Five years after the beginning of the recession real wages in Britain are still well below their pre-crisis level. As of March 2014 real weekly earnings (deflated by the RPI) are at the level of November 2000; that is a staggering 12% below their peak in February 2008. Is that a good thing, improving the competitiveness of British industry? Is it necessary to hold back wage growth to enable a recovery? In our recent book Wage-led Growth we argue that – against orthodox theory – in the present situation higher wages are not a hindrance but an essential ingredient of economic recovery.
In a capitalist economy wages always play a dual role. They are cost to business in production and they are also source of demand. Wages, after all are the main income for most households. It is wages that allow most people to pay for their shopping as well as their mortgage.This had been pointed out two generations ago by John Maynard Keynes, but this aspect of his theory is widely neglected by mainstream economics.
But the effect is empirically powerful. We find that in most countries the marginal propensity to consume out of wage income is substantially higher than out of profit income. Higher wage growth will thus lead to consumption growth, even if it comes at the expense of profits! But won’t higher wage have a negative effect on investment? Yes, they might, but that effect is very small. Investments mostly react to changes in aggregate demand, not primarily to costs. Besides the deregulation of financial markets has had numerous effects on investment: due to the shareholder orientation firms pay out much more as dividends and pursue financial investments instead of expanding their productive capacities. What about the effect of wages on exports? Yes, they do have negative effects, but again this effect is modest (it’s bigger than that on investment though).
Our research results also suggest that this positive effect would be much larger if countries were to pursue a coordinated strategy of wage increases. The reason for this is that exports only react to relative wage costs. If wages grew faster than productivity all over the world, there would be no negative net export effect at all! That might be too optimistic a scenario, but it does illustrate the potential benefits of an international coordination of wage policy.
So, if our argument is right and higher wages would be good for growth, how has Britain been growing at all? The answer to this is that the UK, similar to the USA and Ireland is following what we call a debt-led growth model. It is based on an expansion of credit, which is made possible by a property price bubble. This enabled households to borrow more – and to spend more. Consumption expenditures do react to property prices and it is the growth of consumption expenditures that has fuelled growth in Britain before the crisis as well as after the crisis.
But what about all the talk about ‘rebalancing’ of the British economy? Well, it simply hasn’t happened. In the decade before the crisis private consumption made up about three quarters of growth. In the crisis years 2008/09 the contribution of consumption and investment to growth was negative and government expenditures and net exports had positive contributions. But in the weak recovery of 2010-14 private consumption growth explains an astonishing 88% of growth, with the contribution of investment and net exports being close to zero. In short, Britain is relying on a consumption boom without wage growth. How is that possible? Because of debt and a housing bubble that the present government is eager to reignite. We are on the path to restart the flawed growth model that caused the crisis in the first place.
What is needed is a quite fundamental change in macroeconomic policy and in the growth model. We want to highlight two important requirements. First, the positive role that wage can play in the economy has to be recognised. How can consumption grow without ever increasing debt accumulation? That is only a mystery in a debt-led economy, a wage-led recovery would solve the problem. A sustainable economic growth model needs wages to grow at least in line with productivity and inflation. In the present situation, the government should encourage nominal wage growth in line with trend productivity growth and inflation. Trend productivity growth is about 2% and inflation is about 2%, thus nominal wages should be growing by 4%.
Second, the economy needs to get off its debt addiction. The crisis has been caused by an unregulated and overexpanded financial sector. It’s time to re-regulate it, which also means shrinking it. As any drug addict, the British economy will suffer from withdrawal symptoms. These can be eased by government expenditures but to create healthy demand, Britain needs higher wage growth.
Both authors have contributed to the book Wage-led Growth. An Equitable Strategy for Economic Recovery. The book launch event will take place on 28 May at Kingston University.