Is increasing workers' bargaining power a way of raising real wages?

There is no doubt that the last decade has been a terrible period for average real wages in the UK, with levels still below where they were before the Global Financial Crisis. It is very tempting to related this to the weak baragining power of workers. After all, we were being told before Brexit that the economy was strong, so if the benefits were not going to wages they must have been going somewhere else. Some people go further and say that one of the reasons that the bargaining power of UK workers is weak is because of high levels of immigration, and that therefore immigration must be responsible for lower real wages.

What people often forget is that real wages depend as much on prices as nominal wages. If nominal wages in the economy as a whole rise, firms can just pass additional costs on by raising their prices, leaving real wages unchanged. Equally if nominal wages are depressed because of weak bargaining power or immigration, firms are able to cut prices to become more competitive, rather than keep prices unchanged and raise their profits.

To see what firms have done on average we can look at the chart below, which shows the percentage shares of profits and wages in national income over the last thirty years. (They do not sum to 100 because of factors like self employment income and sales taxes.) The share of wages and profits in national income have been remarkably stable over the last two decades. It is simply not the case that bosses have been expropriating the gains from growth over the last decade.

So what does explain why real wages are still lower than before the Global Financial Crisis (GC), when the size of the economy a whole surpassed its pre-GFC level in 2013?

The first explanation is that GDP is not the right measure to use if you want to know about standards of living, because it can increase just because there are more people producing things in the economy. A much better measure is GDP per capita (GDP divided by the total population), and that only surpassed pre-GFC peaks at the end of 2015. It is one of the great ironies of UK politics (and a big media failure) that the growth the Conservatives like to boast about is in good part due to immigration they want to stop.

Yet GDP per capita is still higher than it was pre-GFC and real wages are not. The main reason for that is the exchange rate. We have had two very large depreciations since the GFC: one that happened as the crisis was unfolding and one as a result of the Brexit vote. This raises the price of imported consumer goods, which reduces real wages relative to GDP per capita. Another way of making the same point is that although each worker is producing a bit more stuff than pre-GFC, that stuff buys less overseas goods than it used to, which means workers are worse off.

The first depreciation probably reflected in part our dependence on a financial sector that was hit by the GFC, but the Brexit depreciation was a completely self-inflicted wound. But that aside, the overall message is that the main reasons for lower UK real wages are stagnant productivity and a decline in sterling.

Does this mean that weak bargaining power has nothing to do with weak UK wages? There are two potential reasons why there could still be some connection. First, there is some evidence that individual firms that have some monopoly power now share less of their surplus profits with workers than they used to, and that might well reflect weaker bargaining power. Perhaps the UK aggregate profit share might have fallen over the last decade if it hadn’t been for these firms passing on less of their surplus to workers.

Second, it might be the case that one reason why productivity is so poor is that nominal wages have remained low. If nominal wages rose because workers had more bargaining power, that might induce some firms to investment in labour saving machinery. This is an argument I examine in a new article in a special edition of Political Quarterly on post-Brext policy.

We have one clear recent piece of evidence on what happens if you raise nominal wages, and that is when minimum wages are increased. If George Osborne’s hike in minimum wages raised labour saving investment and productivity then no one has noticed. More seriously, the near consensus of the empirical literature on minimum wages is that increases generally do not reduce employment, and that appears inconsistent with those increases promoting labour saving investment. Now an increase in the minimum wages is not exactly the same as an increase in the bargaining power of workers, so this piece of evidence is not definitive, but as yet we have no strong evidence that greater bargaining power would spur innovation.

All this suggests that the declining bargaining power of workers is at best only a minor factor behind the decline in average real wages. To increase UK real wages we need to improve productivity, and that means not hitting investment on the head with first austerity and then Brexit. Evidence suggests that the best way to increase productivity is by raising demand so firms need to invest to meet that demand. Raining public investment would be the best way to stimulate aggregate demand.

But that does not mean that we should not increase the bargaining power of workers. There seems little doubt that working conditions in some occupations are pretty bad, and a strong union presence would be an effective way of improving the working conditions of workers. But I also think a strong union presence in a worksplace can have a positive influence on the distribution of real wages.

The average wage measure in the national statistics include some some very high wages at the top of the income distribution. Over the last thirty years the typical or median real wage has fallen by much more than the average, and that is because of rising inequality, a good part of which is due to high pay rises for the top few percent of earners. While some of that is just down to the rise of the financial sector, some is also within a firm. Andy Haldane at the Bank of England has also noted (page 8) that since the 1990s the wage share of older workers has risen, but the wage share of younger workers (below 35) has fallen. Furthermore, as Martin Sandbu points out, it is often inequality in the wage distribution that allows firms to continue to employ workers on low wages to do things a machine could do. Some of this growing inequality may have been a consequence of weaker trade unions.

There are therefore plenty of good reasons to want to increase the bargaining power of UK workers. Just don't expect that to have much impact on the living standards of workers. To raise real wages we need higher UK productivity, and that will only come from stronger private and public sector investment.

Underestimating the impact of austerity

There have been many ideas put forward to explain the low growth in UK productivity, but among mainstream accounts the impact of austerity is not usually high up on the list of possibilities. I have talked before about what I call an ‘innovations gap’, and how the UK is currently suffering a particularly large innovations gap. The idea of an innovations gap can link inadequate demand, like austerity, to low productivity growth.

Let me use a very simple example to explain how an innovations gap can arise after a deep recession followed by austerity. Assume that improvements in technology and production techniques are constantly taking place, or being learnt from other firms/countries, but they need new investment to put them in place. This is what economists call embodied technical progress.

Imagine a firm where demand is not increasing. Will that firm invest to become more productive? Only if the additional profits it can make as a result of investing (suitably discounted) is greater than the cost of the investment. For this firm we therefore need quite a big innovation gap before it is worth its while to undertake investment and before its productivity increases.

Now imagine that demand increases. The firm now has to undertake some additional investment to increase its output. It makes sense to invest in techniques that embody the latest technology. The increase in demand leads to both higher investment (what economists call the ‘accelerator’) and higher productivity.

In a normal recovery from a recession, demand recovers rapidly (growth easily exceeds past trends), leading firms to invest in the latest technology. Any innovations gap that might have opened up in the recession is quickly closed. In contrast, a very slow recovery caused by austerity will reduce the need for investment, allowing a large innovations gap to open up.

This idea fits in with some recent work which suggests that productivity growth in ‘frontier’ firms (firms that already have relatively high productivity) has not slowed, and a gap has opened up between these frontier firms and laggards. (See also here.) This would make sense if the frontier firms are growing (because they are the most productive) but the laggard firms are not. Growing firms need to invest to expand, but stagnant firms are not expanding.

The same model could also suggest how wage led productivity growth could occur (see Ben Chu here for example). As most innovations are likely to be labour saving, then higher wages can increase the profits that come from any particular investment, without necessarily increasing the cost of that investment. So an increase in wages caused by an increase in the minimum wage, for example, could increase investment and therefore increase productivity. The other side of that coin is that the period of stagnant wage growth we have had since the recession provided no incentive for firms to invest in higher productivity techniques.

I doubt that this story explains more than a part of the UK’s productivity gap. In the UK investment in plant and machinery fell sharply in the recession, and has not yet recovered to pre-recession levels, but its decline is unlikely to be enough to explain a productivity standstill. (For an account of some other key factors that could explain the UK productivity puzzle, see here.) But if it explains even a little, it makes austerity a lot more costly.

One way of describing what I’m saying is that austerity influences supply as well as demand. You could say austerity ignores the accelerator as well as the multiplier, which is cute but does not capture the idea of embodied technical progress which is crucial to this argument. It is why it is always best to run a high pressure economy (see Martin Sandbu here who links to an interview between Jared Bernstein and Josh Bivens).

As I explain here, I do not use austerity as just another name for any fiscal consolidation, or fiscal consolidation involving cuts to spending. Fiscal consolidation need not reduce output for the aggregate economy if monetary policy is able to offset its impact. But if interest rates are at their lower bound, as they are once again in the UK [1], fiscal consolidation will reduce output and lead to another needless waste of resources. Since Brexit we have a second period of UK austerity. In assessing how costly this will be, we need to look not just at whether it creates a negative output gap, but also how it creates an innovations gap that reduces productivity.

[1] We know this, because the Bank is increasing the amount of QE.

An optimistic view: a UK investment led recovery

Someone wrote to me the other day to complain that my posts were always negative in tone. I understand where they were coming from, as there is a lot going on here in Europe to be negative about. However just to show that I can do positive, here is how the next few years could be relatively cheerful ones for the UK economy.

The important point about today’s GDP figures, showing 0.7% quarter on previous quarter growth (not annualised), is that this has happened despite what looks like being a relatively poor quarter for employment. The combination means that UK labour productivity growth may have finally resumed after its six year pause. This while nominal wage growth shows clear signs of increasing.

What we could be seeing is an investment led UK recovery. It all goes back to my favourite explanation for the UK’s productivity puzzle: that after the recession, high unemployment (both in the UK and Eurozone) pushed down UK wages, which led firms to put investment that would have led to labour productivity growth on ice, and just employ more people instead. (There may also have been direct labour for capital substitution of the kind beloved by macroeconomists.) With reasonable growth in demand this generated rapid employment growth, cutting the unemployment that helped cause stalling productivity.

It was my favourite productivity puzzle story, not because I was sure it was right, but because it was optimistic. It was optimistic because, as unemployment fell and labour shortages began to become common, the process would stop and investment would resume. Provided demand continued to increase, both actual growth and growth in productivity might continue above trend and we would find that at least some of that output which pessimists thought was lost forever after the recession would return. I also thought there were some grounds for this optimism: stories about the pre-2007 trend being artificially inflated by debt were, well, inflated, and productivity innovations do not take six year holidays.

The caveat about demand remaining strong was crucial, of course. Fiscal policy and you know who will not help beyond 2015, and neither has the recent strength in sterling. However lower oil prices go the other way. The big unknown is monetary policy. If nominal wages start rising before productivity growth resumes, that would be a trigger for the MPC to start putting on the monetary policy brakes too soon. They could still make that mistake, of course, but rising productivity growth coupled with core inflation below 1% should make them wait.

I should add in passing that if this does all happen, it in no way excuses what has gone before. Strong growth after a long recession does not make the recession OK! The cost in terms of lost output (at first compounded by the costs of high unemployment) has been huge, and you know why I think much of it could have been prevented.

I should also stress that this is an optimistic scenario, not a forecast. I know enough about unconditional macro forecasts not to do them. All manner of things could go wrong. But if this is how things do pan out, it will not just be good news, but it will also be fascinating from a macroeconomic point of view. It will show how you can have a prolonged demand deficient recession without persistent high unemployment, partly as a result of what economists call flexible labour markets. This was always something that could happen in theory, but I’m not sure we have many examples where it has happened. However, I should not allow my optimism to count chickens before they are hatched.

That referendum was fun. Shall we do it again?

Whether the UK as a whole gets to choose whether to have a referendum on continuing membership of the European Union depends on the result of the general election in 2015. Given that we have this choice, it is worth thinking about similarities and differences between the EU referendum and the referendum on Scottish independence.

The key similarity is that the immediate economic consequences of independence in both cases are negative: according to John Van Reenen, even more so with the UK leaving the EU. In both cases nationalism will play an important role. I would argue that in both cases independence is seen by many as a means to a particular end. With Scotland, it was a way of ensuring that Scotland would not be governed by a right wing Conservative party. With the EU, it is a way of stopping large scale migration into the UK.

Is another similarity that the established parties are likely to be united in arguing against independence? There must be serious doubt about this. I suspect that Cameron has a strong preference for continued membership, and even that in his eyes the referendum is largely a political ploy to stop Conservative voters moving to UKIP in 2015. However Cameron also has a preference for remaining the leader of his party. He is very unlikely to get significant changes to the terms of EU membership before the referendum, including the free movement of labour. There are said to be between 50 and 100 Conservative MPs who will argue for leaving the EU whatever the outcome of Cameron’s negotiations. There are about 300 Conservative MPs at present. It is therefore possible that, once the negotiations have ended with little gained, a majority of Tory MPs will want to exit from the EU.

This leads to one clear difference between the two referendums. I think it is fair to say that outside Scotland few took the chances of a Yes vote seriously until the final weeks of the campaign. There are three reasons for thinking that will not happen with the EU referendum. First, UK public opinion has until quite recently shown a majority in favour of leaving the EU. Here are the polls conducted by YouGov.

Second, unlike Scottish independence, a majority of the UK press will be arguing for exit from the EU. Third, to make his negotiating stance credible, Cameron will have to at least give the impression that he might decide to recommend leaving the EU if he does not get significant concessions. As I note above, he will not have to try very hard.

This has an important implication which I think has been underestimated by many. Once the election result is known in 2015, if the Conservatives win there is a distinct possibility that the UK may vote to leave the EU. That kind of uncertainty is likely to be bad for non-residential investment, during a period in which we might hope that investment demand takes over from consumption as a primary driver of growth. We also know that, if the Conservatives win the next election, there will be a renewed fiscal contraction. With interest rates likely to be close to their lower bound, there remains limited scope for monetary stimulus to counter these influences.

So this is one important difference between the two referendums. Because most people were assuming a No vote until the last few weeks of the Scottish campaign, it seems unlikely there was sufficient uncertainty for a long enough period to have damaged the Scottish economy, and as far as I know there is no evidence that it did. In contrast, the two years of uncertainty from 2015 and 2017 is almost bound to be damaging for the UK economy.

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.

Private investment, public investment and the private finance of public investment

                When the UK government announced its austerity programme in 2010, it believed that private investment would help fill the gap in demand created by cutting public spending, and in particular offset its very large cuts in public investment. That did not happen, and according to OECD forecasts, is not going to happen in a significant way anytime soon.

UK Investment Growth (Source, OECD Economic Outlook June 2012)

                The obvious response is for the government to borrow to increase public investment, particularly when it is so cheap to do so. But that is a no-no as far as the Chancellor is concerned. So around the time of the budget it announced its solution to this dilemma. It would provide government guarantees to private investment projects, but it would also encourage the private sector to fund traditional public sector investment, like roads.

                Jonathan Portes is right that this is a victory of sorts. In particular, it suggests the government believes monetary policy will neither be sufficient to bring about a recovery on its own, nor will monetary policy counteract any attempts through fiscal policy to increase demand. In addition, as lack of demand is the critical problem right now, anything that might help should be welcomed.

                However, it has to be said that private finance for public investment appears illogical, as Alasdair Smith argues at the FT today. (See also Martin Wolf earlier.) The only clear ‘advantage’ of this approach is that there will be no immediate impact on the measured public sector deficit. But this policy will increase deficits in the longer term. The bottom line is that taxes will have to rise to pay for this investment, and merely shifting when the deficit increases from the present to the future does not alter this reality.

                Unfortunately we have been here before, with the Private Finance Initiative (PFI) used extensively by the previous Labour government. The consequences of PFI are set out in the Office for Budget Responsibility’s (OBR) annual look at the long term position of the UK public finances published today. It does this in two ways. The first, and most straightforward, is to project those finances over 50 years, a time period over which accounting tricks largely wash out. The second is to calculate ‘Whole Government Accounts’, which attempt to add a measure of future government liabilities to the published debt numbers. The OBR notes that “If all investment undertaken through PFI had been undertaken through conventional debt finance, PSND [public sector net debt] would be around 2.1 per cent of GDP higher than currently measured.”

                But it is worse than an attempt to fool the public (and presumably the markets) through bad accounting. The policy is also almost certain to end up costing more. Alasdair Smith suggests that this could involve borrowing at nominal interest rates of 5-7%, compared to interest rates on government debt of around 3%. To quote: “Looking at it another way, the stream of interest and capital repayments that would enable £20m to be raised from private finance would fund between £27m and £34m of public borrowing”.

                Professor Smith ends his article with “The OBR should use the platform of its fiscal sustainability report to give strong advice on how best to finance infrastructure investment.” Unfortunately for the time being at least he will be disappointed. As I have noted before, when the OBR was set up the government was very careful to ensure that its mandate involved crunching numbers but not looking at alternative policies, let alone giving policy advice. From the point of view of good public policy, that was a serious mistake, precisely because it makes it easier for the government to get away with accounting tricks that end up costing the public a lot of money. 

Savings Equals Investment?

This post is for first year undergraduate students (and the occasional blogger) who appear confused.

Q: If consumers spend less and save more, does this mean investment must increase?

A: Absolutely not. Someone increasing their saving does not automatically imply that some firm will decide to buy more capital goods.

Q: But surely savings equals investment by identity in the national accounts.

A: Indeed. Total output = total income = total expenditure = Y. In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition. But here investment includes what is called ‘stockbuilding’ or ‘inventory accumulation’, which includes goods that firms wanted to sell but could not. To make this clear, lets split measured investment (I) into these two components: I=DK (buying new capital goods) +DS (stockbuilding). So if people consume less (C falls), but investment in new capital (DK) stays the same, measured investment rises because firms accumulate inventories of the goods that consumers did not buy (DS rises).

Q: But this situation cannot continue, as firms may be losing money.

A: Exactly. They will cut back on their output, incomes will fall, consumption may fall further, and savings will also fall, cutting back on the initial increase that we started with.

Q: When will this process stop?

A: When firms stop accumulating inventories i.e. when DS=0. Then, and only then, will S=DK.

Q: But how can this be? We have assumed that DK stayed the same, and we started with an increase in S?

A: You have not been paying attention. Each time firms reduce their output to match lower demand, incomes and savings fall. Eventually the initial rise in savings is reversed, because overall income has fallen.

Q: Got it. But textbooks make a big thing about aggregate savings equalling investment. If it is just an accounting identity, why is it important?

A: What the textbooks really mean is that we eventually end up with a position in which S=DK. And that is important, for the reasons we have just discussed. It is called the paradox of thrift. A desire by consumers to increase savings ends up just reducing output, and savings do not increase at all. (Of course they are still saving more of their income: S/Y has gone up, but because Y has fallen, not because S has increased.)

Q: But I thought with all this ‘just in time’ production stuff, firms did not hold many inventories any more.

A: Well we could short circuit the story by forgetting about inventories and having firms accurately forecast what demand will be, and therefore what their output should be. In practice what we call involuntary inventory accumulation can still be important when looking at quarterly movements in national output.

Q: But is it realistic to assume investment – I mean DK – stays the same if savings are initially higher? If there are more savings around, it becomes cheaper to borrow, which will encourage investment, right?

A:  It might, but it might not. In particular, if output is falling, firms may be reluctant to add to their capital stock.

Q: But won’t interest rates keep falling until they do? After all, the asset market has to clear.

A: Savers have an alternative, which is to just keep their savings as money.

Q: But they will put the money in a bank, and the bank will lend it.

A: Maybe, but the bank may just decide to hold on to the cash.

Q: It seems to be really important what people do with their additional savings.

A: Perhaps. But I think the key point is that, most of the time, the person doing the saving is different from, and has different motives to, the person doing any investing. A highly complex financial system links the two. And in that system, there will be lots of opportunities for the additional savings to be parked as money.

Q: Money seems very important here. It is why the extra saving does not have to find its way into more investment.

A: I think that’s right.

Q: If people hold the extra savings as money, will that not increase money demand. What happens if the central bank keeps the money supply fixed?

A: People hold money not just as a way of saving, but also to buy and sell things. And if less is being consumed, there is less need for money on this account. It is difficult to predict what will happen to the total demand for money, which is why central banks nowadays focus on determining short term interest rates rather than the money supply.

Q: That’s not what it says in my textbook. It says the central bank fixes the money supply.

A: Yes I know. I’m afraid it’s a bit out of date. Don’t ask me why.

Q: So if the central bank determines the interest rate, why don’t they ensure the interest rate is low enough to encourage firms to buy more capital goods?

A: That is what they would like to do. There are two problems. First, it may take some time for the monetary authorities to work out what is happening, and what the right interest rate is. (I could talk about real and nominal rates here, but let’s leave that for another day.) Second, nominal interest rates cannot go below zero, and maybe we would need negative interest rates to persuade firms to raise investment enough.

Q: My textbook also says that the classical model assumes interest rates adjust so S=I, by which I assume they mean S=DK. Does that mean the classical model is wrong?

A: Only if you think it applies at all times, and that there is no other reason why output cannot fall. However if we assume that the monetary authorities eventually are able to chose the right interest rate, then the classical model is fine when thinking about economies over a long enough time horizon.

Q: This all seems like common sense. I feel a bit stupid not to have understood this before.

A: Don’t worry, you are not alone.