The Great Economists

by Linda Yueh

  Globalization is one explanation. There’s no example of globalization that’s closer to the West than the reunification of Germany in the early 1990s. Cheaper workers from East Germany, and less costly places to produce just a short distance away in eastern Europe, brought the challenge of globalization home. There was a vast wage differential between West and East Germany. With greater competition, workers in what had been West Germany experienced wage stagnation around the mid-1990s. That’s when Germany gained the title ‘the sick man of Europe’. Growth rates were between 0 and 1 per cent and economic prospects were looking poor. But Germany had a remarkable transformation just before the Great Recession hit.

  At that time Germany was in a strong position because the export markets, in particular in Asia, but also in Europe, were buying Germany’s manufactured products. China needed German capital goods to build its factories, in particular for the production of higher-end consumer goods to which China started to turn by the 2000s. So, when the recession hit, Germany was in a strong economic position.

  This transformation was forced by globalization, specifically the accession of eastern European countries into the European Union in the early 2000s. There was the possibility that German industries could relocate production into these new EU countries, where wages were much lower, and German companies were threatening to do so unless unions or worker representatives agreed to wage restraint and became more flexible about employment terms.

  In the face of the threat posed by globalization, the unions agreed. An important change was that wage negotiations were decentralized from the level of the industry and region down to the level of the firm. In that way, wage deals could reflect the needs of particular companies in a very competitive and fast-changing environment.

  So, Germany gained competitiveness of output at the cost of wages, which, particularly at the lower end, started to fall. At the median, wage growth was essentially stagnant. And that’s partly why German industry has become more competitive. Of course, there have also been improvements in productivity, but wage restraint has played a large role.

  The flexible approach of both employers and unions helped to retain domestic production in many of Germany’s core manufacturing sectors and kept employment in the country, albeit with workers earning less. This is in contrast to a number of its European neighbours such as France and Italy, who have seen some of their manufacturing leave the country. Germany was the first European country to come out of recession. Afterwards, it became something of an economic superstar, exporting a great deal not just to China and other developing countries but also to Europe and the US. As economic conditions improved, though, so did wage pressure, which led to a minimum wage being introduced for the first time in January 2015.

  But global competition isn’t the only reason wages in developed economies are low. Japan was successfully competing in the global economy while its workers had lifetime job security until it suffered a real estate bubble that burst in the early 1990s. Yet, now, it exemplifies another phenomenon that has contributed to low wages: the emergence of non-permanent or temporary workers.

  Across rich countries, the proportion of temporary workers has increased. The OECD, which is a think tank centred on advanced economies, finds that the average wage of a temporary worker versus a permanent one is as much as 50 per cent lower in the worst case (Spain) and nearly 20 per cent lower even at the more equal end (Germany).

  In Japan, the proportion of temporary workers in the labour force has doubled since 1999. A large portion of those on temporary contracts are women. Almost 40 per cent of the workforce has comprised casual and part-time employees, whose wages are often much less than half of those with permanent employment contracts. The lifetime employment system that was part of the Japanese miracle in the 1980s ended up with the collapse of that system a decade later.

  After the crash, Japanese companies were looking for short-term profits so had to reduce labour costs. Replacing full-time with non-regular workers was one solution. These replacements are often haken, or temporary agency workers. Their employment lacks security, they earn less than half a regular worker’s wage and, unlike permanent workers, receive no guaranteed wage increases.

  Another factor keeping wages down is that it is difficult for Japanese workers to move to another company. The lifetime employment system created a labour market where few change employers after getting a permanent job. As a result, Japanese workers do not have a strong bargaining position. And competition from temporary workers restrains the wages of all workers.

  This helps to explain why median wages in Japan have been stagnant for two decades and raising wages is a priority for a Japanese government desperate to get the economy going again through consumption growth fuelled by higher incomes. There are also social consequences that the government is keen to avoid. Men in temporary employment, for example, are less likely to settle down, because their earnings are not enough to support a family.

  But it’s not only Japan that’s seen the rise of job insecurity, or only temporary workers that are a cause of low wages. There’s another factor that’s seen most acutely in the world’s biggest economy: automation.

  The number of robots used in manufacturing is increasing dramatically. It’s most concentrated in sectors like automobile production, but it’s spreading throughout the advanced economies. Over the last couple of decades in the US and across the industrialized countries, technology has improved in leaps and bounds. Computers have complemented and enhanced the skills of professionals, so jobs at the high end of the skill distribution are growing. But the same innovations have replaced the jobs of people in the middle of the skill spectrum, for example in automated factories. Jobs at the lower end of the skill distribution are less affected, since services jobs such as fast-food restaurants are still filled by people. So, jobs at either end of the skill distribution are growing, while those in the middle are declining.

  The middle class (those earning between 50 per cent below and 50 per cent above the median income) has shrunk to less than half the US population for the first time since at least the early 1970s, according to the Pew Research Center. The data from the last recession show why: more than half of jobs created since 2010 are low wage. This process, which has been happening for over a quarter of a century, is known as the ‘hollowing out’ of the middle class.

  So, technology has benefited some more than others. While technology helps to raise overall economic growth, it does not follow that the gains are shared equally by firms and workers, a development that would not surprise Joan Robinson. In 2015, the US produced around $18 trillion of GDP. About $10 trillion is paid to workers in wages and benefits, but the rest is largely company profits. Over the past few decades, the proportion of earnings that goes to workers in the form of wages has gone down, while the proportion going to businesses in the form of profits has gone up. This is another reason wages around the world are not rising as expected alongside productivity and economic growth. Thus, even if productivity increases, wages may not increase proportionately.

  Trade union membership also plays a role. US data for the last hundred years show that when the proportion of workers in trade unions has dropped, the share of income going to the poorest Americans has also fallen. Trade union density is now less than 10 per cent and the share of income going to the bottom 90 per cent of households is also at a near century low.17 In short, weaker worker bargaining power and technology have contributed to the shrinking middle class in America. Coupled with globalization and the growth of part-time jobs, these factors help explain low wages in the US and elsewhere.

  Of course, wages in rich countries are not low in absolute terms. The level of wages even at the lower percentiles of the distribution in Germany is much higher than in many other European countries. Even so, wage growth is a problem, especially for those in the middle class who are experiencing earnings stagnation.

  What would Joan Robinson make of the low-pay challenge?

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bsp; Robinson’s theory of wage determination

  In Robinson’s model of the labour market, firms determine how much labour to employ by comparing their output and cost. Taking into account how much revenue it produces, a firm sets its employment level at the point where the ‘marginal product’ of what is produced is just equal to the ‘marginal cost’ of employing the next unit of labour. This is regardless of whether the product or factor markets are perfect or imperfect. When markets are imperfect, then employers have market power and can ‘exploit’ workers by paying them less than what is earned from their output. Because such exploitation arises from the unequal bargaining strength of employers and employees, one way to reduce exploitation is to increase the bargaining power of workers, for example through trade unions or collective bargaining. Legislation to place workers on a more equal footing with employers is another avenue. Germany did that by giving workers statutory representation in the boardroom. The rights of non-unionized workers also require protection.

  Bargaining strength is important in many cases, but raising wages through bargaining is not the sole solution to the problem of exploitation in Robinson’s theory. That could result in unemployment and continued exploitation at the higher wage, since a firm with market power could demand a sub-optimal amount of labour. The remedy would be to remove the source of the market imperfection by increasing competition. This would erode a firm’s monopoly or monopsony power. In a competitive market, a firm that exploited its workers would lose them to another firm that did not. Greater competition for workers would prevent their wages from falling too low. In Robinson’s view, the remedy for low wages would be to fix the imperfections in the market itself by regulating to increase competition. That would provide a longer-lasting solution.

  But Robinson also thought that greater competition might drive down wages, because prices fall as competition increases, and workers are paid the value of their marginal product; that might even be less than the former exploitative wage. She believed a minimum wage would help, and attached great importance to government intervention to improve exploitative outcomes as well as increasing competition in markets.

  Accordingly, she would probably have been in favour of the OECD’s recommendations to boost pay by reforming labour markets to make them more competitive. Regulating markets so there are fewer entry barriers increases competitiveness, and that has improved employment outcomes across advanced economies. Allowing the more productive firms to flourish means that they will attract workers away from less productive ones. This reallocation of jobs generates benefits for the economy as well as for the workers who have better job opportunities.

  The OECD is also concerned about the growth of temporary contract workers. This would certainly worry Joan Robinson. The increase in temporary or part-time jobs would fall under her theory of ‘hidden’ or ‘disguised’ unemployment. The United States measures not only the number of people who are officially unemployed, but also those who want and are available for full-time employment but have had to accept part-time work. When this number is added to the official unemployment rate, along with those who are available for work but not seeking employment, the US unemployment picture looks less rosy. This U-6 unemployment rate, as it is known, has fallen alongside the official unemployment rate since the financial crisis, but it hovers around 9 per cent. The U-6 unemployment rate rose as high as 17 per cent during the Great Recession, more than doubling from around 8 per cent before the crash.

  Disguised unemployment contributes to low wages, as discussed earlier when we examined the increase in part-time work in advanced economies, and is another example of how Robinson’s ideas have shaped how we think about unemployment. Instead of being content to take the official unemployment figures at face value, recognizing underemployment as a form of unemployment helps to identify another pressure driving down earnings. In Robinson’s view, when workers move from lower to higher productivity jobs, then those workers should earn higher wages, provided the market is competitive. By utilizing Robinson’s definition of unemployment, the United States has a truer picture of its workforce with which to assess its economic policies. It’s a practice that some other countries such as those in Europe are beginning to develop, which is unsurprising, given the increase in part-time work and the challenge of low pay in advanced economies.

  Robinson believed that government policy can play a role in addressing low wages, so long as policymakers examine the deeper causes of pay. The exploitation of workers will continue so long as firms wield market power. But, similarly to Joseph Schumpeter, she believed that the monopoly power of firms would not survive. Any firm that was earning ‘rents’ would attract other firms to the same industry. Greater competition means that monopsonies will not last. Still, like her one-time mentor, John Maynard Keynes, Robinson believed that addressing the short-run issues that workers face during periods where there are monopolies exploiting them are more important than waiting for the market structure to sort itself out in the long run. Given how long the problem of low pay has persisted, and the continuing fall in the share of income going to workers versus that going to the owners of capital, Robinson would say this issue requires urgent action. Her theories do not address all of the causes of low pay, but they can help to identify some of the ways in which slow wage growth can be remedied.

  A remarkable life

  There is no doubt that Robinson’s research has helped economists sort out some of the answers to questions such as why pay does not behave as predicted by perfectly competitive markets. But, as she also stresses, without scientific proof like in natural science, economic analysis cannot offer definitive answers. The best that we can strive for is to be guided by more realistic models of the labour market. Robinson thus points out one of the reasons why we should all study economics: ‘The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.’18

  Joan Robinson passed away in 1983 after a long and influential life. Her work opened up a whole new way of looking at markets by rejecting the standard economic views of wages and others based on an unrealistic belief in perfect competition. Those markets don’t really exist, but low wages do.

  The solution to the problem of pay, unsurprisingly, is complex, as would be expected in Robinson’s complicated world of imperfect competition, worker exploitation and the resultant low wages. Still, for workers who are in work, it’s a problem that can be solved. As Robinson remarked: ‘The misery of being exploited by capitalists is nothing compared to the misery of not being exploited at all.’19

  CHAPTER 10

  Milton Friedman: Are Central Banks Doing Too Much?

  The 2008 financial crisis has introduced new economic terms into popular use, like central banks undertaking quantitative easing (QE or cash injections), forward guidance (central banks saying what they think interest rates might be in the future), negative interest rates (central banks charging commercial banks for depositing money with them) and macroprudential policy (central bank regulations aiming for financial stability), to name a few. These are in addition to using interest rates to target price stability or inflation, and are ‘unconventional’ or fairly new monetary policy tools.

  All of which raises the question: Are central banks doing too much? And is what they are doing working to help the economy? It’s untested ground. Bank of England Governor Mark Carney quipped that they’re trying to get ‘theory to catch up with practice’, while former Fed Chairman Ben Bernanke reworked the classic economics joke: ‘The problem with QE is that it works in practice, but it doesn’t work in theory.’fn1

  The main unconventional policy is QE. It has been restarted once again in Britain after the referendum vote in June 2016 to leave the European Union. QE is also being used by euro area countries and Japan even while the US central bank has ceased. Injecting cash to boost the economy because interest rates have been cut to zero or even into negative territory is
one of the most controversial monetary policy tools in recent times. Cutting rates is one way of making lending cheaper, which can increase borrowing by households and firms who then respectively spend and invest and so aid the recovery. But because interest rates were at rock bottom, central banks needed another way to increase the amount of credit in the economy. QE was that policy. Simply put, central banks electronically ‘printed’ money and used it to buy bonds, which are government or corporate debt. This put money onto the balance sheets of companies that thus sold their bonds in exchange for cash, which central banks hoped would be invested and boost the recovery.

  This represents a new era in monetary policy. The leading scholar in monetary economics is Milton Friedman. He made his name researching the causes of the Great Depression that followed the last systemic banking crash in 1929. His conclusion that the crisis was due to poor monetary policy fundamentally changed our understanding of that period and of post-crisis policies.

  To this day Friedman remains a divisive figure in popular opinion, but that’s largely a reflection of the very libertarian and pro free-market positions he was to take publicly later in life rather than the body of economic research that led to his 1976 Nobel Prize. He was viewed as one of the key influences behind the Reagan and Thatcher administrations in the 1980s, both of which were ideologically driven towards smaller government and more laissez-faire capitalism. Both leaders attracted criticism, some of which inevitably reflected on Friedman as a well-known conservative who was central to their economic thinking.

  Like most academics, by the time he received his Nobel Prize he was really past the zenith of the research that propelled him to the award in the first place. This is generally true of grand prizes, but particularly true for the economics Nobel Prize in the years following its inception in 1969, when there was a lot of catching up to do to recognize the pioneers. Between the late 1930s and early 1960s, Friedman produced a remarkable body of work. His theories on monetary policy and other economic concepts, such as what drives people to consume, remain deeply engrained in the subject and in public policy today.