1. The perverse effects of declining wages and declining wage shares Marc Lavoie Department of Economics University of Ottawa

2. Two issues that need to be conceptually distinguished What if wages and prices fall together, without any change in real wages (assuming a constant level of labour productivity)? What if real wages relative to productivity fall, that is, what if the wage share falls? These issues need to be tackled at the macroeconomic level. If we only look at these questions at the micro level, we are likely to be subjected to the fallacy of composition.

3. The impact of lower prices and lower wages

4. The standard view Lower prices with lower wages have a positive impact on real aggregate demand because: –The real wealth (V/P) of households becomes higher. They feel richer. Positive effect on consumption. –The economy will become more competitive on international markets. Positive effect on net exports.

5. A critique of the standard view Nominal wealth is unlikely to remain constant when prices fall. The value of real estate will fall and stock market prices will fall. What about real debt (D/P) ? Households still need to pay their mortgages, their credit card balances, their car loans, etc. All of these remain unchanged in nominal terms, thereby leading to a rise of the debt burden in real terms. Firms still need to make interest payments on their bank loans, on the bonds they issued in the past, etc. Their real debt also rises. In a global financial crisis, where prices or inflation rates are falling in all countries, the export channel is non- existent.

6. The alternative view Lower or falling wages and prices have a negative effect on real aggregate demand because debt is usually in nominal terms: –The real burden of fixed debt becomes larger for households; they may also wait for further price decreases. Negative effect on consumption. –The real burden of fixed debt becomes larger for firms, so profitability gets reduced; they may also wait for further cost reductions. Negative effect on investment.

7. The alternative view is now endorsed by many central banks Central bankers now fear wage and price deflation because: –Monetary policy is conducted through changes in the real interest rate (nominal rate minus the expected inflation rate) –Nominal interest rates cannot fall below zero. –With wage and price deflation, real interest rates cannot be pushed down to zero or into the negative range. Therefore expansionary monetary policies become impossible. –Japan (1994-2004) is a good empirical illustration of monetary policy impotence under wage deflation. The non-conventional monetary policies now suggested, such as raising bank reserves, were also totally useless.

8. Lawrence H. Summers (and Delong) on the Great Depression, AER 1986

9. The impact of lower real wages and lower wage shares

10. Macroeconomic impact of real wages Aggregate demand is made up of four components: Y = C + I + NX + G Increases in real wages relative to labour productivity (or in the wage share) will have an impact on the first three of these components. –A direct positive impact on consumption because the propensity to consume out of wages is higher than the propensity to consume out of profits (by about 0.30). –A direct negative impact on investment, because profitability at given rates of capacity utilization gets reduced (with however a possible indirect positive impact through the accelerator, with higher real wages raising rates of capacity utilization). –An uncertain, but usually negative impact on net exports.

11. Wage-led or profit-led ? An economy is said to be wage-led when increases in real wages relative to labour productivity (that is, the wage share) lead to higher economic activity. An economy is said to be profit-led when increases in real wages relative to labour productivity (the wage share) lead to lower economic activity.

12. Empirical studies on growth regimes There has been a large number of recent empirical studies (Hein, Stockhammer, Naastepad, and their co-authors), in particular on various OECD countries, based mainly on 1960-2005 data. As is often the case of macro studies, the results are somewhat ambiguous (the same author may obtain contradicting results in two different studies with different methods). Some countries seem to be wage-led, others profit-led. However, some generalizations can be drawn.

13. Generalizing the empirical results Some countries appear to be wage-led or neutral, including France, Germany, Italy, Spain, the UK, Korea. Some countries seem to be profit-led, including Austria, as well as Japan and China (because the saving rates of households are high). However, neutral or profit-led countries are often driven by the positive impact of reduced real wages on net exports. For instance, the Euro 12 area as a whole is clearly wage-led (an increase of 1 percentage point in the wage share leads to an increase of 0.2% in GDP). Once again we face a fallacy of composition: not all countries can simultaneously increase net exports by reducing real wages. In other words, taking into account only the consumption and investment effects, we conclude from these studies that the world economy is wage-led.

14. Conclusions

15. Fallacies of composition It is in the best interest of each firm and each country taken individually to reduce nominal and real wages when others don’t. However if all firms and all countries act in such a way, the overall profits of firms and overall growth will be reduced by spreading competitive deflationary pressures. Governments must take actions to prevent wages and real wages from falling.

16. Some means to stop wages from falling Enabling factors: State or public support –Improvement of unemployment benefits, to improve the bargaining power of workers, stopping wages from falling. –Government as an employer of last resort, offering meaningful work to whoever asks for it, so that this labour force will be ready to enter the private employment market when needed, with no loss in human capital. –Governments must stop asking for concessions from labour unions when providing financial help to failing firms, especially when these firms are from bellwether industries (e.g., automobiles: GM, Chrysler), as these concessions may spread to other sectors of the economy. Specific measures –Upkeep or increase minimum wages. –If adopting work sharing, hourly wages must be increased at least in proportion with the hourly productivity gains expected to arise from work sharing, otherwise there will be hardly any favourable impact on employment.