Does Wage Growth Retard Economic Growth?

By Dr. O.G Dayaratna-Banda
Department of Economics and Statistics
University of Peradeniya

Adoring the discarded neo-liberalism

The Secretary to the Treasury of Sri Lanka has seemingly informed the Vice Chancellors of the Universities at a meeting held at the UGC that the “increase of the salaries of university academics or any other public sector workers would seriously undermine economic growth”.
Similar sentiments have been expressed by those who hold key positions at the Ministry of Higher Education. This appears to be the official stance of the government. Apart from intellectual paucity and empirical invalidity, this statement discredits the intellectual consciousness of the university academics.
The Treasury of Sri Lanka has surrendered to a very peculiar theory that “salary growth negatively causes economic growth”. This argument is arising from the textbook neo-liberalism, a doctrine that started to influence the policy making process of developing countries in various forms since the 1970s. This doctrine advocated profit-led growth policy in diverse forms. The profit-led export promotion growth model in most countries was associated with suppressing wage costs and domestic consumption in order to remain internationally competitive and to achieve growing shares of world markets as far as possible. However, recent global experience suggests that this growth model does not generate sustainable growth outcomes.
Neo-liberal theoreticians got the rich nations to embed this doctrine in the policies, agendas and strategies of the multilateral institutions such as the IMF and the World Bank. The policy agenda of the neo-liberal theory promotes various policy adjustments including the following in order to promote export and curtail domestic demand through wage-suppression. According to this doctrine, developing countries should:

a.    adopt a balanced budget policy since expansionary fiscal or monetary policies are detrimental to economic growth,
b.    reduce the size of the public sector and control public sector   wage growth,
c.    control wage growth to create export competitiveness,
d.    remove minimum wage regulations,
e.    adopt a policy of suppressing trade unions and others to reduce cost of labour so that profits accumulated by the afflu-            ent class will be reinvested, which, in turn will foster economic growth,
f.    adopt profit-led and export-promotion growth policies through various arrangements to contain domestic demand including wage-suppression.
By the 1990s, most developing countries abandoned economic neo-liberalism which had generated serious negative consequences for growth and social policies. Developing countries, in fact, switched to a mixed economic policy regime in which both state and markets play a complementary bigger role. The Neo-liberal agenda may work in economies that have already reached full-employment levels or those which have achieved developed economy status, and not in growing underdeveloped economies. In full employment economies, stabilization is the central issue for which neo-liberal prescriptions may work. After the global financial crisis of 2007-2008, most economists realized that neo-liberal policy prescriptions are not even able to stabilise developed economies. However, the political leadership of the present government has seemingly been misguided by the bureaucrats to surrender to this discarded doctrine of economic neo-liberalism.
Empirical evidence suggests that domestic demand-led growth policies appear to foster economic growth in developing economies. As against the theory presented by the Treasury of Sri Lanka, I would like to emphasize the success of the domestic demand-led or wage-led growth in developing countries.

Wage-led cum domestic demand-led growth

One can argue that there is a mutually reinforcing feedback between wage growth and economic growth as depicted in the diagram. It means “economic growth tends to stimulate wage growth and wage growth in turn stimulates economic growth”.
No sustained economic growth without real wage growth

There is a considerable amount of empirical evidence from various countries that economic growth needs to accompany higher wages. A recent publication (2009) titled “no sustained economic growth without real wage growth” emphasized that “Americans have somehow survived despite this stagnation (of wages) by resorting to a small bag of budgeting tricks. But now those tricks are not going to work any more.  Simply put, from here on in, we are not going to have any sustained economic growth until real wages finally grow too”. The study, therefore, recommends that wage growth is essential to facilitate faster economic growth because it is the growth of wages that can create additional demand for the additional output created through the growth process. The study went on to say that “… we are not going to see any sustained recovery in the American economy until average Americans see a real and sustained increase in their compensation for labor…”

Realising the tragedy of profit-led growth and merits of wage-led growth

In a recent high level academic conference held in the United Kingdom, growth economists emphasised the importance of shifting from the profit-led growth model to a wage-led growth model. The summary of the arguments presented there is following. “Neo-liberalism has led to a polarization in the distribution of income and given rise to a finance-led growth model that collapsed in the worst crisis since the 1930s (occurred in 2007-2008). Wage-led growth aims to link wage growth to productivity growth and inflation.” Growing wages could then generate higher demand by fuelling consumption. But such a strategy could also ignite the growth of the capital stock if consumption demand has second round effects on investment, and if wage growth induces technological change and productivity growth.
For the last three decades, most countries in the European Union have practiced a profit-led growth strategy seriously increasing the income inequality prior to the global financial crisis of 2007-2008. Thorsten Schulten in his article titled A European Minimum Wage Policy for a More Sustainable Wage-Led Growth Model argues that “compressing the wage structure from the lower end would lead to a more egalitarian distribution of income and stabilise the wage share.” He argues that the rapid increase in income inequality led to a situation where private demand from wage income lagged systematically behind the overall economic development and thereby dampened economic growth. Two growth models practiced by many countries have contributed to the global imbalances and financial crisis of 2007-2008. The first was a credit-based growth model typified by the United States and some others. In these countries growth was driven by private consumption but it was based on household borrowing rather than wage income growth. A second strategy was followed by countries such as Germany, Japan and China which adopted an export-led growth model that sought to offset a lack of domestic demand by export surpluses. The global financial crisis has now shown that neither growth model is sustainable. Schulten asserts that “the development of a new post-crisis growth model has to shift the focus again to a more wage-led growth strategy and a much more equal development of incomes. While trade unions have to do their own job to regain their organisational power, policymakers could promote a more equal income distribution essentially through two channels, the first being a more progressive tax policy with an emphasis on higher taxes for top income earners and the second a re-regulation of labour market institutions in order to re-balance the power relations between capital and labour and to strengthen trade unions’ structural and institutional power.”
Henry Liu (2010) explains how to achieve economic development through wage-led growth. He states that stagnant worker wage income leads to overcapacity in the economy resulting in slow economic growth and economic stagnation. In the economics of development, there is an iron-clad rule that “income is all”. The rule states that the effectiveness of developmental policies, programs and measures should be evaluated by their effect on raising the wage income of workers; and that a low-wage economy is an underdeveloped economy because it keeps aggregate consumer demand below its optimum level, thus causing overcapacity in the economy that needs to be absorbed by export.” No growth of wages means that developmental policies, programmes, and measures have failed. Growth of income of workers is the key factor in generating national wealth in a country.
Economic growth experience of Taiwan and Singapore in 1970s and 1980s also points to a wage-led growth. James, Naya, and Meier (1989) discuss the role of wage-led growth in East Asian rapid development. Taiwan and Singapore adopted high wage policy to accelerate economic growth. For instance, during the rapid growth period from mid 1970s to early 1990s Singapore reported about 70% real wage growth. The idea of this high wage policy is to promote skill intensive economic activities and to move workers from unskilled to skilled worker categories. This wage-led growth policy has significantly contributed to accelerating economic growth in Singapore and Taiwan. This policy has also significantly contributed to reducing poverty and income inequality in those countries.

Role of Trade Unions in Wage-led Growth

What is the role of Trade Unions in the wage-led and domestic demand-led growth? Lingens Jorg (2004) in his book titled Union Wage Bargaining and Economic Growth emphasized that trade unions might foster economic growth. Trade unions would stimulate economic growth by signaling the policy makers that there is a shortage of domestic private demand and that raising wages is essential to fill the demand-supply gap. If policy makers do not positively respond to these signals by raising wages, sooner or later, higher growth will not be sustained because of the lack of aggregate demand.
A recent article appeared in an official e-news channel reported that wages in China have nearly doubled over the past four years, outpacing the rate of growth of the economy. This rapid growth of wages occurred because the Government of China and the private corporate leadership have recognised the fact that it is the growth of domestic demand from the Chinese people that can make the rapid economic growth more sustainable.

What can the middle class do in wage-led growth?

The importance of the middle class in fostering economic growth through wage-led growth should also be recognised. A study titled Exiting from the Crisis: Towards a Model of More Equitable and Sustainable Growth , a group of leading economists including Nobel Economics Laureate Joseph Stiglitz (2010) showed the complete failure of the profit-led export promotion growth model. The book emphasized that “too often, we think of good jobs or boosting incomes for middle-class families as the outcome of growth. But a key lesson from the past few years is that placing the incomes of the middle class at the center of our growth framework may be the only path to sustainable growth.” This is diametrically opposed to the most common neo-liberal theory that growth comes only through sustained focus on the need of business to see reduced costs, regardless of the implications for employment and wages. Professor Joseph Stiglitz and associates emphasized that a policy of constant wage growth for middle class would stimulate economic growth. The path to growth runs though the middle class. It is the expansion of the middle class and their incomes that can create stronger domestic demand for the goods and services created through the growth process. Expansion of middle class also means reducing the poor segments of the society.

Who benefitted from the doubled income in Sri Lanka?

The Budget Speech 2011 states that the per capita income of Sri Lanka has doubled in 2010 compared to 2005. It also says that the economy has recorded a higher rate of growth during this period. If this information is correct, then, a pertinent question to ask is as to whose income has doubled since 2005. Since the income of the fixed income earners, including public sector workers, have not doubled in real terms since 2005 because their salaries/wages did not double, one may wonder that the variable income earners including the affluent class of the country might have received a bigger share of the doubled income. Then, again, the government is saying that the income disparity has narrowed since 2005. If the income disparity has narrowed, the income of most people should have almost doubled as a consequent to the doubled per capita income of the country. This has not happened with regard to most public sector workers including university academics. Another point is that if the economy’s per capita income has doubled since 2005, it is the responsibility of the government to raise the wages of the fixed income earners working in the public sector including university academics so that they would also benefit from that growth. If there is no growth of wages, one may wonder as to what is the use of having higher economic growth. Does that rapid growth and doubled income mean to help the crony capitalist class in the country who can later smuggle that wealth to whichever country they want to migrate?

Wage growth and inflation

A main argument presented by the political leadership and bureaucrats when there are demands for salary hikes is that wage increases create inflation through raising cost of production. This argument is not true for developing countries which operate at well below the full employment levels along with strong shortages of effective aggregate demand. One needs to recognise the fact that economic growth is the central issue in countries like ours, not the stabilisation. For a growing economy, periods of excess money supply stemming from expansionary fiscal policies are required. For this to happen, a certain level of inflation has to be tolerated by the society. Reducing inflation to very small rates through fiscal and monetary disciplining by undertaking credit market repression and wage repression is extremely detrimental to economic and social progress of countries like ours. It is well known that, in countries like ours which operate at well below the full employment levels, policies to promote aggregate demand will not be detrimental to economic growth. In a recent in-depth and rigorous empirical study with reference to Sri Lanka, we found that expansion of government spending through deficit budget policies since the 1980s have not negatively affected private investment and have, in fact, positively contributed to economic growth (Priyadarshanee and Dayaratna-Banda 2010). Apart from this, any sensible person would realise that a huge amount of public funds are spent on various wasteful activities which can easily be diverted to raise wages in order raise demand to facilitate economic growth.

Elusive quest for sustainable growth through wage-repression

A careful analysis of the policy response of the present government regarding the salary hike demands of university academics and others leads to the conclusion that UPFA political leadership has surrendered to the neo-liberal agenda of the bureaucrats and multilateral institutions. They have completely disregarded the fact that wage repression and profit promotion has generated dismal consequences in most countries. Wage-repression will not generate prosperity. It will, in fact, generate economic misery. It is still not too late for the UPFA political leadership to realise that it is a wage-led cum domestic demand-led growth policy that would promote growth and make the already achieved rapid economic growth more sustainable. Such a growth strategy will also create a more egalitarian and humane society.