The Great Wage Stagnation

The financial crisis and consequent Great Recession has re-ignited an intense debate about whether western capitalism is facing a crisis.

In a much read and debated e-book, Tyler Cowen has argued that the modern economy suffers from a deficit of truly great innovations, ones that dramatically improves the quality of lives and creates large numbers of jobs. He has also claimed that growth is slowing because economies have already gotten most of the innovative benefit out of previous big leaps and are now squeezing out more marginal gains.

Such trends are not exclusive to technology. There have been numerous studies which have pointed to disconcerting trends in the labour market. In the latest, Economix points to a new report from the Resolution Foundation, a British research organization, that examined trends from 10 rich countries over the 2000-07/08 period and finds weakening relationship between workers incomes and economic and productivity growth. Here are some of the findings from the report.

1. The growth rate of median pay versus economic growth per capita from 2000 to the start of the Great Recession for these ten countries indicates that wages have more or less stagnated in many countries and have lagged behind GDP growth rate in all these countries.



2. The authors represent the changing dynamics of relationship between GDP and wages using the graphic below which removes subsidies and taxes and focuses on production at basic prices or Gross Value Added (GVA) by any unit of labour engaged in economic production in both private and public sectors. It illustrates the movement from GVA at the economy wide level to the wages received by individuals as a three stage process.



3. In all these countries, the share of wages as a proportion of all employees compensation has been fallin, with the decline picking up in the last decade. Interestingly, during the same period, the proportion has either remained stangnat or even moved up in Germany, France, Sweden, and Finland.



4. The summary of findings are captured in this table. (Click on image to enlarge)

Confession of the week!

In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought.

Lawrence Summers

The changing dynamics of public rent-seeking in India

Ashutosh Varshney recently wrote about the dynamics of rent-seeking in India,

It is worth noting that the countryside, where 68 per cent of India currently lives, is not where most of national income is generated. At this time, not more than 25-30% of India’s GDP comes from villages, with agriculture accounting for a mere 15% of GDP. More simply stated, over two thirds, perhaps as much as three fourths, of the nation’s GDP is generated in cities where less than a third of the country lives, whereas less than a third, perhaps as little as a fourth, of the country’s GDP is produced in the countryside where over two thirds of the national population resides.

As a consequence, for politicians, the city has primarily become a site of extraction, and the countryside is predominantly a site of legitimacy and power. The countryside is where the vote is; the city is where the money is. Villages do have corruption, but the scale of corruption is vastly greater in cities.

In fact, this analysis, while broadly accurate, can be made more nuanced. The top tier of the political and bureaucratic establishment is increasingly getting its dominant share of rents from the high rent yielding infrastructure sector. These sectors are predominantly urban in nature and their rent interfaces (say, decision makers and corporate offices) are located in urban areas. As opportunities in these sectors have grown, the politicians and officials in the upper tier have vacated their traditional rent space for those at the lower rung.

Consider this illustration. Since independence, until a few years back, the major sources of rent-seeking for everyone was in the local sources of patronage - dealership of fair price shop, control over anganwadi center and school, local officials postings, small local engineering works (of the panchayats and other departments) etc. The large construction works and private industrial establishments, except in industrial belts, were generally absent or marginal. The rents available too were minimal. Everyone from local government politicians to the state and central legislators sourced their rents from this small pie.

Over the last decade or so this landscape has been undergoing a transformation. There have been steep increases in infrastructure investments even in rural areas, which in turn have spawned off property booms in their catchment areas. Big infrastructure contracts involve large private contractors, who provide great opportunities for the local political establishment. Private investments too have flowed into many areas. Since the pie has expanded dramatically, the upper levels of the political establishment can now feast on these larger opportunities and leave their local minions to corner the older set of opportunities.

Obviously, the degree of evolution of this pattern varies from state to state. In certain states, this pattern has advanced considerably. In any case, this transformation only shifts the agents of corruption without altering any of the existing incentives to seek rents.

From hope to despair in a week?

It was just a week back that the markets were celebrating a much debated deal to bailout Greece in return for structural reforms and austerity and provide liquidity support for beleaguered European banks. Then on Monday, faced with strong public opposition, George Papandreu stunned everyone by deciding to call for a referendum on the austerity and bailout deal agreed with the other Eurozone members.

For all practical purposes, this referndum would be a vote on whether Greece should stay or leave the Eurozone. In fact, the Times quoted the German Chancellor Angela Merkel who has described the referendum as "about nothing else but the question, does Greece want to stay in the euro zone, yes or no?"

It heightens the risk of a sovereign default by Greece and even a possible Euro-exit and return to Drachama ending a 10-year experiment with the Euro. The big question facing policy makers in Athens and Brussels is whether the benefit of having a cheap currency under Greek control would outweigh the costs of defaulting on its debt and abandoning the euro. More worryingly, it threatens to unravel the comprehensive debt deal reached last week to shore up Eurozone economies and thereby endangering the Italian economy with potentially catestrophic consequences for the world economy itself.

Over five of the most volatile trading days, Greece has seen the best and worst of financial market volatility. Greek CDS spreads fell from 5500 points to 3100 points and then has risen to 5600 points, all in the space of five trading days.



The yields on 10 year Greek bonds too have risen steeply, cancelling off gains from the debt deal.



Update

From despair, there arises some hope as the Greek Prime Minister musters opposition support for the debt deal and calls of the proposed referendum, thereby taking his country away from the edge, atleast for the time being. Adding more cheer for the markets, the ECB, under its new President Mario Draghi, cut its benchmark rates by 25 basis points to 1.25%

The focus should shift from Mumbai to New Delhi

The sources of India's most recent bout of inflation, as pointed out in a series of excellent recent speeches and papers by RBI officials (see also Amol Agarwal here), may be rooted in structural factors like demand shocks (increased protein consumption) and supply constraints. The continued fiscal accommodation, especially by way of the expansion of the mandate of policies like NREGS, may have contributed towards amplifying the upward pressures.

This means that monetary policy may have limited traction with restraining inflationary pressures, beyond cooling the economy and restraining growth in aggregate demand. Any further changes in monetary policy can only have marginal impacts, especially since the markets have already priced in the RBI's firm commitment to rein in inflation by lowering aggregate demand and thereby slowing down the economy. Blaming the RBI for taking only baby steps or being too predictable with its interest rate increases or even giving up its shock value (the recent announcement that it may not hike rates in December) looks unconvincing.

Translated into English, all this effectively means that the focus of attention on inflation fighting has to shift from RBI to the Government. It means that governments, both states and center, will have to initiate steps to ease supply-side constraints - infrastructure bottlenecks and agriculture production capacity. An aggressive program of investments in these areas is immediately required. Fiscally constrained governments need private sector assistance in many of these areas if there is to be any meaningful impact to ease supply constraints. The very nature and dynamics of their interventions also means that the expectations for immediate outcomes that we associate with RBI's monetary policy actions should be shelved.

It is interesting that during the Great Recession and the economic slowdown that followed the sub-prime crisis, governments across the world have been largely missing in action. Almost expecting this, public debates have been focussed on getting monetary authorities to pull economies out of their current mess. In the developed economies, central banks have indulged in monetary accommodation through unprecedented quantitative easing policies.

In India, the focus on its central bank has been for a different reason. Unlike the developed economies, the problem here is an overheating economy which has unleashed inflationary pressures. Accordingly, attention has been on the RBI to use monetary policy to deliver the magic bullets to lower inflation and boost growth. But, as aforementioned, this strategy has serious limitations and will not yield results. RBI can at best buy time by cooling the economy and buying time for the government to get its act in order. Only governments can fulfill the growth creation and sustaining role effectively.

The only issue at debate is whether the RBI should pause or not. The fundamental objective of the 13 consecutive rate hikes has been to rein in an over-heating economy. This growth restricting objective has to be weighed against the more important medium to long term goal of getting the economy to quickly expand its potential output and productive capacity. This requires massive investments in infrastructure and food production, both by the governments and the private sector.

Has the interest rate crossed the threshold where it has started adversely affecting these investments? This should be the critical question guiding RBI's monetary policy decisions in the months ahead. As for inflation, it is time for New Delhi to assume centerstage and take the "inflation bull" by its horns.

Do small firms underpin economic vibrancy and create major share of jobs?

One of the recurrent themes in the debate about the problems facing the US economy has been the relative weakness of small enterprises who are traditionally believed to have provided the labor market firepower in the aftermath of recessions and also underpin economic vibrancy of any economy. However, this conventional wisdom has been questioned by Jared Bernstein and Tyler Cowen in different contexts.

Tyler Cowen points to an interesting possible structural cause for the economic weakness in Italy and some of the peripheral economies - the over-sized role of smaller firms in their economies. Referring to Italy's vibrant clusters of family-owned niche businesses, he writes,

"With the advent of modern communications and information technologies, arguably the return to 'small family firms' has fallen. The return to 'largish projects consummated over large distances' has gone up. For Europe, the big winners here are the Nordic countries, which have worked very effectively with information technology and which do not rely so much on family ties to get efficient, non-corrupt management. The losers are Italy and Greece and Portugal too... Portugal is cursed by being stuck with all these small firms, inefficiently small for legal and regulatory reasons. These countries seem to be locked out from some of the major sources of contemporary economic growth."

He also points to Serguey Braguinsky, Lee Branstetter, and Andre Regateiro, who studied the transformation of Portugal's firms and found,

"For decades, the entire Portuguese firm size distribution has been shifting to the left... Portugal's shrinking firms are linked to the country's anemic growth and low productivity. We show that the shift in the Portuguese firm size distribution is not reflected in other advanced industrial economies for which we have been able to obtain comparable data."

Matt Yglesias has an excellent graphic that clearly refutes the small-firms-cause-economic vibrancy thesis.



I cannot but not agree with his broad assessment of firm growth in any economy. He writes,

"The way a healthy economy works is that you start with a bunch of firms and then it turns out that some of those firms are better-managed than others. The well-managed firms expand while the poorly-managed firms go out of businesses. At the end of the day, then, you wind up with the majority of workers working for relatively well-managed firms. Because the firms are well-managed, the workers are more productive and earn the well-known-in-the-literature large firm wage premium. Alternatively, you can have an economy like Italy’s with lots of barriers to competition so that poorly managed firms stay in business with low productivity."

Jared Bernstein writes about the role of small businesses in the US economy,

"It’s not small businesses that matter, but new businesses, which by definition create new jobs. Real job creation, though, doesn’t kick in until those small businesses survive and grow into larger operations."

Bernstein's assessment and the findings from the study of Portuguese economy has important lessons for India, where small businesses and policies favoring them are seen as holy cows. Braguinsky et al write about the distortionary role played by Portugal's uniquely strong protections for regular workers,

"Drawing upon an emerging literature that that attributes much of the productivity gap between advanced nations and developing nations to the misallocation of resources across firms in developing countries, we develop a theoretical model that shows how Portugal's labor market institutions could prevent more productive firms from reaching their optimal size, thereby constraining GDP per capita."

Their assessment of the Portuguese economy would also apply to India which too has similar tight labor market restrictions aimed at protecting smaller enterprises,

"Portugal's policy commitment to employment protections for regular workers in the formal sector is extreme, even by Western European standards. We present a model in which high levels of employment protection e ectively operate as a tax on wages, and can produce a shift in the rm size distribution, relative to the distortion-free benchmark, that reflects, in some ways, what we have seen in Portugal. An immediate implication of our model is that the same policy regime that shrinks firms also lowers aggregate productivity. Even a uniform tax tends to hit the most productive enterprises disproportionately hard, causing a degradation of the allocation of resources across enterprises. More resources are tied up in smaller, less protective enterprises and fewer resources are allocated to the most productive firms, relative to what we would see in a distortion-free economy."

In simple terms, the major share of job creation happens when small industries which started recently consolidate and start their expansionary phase. Public policy should accordingly facilitate this expansion. Unfortunately, both public policy and pervailing socio-economic institutions and conditions, both hinder such expansion.

Enabling reservation requirements in Urban Housing

My op-ed in Mint today presents an alternative strategy to enabling the regulatory requirement that earmarks certain proportion of land in layouts and built-up area in apartment complexes.

The larger message is that simple and apparently logical regulatory restrictions come up short when faced with real-world implementation. In the circumstances, a more nuanced strategy that aligns the incentives of all sides stands a better chance of success.