Thursday, February 3, 2011

Wages and Productivity


For my money,the most savvy economist around.---rng
Ravi Batra, "The Crash of the Millennium,"  
New York: Random House/Harmony Books, 1999, pp. 66-69

WAGES AND PRODUCTIVITY

Supply and demand for goods are linked to the 
workforce through wages and productivity. What 
happens in the national labor market is the key to a 
country's economic health. Supply and demand for 
workers determine wages and employment. Skilled and 
motivated workers are the backbone of high 
efficiency, but what is perhaps crucial is that 
company wages reflect labor productivity. When new 
technology raises hourly output, then fairness 
demands that workers are properly compensated for 
their hard work and skills. This is not only a 
question of ethics but of labor peace and social 
prosperity as well.

Wages are the main source of demand, productivity the 
main source of supply, and if the two are not in sync 
with each other, then national supply and demand 
cannot be in balance for long, and eventually the 
economy runs into major trouble. For a while the 
balance between the two forces can be maintained by 
raising artificial demand through excessive business 
investment, or through the expansion of consumer 
debt, money supply, corporate debt, government budget 
deficits, and even exports, but these are mere 
palliatives that may mask the problem for some time. 
Artificial spending is the stuff of which economic 
disasters are made. Frequently it culminates in 
recessions, but occasionally it has even spawned 
depressions and inflation—-even hyperinflation. 
Whenever and wherever a country has suffered a major 
depression, you will find a persistent and 
substantial wage-productivity gap. The bigger the 
size of artificial demand, the greater the eventual 
trouble.

A SIMPLE ILLUSTRATION

When the labor market is distorted in the sense that 
real wages lag behind productivity, the entire 
economy behaves irrationally. Let us take a simple 
example in a very simple economy. Suppose there are 
one hundred workers in a society, and each produces 
$5 worth of output. Worker productivity is then $5, 
and if everybody is employed, total output or supply 
will be $500. U.S. experience of the 1950s and the 
1960s reveals that a high-growth economy with 
practically no unemployment and inflation requires 
that about 80 percent of output go to labor and the 
remaining 20 percent to the owners of income-
producing property or capital, which is also an 
important resource contributing to productivity. 
(Capital owners usually earn incomes through their 
labor as well, so the 20 percent share is not their 
only source of earnings). Under this rule, wages will 
be 80 percent of output, or $400, and profits the 
rest, or $100.

Keeping the argument as simple as possible, let us 
suppose that initially all wages are consumed and all 
profits are invested into new technology and the 
replacement of worn-out capital so that consumption 
spending is $400, investment spending is $100, and 
the aggregate spending is $500. In this case, the 
economy functions smoothly, for both national supply 
and demand for goods equal $500.

Now assume that owing to new technology, worker 
productivity doubles to $10, so the value of output 
generated by one hundred workers rises to $1,000. If 
wages and consumption also double to $800 and the 
profits and investment to $200, again national supply 
and demand for products will remain in balance, this 
time each equal to $1,000. However, suppose wages 
rise only to $600, while profits up to $400. 
Consumption now equals $600, and it is clear that 
investment spending must now be $400 lest national 
demand be short of supply, resulting in 
overproduction. Would businesses be willing to put 
all their profits into new investment, when consumer 
spending grows slowly? The answer is most likely not.

If you are investing $200 when your sales are $800, 
you are not likely to increase your investment for 
business expansion when your sales go down to $600. 
If companies realize that the current demand for 
their goods is inadequate, they will trim their 
investment even below $200. The purpose of capital 
spending, after all, is mainly to meet consumer 
demand; you would expand your business only in 
proportion to your sales. If sales fail to 
materialize, investment will decline. With consumer 
demand less than $800, the companies will invest even 
less than $200, in which case total spending will 
fall way short of supply, businesses will be stuck 
with unsold goods, and layoffs will have to follow. 
Thus the simple example makes it clear that when 
wages lag behind productivity, distorting the labor 
market, the product markets will also be out of 
kilter.

It is of course possible that, for a while, the 
companies may not be aware of the shortfall in 
consumer demand; their high profits may convince them 
to expand their capital expenditures all the way up 
to $400 and to buy more machines. In this case, 
demand and supply will each equal $1,000, and the 
economy will reveal no signs of the potential 
imbalance possible from the slowdown in consumer 
spending.  The growth process, however, will 
continue. With investment skyrocketing to $400, the 
use of new technology and worker productivity will 
climb even faster.

Suppose in the next round output per employee jumps 
to $20, so total supply, with full employment of 
labor, soars to $2,000; if wages and consumer demand 
rise only to $1,200, then investment must climb to 
$800 to maintain the balance between supply and 
demand. It is clear that with wages lagging behind 
productivity, the growth process will become 
explosive, requiring ever-increasing doses of 
business investment to maintain high employment and 
the living standard.

This process is purely artificial in the sense that 
businesses will be selling a large portion of their 
goods to each other rather than to consumers to 
sustain their prosperity. It's like a Ponzi scheme in 
which you have to create sellers to buy your products 
and sell them to other sellers. Such schemes always 
collapse. When firms raise their capital spending and 
buy more machines from other companies, in reality 
they sell goods to each other, because consumers 
certainly have no use for plant and equipment. Sooner 
or later, a point will come when the companies are 
unable to sell all their output, and a recession or a 
depression will result. If the growth process 
continues for a long time, then the potential 
overproduction becomes so large that a depression 
becomes inevitable.

It is noteworthy that the power of this logic in no 
way depends on the simplicity of our assumptions. In 
the real world, some workers do save, and not all 
profits may be invested. Furthermore, there is a 
large government sector today in most economies, 
which additionally have to reckon with the ills of 
inflation. Labor income also may not initially amount 
to 80 percent of output; these assumptions are not 
crucial to the argument. What is critical is that 
real wages grow slower than the rate of productivity 
resulting from new technology and business 
investment.

What could be done to rectify the problem? Since the 
fundamental source of the imbalance in both the labor 
and product markets is that wages trail productivity, 
the solution is clear. Either a law should be passed 
that all output be divided proportionately between 
labor and capital, or some institutions should be 
created such that wages grow in sync with hourly 
output. This, of course, has not been done anywhere 
in the world, even though the wage-productivity gap, 
hereafter called the wage gap, has been soaring all 
over the globe for the last three decades. Then how 
has the balance been maintained between demand and 
supply for products?
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