Saturday, June 5, 2010

What is labor's share?

How does labor's share of income and wealth happen? (Forgive me, this is sort of a thinking-aloud and lengthy post.)

In our time, large increases in productivity are going everywhere but to the laborers who are doing the work- to the financial sector, to capital, to government, and especially to the rich in the form of income and wealth inequality. Why is this, and what can be done about it? I will discuss a hierarchy of processes that affect this balance, from the easily understood to the more arcane.

(Please see a recent NYT story for a discussion of this inequality, with useful graphics.)

- Direct conflict: strikes, unionization, union-busting
One method of altering the share of income going to labor is to agitate directly for that increased share. Unions are the primary vehicle of pro-labor agitation, and in their heyday made America a much better place, with a more-equal distribution of income and other advancements in workplace decency. Conversely, antiunion government policies ("right-to-work" laws, strike breaking assistance, and race-to-the-bottom tax breaks for business relocation) and corporate agitation have the reverse effect. Since the 60's, antiunion agitation by large employers like Walmart, Ronald Reagan, and many others has been markedly more effective than pro-union activity. Thus, on balance, this effect has contrbuted to decreasing the labor share of GDP in recent decades.

- Labor markets:
Theoretically, the labor market lets employers bid for available labor, and in flush times, even for unavailable labor, poaching from other employers. Conversely, it lets workers bid for acceptable workplaces and higher salaries. In the aggregate, employers have to pay labor enough to staff the enterprises from which they can then reap excess profits and value. What limits labor supply, and what sets the price?

Conventional theory claims that it is productivity that ultimately sets the labor price.. that employers hire workers at the market wage rate until the marginal profit per extra worker reaches zero, assuming that the last worker is less productive in the enterprise setting than the first one.

A more realistic scenario might be that employers have certain models of how to run their enterprise at a certain scale with a minimum amount of labor. They hire that labor at the prevailing wage, then pursue productivity gains that allow them to eliminate those individual employees representing the lowest profit to wage ratios. The employer has no interest in hiring to the limit of marginal utility, since that is a waste of effort and profit in an organized business model which is not, typically, infinitely expandable. Thus there is no need to clear the labor market from an individual employer's perspective, and nor does pay in a given company necessarily rise to the level of productivity. In aggregate, however, new enterprises will hopefully be founded to employ marginal labor, depending on a variety of cultural and governmental settings, discussed below.

Businesses also have a variety of other advantages in the labor market. One is assymetric information, where a culture of secrecy surrounds salaries outside the HR department, putting applicants at a severe disadvantage. Secondly, employees tend to be more loyal to companies than the reverse, valuing stability for personal reasons and setting themselves up for undervaluation. Thirdly, in the internal competition to be a high profit-to-wage employee, the profit side of the equation is highly flexible, in the form of extra time spent, creative effort, and other contributions (though the reverse might also be cited, in Dilbert fashion, with pointless meetings, personal activities, self-dealing, and other drags on profit). On the other hand, pay is highly inflexible, raised only in the most notoriously grudging manner.

I'd rate this process as tending toward lowering the labor share as well, though it is perhaps the only process of those discussed here that can lead to wage gains when the stars are all aligned, which it to say, when enough entrepreneurs and businesses have pending business needs and credit available to bid up salaries. This happened most recently during the late Clinton years, not due to that administration's economic policies, but mostly due to the techno-cultural ferment of the computer and internet boom which raised productivity even faster.

- Immigration and trade policy:
Another broad influence on the macroeconomic settings and on labor power in particular is immigration policy, or lack thereof. While legal immigration is relatively balanced and doesn't lead to overall distortions in the employment market, illegal immigration has huge effects on the lower end of the labor market, essentially removing the wage floor for unskilled workers. The enormous tide of illegal immigration from Latin America is great for employers, who bid down unskilled pay to minimum wage and below, with under-the-table arrangements, and other means of keeping menial work not only underpaid, but distasteful. The upshot of this process is the typical mantra that such immigrants "do work that citizens don't want to do".

The alternative to importing and underpaying labor is offshoring work to low-wage countries. The usual theory of comparative advantage would say that we gain from this exchange, freeing domestic labor for higher-value pursuits, while getting advantages of trade. This only works when domestic labor is actually employed in higher value pursuits- something that is not the rule, needless to say. Scandinavian countries take a strongly supportive role in labor mobility, sponsoring serious retraining for displaced workers, leading to real jobs in such higher-value industries. The lesson is that the state has an important role to play in making such economic freedom for companies work for the labor force and country at large.

At any rate, our immigration and trade policies have been strongly on the side of decreasing labor's share of income, winking at a flood of low-skilled immigration, and providing trade agreements that favor US businesses, occasionally consumers, but never labor (NAFTA, for example).

- Macroeconomic policy:
A key insight of Keynes was that demand leads to production. Enterprises don't produce what doesn't sell, and they can only sell to someone who has money to spend, which was earned or was given by the government. Collapses in aggregate demand, such as we see currently as the private economy swings from excessively high indebtedness and consumption to higher saving, lead directly to lower production, and thence to a spiral of deflation unless the state (which prints the money, after all) steps in to fill the demand gap. The state ideally supplies money up to productive capacity, also funding the increased private saving and leakage via the trade deficit while also keeping aggregate demand afloat.

The stimulus package of the last year was a step in this direction, but clearly not enough, as unemployment remains painfully high and we head into what looks like a double-dip recession. High unemployment leads naturally to a lower wage share of GDP, as employers can bid lower for workers, as well as employing fewer overall.

On the long term, macroeconomic settings have critical effects on this balance, as the Federal Reserve's fundamental directive makes clear- "maximum employment, stable prices, and moderate long-term interest rates". Have they been pursuing maximum employment? I don't think so. Recent decades have seen the decline of Keynesianism and the rise of monetarism, after the inflation, stagflation, and resource shocks of the 70's led economists to pitch full employment under the train in favor of fighting inflation. The chosen weapon was high interest rates, which choked credit and business formation, lowering employment in what was generally viewed as "necessary pain" to wring inflation (in the form of escalating wage demands) out of the economy. All this was quite effective on the inflation front, but what of employment? Maximum employment has been reinterpreted as NAIRU, or the rate of unemployment consistent with low inflation. What unemployment is that? Well, it is very difficult to say. Could be 5%, or 10%. Right now, we have low inflation, so we could be at the NAIRU- no one really knows.

The fact is that there is no analytical method to determine the NAIRU. It is whatever unemployment rate has been consistent with low inflation in the past, and might change at any time, depending on cultural, technical, or other factors. It is a chimerical construct allowing policy makers to accept some arbitrary amount of unemployment as good rather than bad. But there are other ways to skin the cat of inflation, rather than through unemployment. Employment is very high in Japan while inflation remains very low, probably due to a high savings rate that keeps aggregate demand relatively low. The US in the 50's and 60's also had consistently high employment with low inflation, until the Vietnam war and other compounding fiscal and resource problems led to rising inflation in the 70's.

In that time period the US probably benefitted from consistent export surpluses which allowed rising private net saving with low government debt (i.e. even without government deficits, the private economy gained net financial resources from trade that it could save). Now that our trade balance is consistently in deficit, the government has to continually replace that leakage with deficit spending, leading to accumulated government debt, pending eventual re-alignment of our trade position. (Debt which is not bad, by the way. Who worries about our 28 trillion of accumulated private debt, compared to the 10 trillion of public debt? No one.)

At any rate, the Fed has focused on wringing out residual inflation over the last thirty years, accepting substantial levels of unemployment and underemployment along the way. The Fed has been pilloried for keeping interest rates too low in the last decade, fueling the housing boom with easy money. I would disagree. The Fed was partially at fault, but not for low rates- those were fine, general inflation being quite dormant. Rates are a very blunt instrument, penalizing all businesses and workers for the sins of one sector in this case. No, the Fed's fault lies in lack of regulation, both of the mortgage industry, and of the high-finance industry, which created such an Everest of fraudulant "instruments". Its laxity was driven by ideology, assuming that markets self-correct and that active and adversarial regulation is unnecessary. They do self-correct, but not in a timely fashion. After all, Ponzi schemes self-correct as well, eventually! The Fed was established to mitigate this kind of destructive self-correction that was recurrent in the 1800's, and it failed spectacularly in that role.

High interest rates are a drag on business and labor, but more pernicious for labor, since while the number and size of businesses can go down during a recession, the population can't- it keeps going up, leading to the agony of unemployment, as well as the market effects noted above where wages are bid down to the lowest level necessary to hire the desired worker. I.e., the labor share of a shrinking GDP decreases. This is one reason why most economists take economic growth as such an automatic good- even though growth may represent unsustainable resource use, pernicious monetization of human needs, and counterproductive activities of many other kinds, the basic need for employment is only met in a setting of economic growth.

The Fed was also at fault for persistently calling for federal fiscal discipline and balanced budgets, via ideologs like Alan Greenspan. It was this fiscal discipline, briefly expressed as federal budget surpluses, which drove the private economy into high debt which has now imploded. Government spending has to cover leakages from the private economy- leakages like trade deficits and net savings to government bonds which reduce money available for consumption. With the economy in perpetually high trade deficit, and the dollar not adjusting due to its special position as the world's reserve currency, (among other reasons), far more government deficit spending was needed to keep the private economy from consuming out of private debt as has happened over the last decade. Issuing government debt for all these deficits was also not necessary- debt is purely a monetary operation to guide interest and inflation rates, and is not required to directly "fund" government spending.

- Cultural settings of education and optimism:
Now I transition from what is economics (loosely construed!) to what is practically theology. Entrepreneurs create jobs, combining inspiration, skills, labor, and capital into new ways to fulfill human needs. Apple Computer is a great example of a persistently entrepreneurial operation, which keeps coming up with new businesses- ways to transform mundane materials and engineering talent into satisfied human desires and economic flows.

Entrepreneurs need a variety of external ingredients, principally labor with the education or skills to realize a new vision, and capital. If capital is scarce, as it is right now, then labor excess is not going to make up for it, unless its price is bid dramatically down, perhaps to garage start-up levels. Conversely, all the money in the world isn't going to make an Apple Computer- it takes education and more broadly a culture of technical innovation, even geekery. This is what makes urban environments so productive relative to rural ones- labor's share is higher in dynamic urban environments because the balance of entrepreneurs with the necessary ingredients for job creation is high, compared to the labor pool, leading to economic growth. In rural areas, wages are low, but that is not enough to offset the lack of an educated labor pool flexible enough and concentrated enough to turn its hand to many different value-creating ideas.

But not all urban environments are dynamic, and this is California's achilles heel looking to the future. Our schools have dropped to among the worst in the nation, as we have counted on the cultural / physical climate and the UC system to attract bright people from elsewhere to employ a workforce which is heading toward unskilled labor due to demographic and immigration trends. As California becomes increasingly dysfunctional politically, educationally, and economically, entrepreneurs may lose access to the requisite concentration of skills and eventually the sense of optimism to keep building high-tech businesses in the state. This would seriously impair not only economic growth, but also, given a lower rate of business formation and job growth, labor's share of the economy.

- Conclusion:
Now, it could be that capital and high earners have in all truth become more important than labor to the production of GDP in the US, deserving their higher and growing share. Perhaps with rising automation and other technological conveniences, the marginal product of low-skill labor has declined, while the leverage of high-creativity and capital-intensive work has increased. Perhaps the ceaseless winner-take-all nature of many professions has properly segregated very high producers from the riffraff, now unsupported by blanket protections they might have enjoyed in the past like unionization and conveyer belt-like promotion and seniority systems. We may have transitioned to an Ayn Rand-ian meritocratic system which has finally uncovered the true relative worth of various economic actors, both human and monetary.

However, I doubt that is the case. First principles would indicate that with rising wealth, the economic value of that wealth as capital should decline relative to the labor which is the true source of creativity in employing it. The more wealth we pile up, the less useful each increment is in funding productive activity. Thus one suspects that the evident higher returns to wealth in recent times are a form of rent, perhaps due to rampant financialization and excessive private indebtedness that has afflicted the US economy in recent decades.

Secondly, inequality between high and low earners is very hard to defend if one takes our educational system seriously, since it cranks out broad classes of certified people for the various professions and other pursuits. While there are surely fine differences in personal characteristics that make people variously productive after such training, they are unlikely to correspond to the differentials of hundreds-fold present in today's business pay structures. Not in any linear fashion, at any rate. Far more likely is that these markets are defective, either because of intrinsic problems of tournament-like markets, or because executives defeat market mechanisms by collusion, misappropriation of shareholder equity, etc., while using the same markets to consistently underpay employees.
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