The standard view in economics and in policy circles is that wage increases come at a cost that impacts individual firms negatively. According to this view, wage increases also lead to losses in a firm’s competitiveness in foreign markets. Thus, until the advent of the global financial crisis, mainstream authors paid little attention to the fact that wage growth had lagged behind the sum of productivity growth and inflation, in most countries and for several decades, and that as a result wage shares had fallen. There was also little concern with the rise in wage dispersion— the gap between the income share of the top 1% and the rest that became a part of the lexicon during the Occupy Wall street movement.
The standard view has changed to some extent among economists, as rising income inequality is now being considered as one of the possible contributing causes of the financial crisis. Despite this, however, tax policies and labour market policies in Canada, in Europe, and elsewhere remain tilted towards pro-capital distributional policies. These types of policies will further dampen wage growth and are thus likely to worsen the outlook for a global economic recovery.
The reason for this is the existence of a ‘paradox of cost’. Since Keynes, it has been well-known that an increase in the proportion of income being saved by households will not lead to an increase in overall saving and will lead to a fall in macroeconomic activity. Similar to this ‘paradox of thrift,’ there exists a paradox of costs, whereby wage increases produce positive macroeconomic dynamics. In some countries, wage growth can generate demand growth and productivity growth and hence a virtuous circle. The standard negative view about wage increases is thus subjected to the possibility of a fallacy of composition.
I was asked by the International Labour Office (ILO) to set up a team of researchers to investigate the possibility of the paradox of costs. Perhaps the most striking component of this effort was the empirical result obtained by Özlem Onaran and Giorgos Galanis. They showed that in all G-20 countries, a one percentage point increase in the wage share of a country has a positive impact on the domestic demand of that country (meaning here consumption and investment activity). For instance, a one percentage point increase in the wage share in Canada leads to a 0.14 percentage point increase in domestic demand. This is because wages are more fully consumed than profits.
This positive effect on GDP becomes smaller, but remains positive, when the effects on external demand (exports minus imports) are taken into account, as is the case for the USA and the Eurozone area for instance. On the other hand, apparently giving support to the standard view based on the competitiveness argument, there are some countries where an increase in the wage share of a given country, due its detrimental effect on net exports, generates a negative impact on total demand. This is the case in Canada in particular, where a one percentage point increase in the wage share generates a 0.15 decrease in GDP (see the first column of the Table below).
But if the wage shares in Canada and in the USA were both to increase at the same time by one percentage point? Will this negative effect still persist? What the Onaran and Galanis study shows is that this negative effect on GDP gets reversed to a positive effect in Canada, Mexico, Argentina and India when it is instead assumed that the one percentage point increase in the wage share occurs simultaneously in all G-20 countries (see the second column of the table). The impact of such a coordinated increase in the wage share is a 0.36 percentage point increase in the overall GDP of all G-20 countries, which represent more than 80 per cent of world GDP.
In addition, as shown by Ro Naasatepad and Servaas Storm in another module of the ILO study, faster growth in real wages induces positive effects on the growth rate of labour productivity, and hence, in the long-run, to higher living standards.
What the ILO study made clear is that economic policy needs a complete turnabout. Past policies have generated unsustainable economic strategies, based on debt-led consumption booms and export-led mercantilist policies. What we need is a coordinated wage-led strategy, endorsed by all or most G-20 countries. It holds promise to provide sustainable growth and a world-wide economic recovery.
Marc Lavoie is Professor in the Department of Economics at the University of Ottawa. All modules referenced in this article and more can be found in the newly published book, Wage-led Growth: An Equitable Strategy for Economic Recovery (Palgrave-Macmillan, 2013).