begin to rise, the central bank tightens monetary policy. This would raise the cost of capital, and could be interpreted as an attempt to prevent real wages rising. In other words, a strong signal to the firm to stick with its labour intensive production methods. We enter a kind of low productivity, low wage trap. Monetary policy, which in theory is just keeping inflation under control, is in fact keeping real wages and productivity low.

Monetary policy makers would describe this as unfair and even outlandish. A gradual rise in interest rates, begun before inflation exceeds its target, is designed to maintain a stable environment. As the owners of the garage begin to appreciate this, they will eventually decide to invest in that car washing machine. On the other hand, if they sense that inflation might rise above target, they will not invest, however strong short term growth might be.

I’m not sure I believe this. As Chris Dillow argues here, investment may be particularly prone to confidence or animal spirits. Would these animal spirits be stimulated more by strong demand growth, even if it was accompanied by forecasts of 3% or 4% inflation, or by monetary tightening to prevent this inflation ever happening?  

I also have another concern about a monetary policy which tightens as soon as real wages start increasing. What little I know about economic history suggests an additional dynamic. As long as the firm is employing labour rather than buying a machine, there is no incentive for anyone to improve the productivity of machines. The economy where real wages and labour productivity stay low may also be an economy where innovation slows down. The low productivity economy becomes the low productivity growth economy.