Higher wages could be the answer to our economic woes

It’s not mad to suspect that looser government fiscal policy and higher wages for workers could help shake us out of our almost decade-long economic funk

Ben Chu
Sunday 02 April 2017 20:33
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The Bank of England says productivity growth must precede wage rises. But is this always right?
The Bank of England says productivity growth must precede wage rises. But is this always right?

What comes first: the chicken or the egg? Productivity growth or wage increases? Most economists generally assume that the chicken of productivity growth comes before the egg of workers’ pay hikes.

In this mental model productivity (the amount of output that the economy produces per hour of labour) rises thanks to technological advances or more efficient ways of working. This boosts firms’ revenues and profit margins. Companies are then able to pay their workers more and everyone is better off.

The general view of most policymakers and analysts is that if firms, in aggregate, increase workers’ wages before there has been an increase in national productivity, the result will simply be a damaging burst of economy-wide inflation as too much money chases too few goods and services.

This is the kind of description of the way the world works that one can find from economic authorities such as the Bank of England and the Office for Budget Responsibility. This is why there’s so much emphasis given to policies and schemes designed to increase our economy’s productive potential. “Raising productivity is essential for the high-wage, high-skill economy that will deliver higher living standards for working people,” is how the Chancellor Philip Hammond summed it up last year.

But is this story entirely right? What if wage increases for workers did not always need to follow productivity growth, but could precede it, perhaps even cause it? What if the egg came before the chicken? Some fascinating research posted on the Bank of England’s Bank Underground blog by Alex Tuckett last week provides some evidence that wage-led productivity growth may indeed be a possibility.

Tuckett takes a dive into the data of wage growth and output growth in each broad industrial sector of the UK economy. “A careful analysis of the sectoral data suggests that the relationship between productivity and wages is not simple, and that causality may run in both directions,” he concludes.

This is an important finding given the UK’s current economic condition. Productivity growth has collapsed since the financial crisis. So has wage growth. Real average wages in the UK still languish some five per cent below their level in 2008 (despite the overall growth of GDP in that time). And the Brexit-related slump in the pound has pushed up inflation, meaning real wages are falling once again. On the basis of the OBR’s projections, we are on course for the weakest decade of real wage growth since the Battle of Trafalgar.

Under the dominant economic story, the collapse of productivity growth is the fundamental reason wages are on the floor and to rectify the latter productivity needs first to be fixed. Attempts to bypass this are often criticised as counterproductive. In his summer 2015 Budget George Osborne mandated a chunky hike in the minimum wage. This drew the disapproval of many economists who argued that low wages for those at the bottom reflect their low personal productivity and that significantly increasing their wages by government diktat will merely increase unemployment.

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But if the chicken follows the egg, perhaps wage increases will prompt higher productivity in firms that employ low-wage labour. Perhaps, in order to protect their profit margins, managements will be spurred into increasing the efficiency of their operations. Perhaps they will invest in more capital equipment to enable their workforce to produce more per hour of their time. Think of a hand car wash installing automatic equipment but retaining the same amount of staff, retraining them to operate the new machinery, and doing more business. This would make minimum wage increases positive for productivity.

And perhaps this is true on a macroeconomic level too. Simon Wren-Lewis of Oxford University has hypothesised that there exists a significant “innovation gap” in the economy, which has built up since the financial crisis due to pessimism about future levels of consumer demand (made worse by George Osborne’s deep capital expenditure cuts after 2010). “Most firms…[could be] using out-of-date production techniques which are too labour intensive,” Wren-Lewis suggests.

If output and wages were given a positive shock, by government fiscal stimulus for instance, perhaps the overall productive capacity growth rate of the economy would rise in response because some companies would be prompted to step up their capital investment and also research and development programmes. And this investment might create positive spill-overs. Economists in the US have reasoned along similar lines, suggesting that aggregate supply could be dragged up by stronger aggregate demand.

Economic history strongly suggests that, in the long-run, productivity growth does indeed determine wage growth. And the idea that doubling everyone’s pay overnight would double our productivity is obviously fanciful. Yet it’s not mad to suspect that looser government fiscal policy and higher wages for workers could help shake us out of our almost decade-long economic funk.

And after many years of productivity growth forecast disappointments it’s surely time we took the respectable hypothesis of wage-led and aggregate demand-led productivity growth more seriously – and that economic policymakers summoned up the courage to put it to the test.

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