Eckhard Hein, Arne Heise And Achim Truger Eds. - Wages, Employment, Distribution And Growth_ International Perspectives (2006, Palgrave Macmillan).pdf

Wages, Employment, Distribution and Growth International Perspectives

Edited by

Eckhard Hein, Arne Heise and Achim Truger

Copyright material from www.palgraveconnect.com - licensed to University of Newcastle, Australia - PalgraveConnect - 2014-03-15

Wages, Employment, Distribution and Growth

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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International Perspectives Edited by

Eckhard Hein Arne Heise and Achim Truger

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10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Wages, Employment, Distribution and Growth

Selection and editorial matter © Eckhard Hein, Arne Heise and Achim Truger 2006 Individual chapters © contributors 2006

No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2006 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin's Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978-1-4039-4962-2 ISBN-10:1-4039-4962-X This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging in Publication Data Wages, employment, distribution, and growth / edited by Eckhard Hein, Arne Heise, and Achim Truger. p. cm. Includes bibliographical references and index. ISBN 1-4039-4962-X (cloth) 1. Labor supply. 2. Wages. 3. Income distribution. 4. Economic development. I. Hein, Eckhard, 1963- II. Heise, Arne, 1960- III. Truger, Achim. HD5706.W24 2006 331.1—dc22 2005051392 10 9 8 7 6 5 4 3 2 1 15 14 13 12 11 10 09 08 07 06 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

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All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

List of Tables and Figures Notes on the Contributors Introduction Eckhard Hein, Arne Heise and Achim Truger 1

Labour-Market Flexibility and Economic Expansion Amit Bhaduri

2 The Causes of High Unemployment: Labour-Market Sclerosis v. Macroeconomic Policy Thomas I. Palley 3

Is Capital Stock a Determinant of Unemployment? Philip Arestis, Michelle Baddeley and Malcolm Sawyer

4

Deflation Risks in Germany and the EMU: The Role Wages and Wage Bargaining Eckhard Hein, Thorsten Schulten and Achim Truger

5

The Influence of Unemployment, Productivity and Institutions on Real Wage Trends: The Case of Italy 1970-2000 Enrico Sergio Levrero and Antonella Stirati

6

Unequal Fortunes, Unstable Households: Has Rising Inequality Contributed to Economic Troubles for Households in the USA? Heather Boushey and Christian E. Weller

7 The Effects of Economic Liberalization on Income Distribution: A Panel-Data Analysis Gerardo Angeles-Castro 8

Pensions and Distribution in an Ageing Society: A Non-Conventional View Sergio Cesaratto

9

Do Profits Affect Investment and Employment? An Empirical Test Based on the Bhaduri-Marglin Model Ozlem Onaran and Engelbert Stockhammer v

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Contents

vi Contents

223

11 The Dynamics of Profit- and Wage-led Expansion: A Note Amit Bhaduri

247

Index

255

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10 Class Conflict and the Cambridge Theory of Income Distribution Thomas I. Palley

Tables 2.1 Country macroeconomic and labour-market institution data 2.2 Time-series unemployment rate regression, pooled annual data, 20 OECD countries, 1983-94 2.3 Decomposition of the causes of changing unemployment rates into factors due to changing labour-market institution (DMICRO) and macroeconomic slowdown (DMACRO) 2.4 Measures of country income distributions 3.1 Cointegrating vectors 3.2 Model specification statistics 3.3 Key to variables and statistics/diagnostics as in Tables 3.1 and 3.2 4.1 Wage trends and extent to which the scope for distribution is exploited in the EMU 4.2 Wage trends and extent to which the scope for distribution is exploited in Germany 5.1 Determinants of rates of change in industrial wages 5.2 Determinants of rates of change in real earnings in the business sector 5.3 Rates of change in hourly productivity, hourly labour costs, real exchange rates in manufacturing in the main industrialized countries 6.1 Levels and changes of profit shares and labour shares of national income 6.2 Savings and consumer debt, business cycle averages 6.3 Selected use of non-financial corporate resources, business cycle averages 6.4 Selected macroeconomic measures, business cycle averages, 1948-2003 6.5 Sources and uses of household finances 6.6 Regression results for determinants of household debt, 1980-2003 6.7 Regression results for determinants of mortgage debt, 1980-2003

24 30

37 41 60 61 62 81 82 98 100

107 119 124 125 126 134 136 138

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List of Tables and Figures

viii List of Tables and Figures

Figures 2.1 The economic policy menu 4.1 Unit-labour-cost growth and inflation rate (consumer prices) in Germany, 1961-2003 (per cent) 4.2 Unit-labour-cost growth and inflation rate (consumer prices) in EMU, 1961-2003 (per cent) 4.3 Labour income shares in Germany and the EMU, 1960-2003 (per cent of GDP at current factor costs) 4.4 Unit-labour-cost growth in Germany and the EMU, 1991-2003 (per cent) 4.5 Inflation rate (consumer prices) in Germany and the EMU, 1991-2003 (per cent)

139 140 144 159 163 166 168 169 175 175 184 188 190 192 197 209 211 214 216 251

44 74 75 76 78 78

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6.8 Regression results for determinants of credit-card debt, 1980-2003 6.9 Regression results for determinants of debt composition, 1980-2003 6.10 Regression results for economic distress measures 7.1 Estimation methods 7.2 Scenarios 7.3 Scenarios using changes in trade volume (CTRAGDP) 7.4 Exports by sector to total exports 7.5 Level of employment (UNEMP), employment by sector (EMPSEC) and government size (GOVEXPEN) A7.1 Characteristics of data-sets on income inequality A7.2 List of countries (93) 8.1 Evolution of the world population: alternative UN scenarios by regions (billions) 8.2 Impact of migration flows: alternative UN scenarios (thousands) 8.3 Evolution of labour supply 2000-50, OECD projections 8.4 Evolution of participation rates in OECD countries: scenarios by the OECD 8.5 Changes in old-age pension spending 2000-50, OECD estimates 9.1 Summary of the model 9.2 Hypotheses 9.3 Summary of impulse responses for the UK, the USA and France 9.4 Summary of impulse responses for South Korea and Turkey 11.1 Classification of regimes (a > 0, p > 0 or p < 0)

List of Tables and Figures ix

5.1 5.2 5.3 5.4 10.1 10.2 10.3 10.4

10.5 A10.1 A10.2 A10.3 A10.4

Remuneration per employee in Germany and the EMU, 1991-2003 (annual increase in per cent) Annual rates of change of real hourly wages of production workers in trade and industry, 1956-2000 Real gross and net wages in industry (1972 = 100), 1972-2000 Unemployment and rate of growth of real wages in industry, 1960-99 (moving averages) Unemployment rates and annual rates of change in industrial and total employees, 1971-2000 The national income tree The Kaldor (1956) model The Kaldor-Pasinetti-Kalecki model Ambiguous effect of an exogenous increase in the degree of monopoly power in the Kaldor-PasinettiKalecki model Expansionary effect of a redistribution of the wage bill to workers in the Kaldor-Pasinetti-Kalecki model Profit-led dynamics with IS steeper than MM Profit-led dynamics with IS flatter than MM Wage-led dynamics with MM flatter than IS Wage-led dynamics with MM steeper than IS

79 95 96 99 105 225 227 230

235 236 242 242 243 243

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4.6

Gerardo Angeles-Castro is a PhD student sponsored by Conacyt (Mexico), and Teaching Assistant at the Economics Department, University of Kent, UK. Philip Arestis is Professor and University Director of Research, Cambridge Centre for Economic and Public Policy, University of Cambridge, UK. Michelle Baddeley is Deputy Director, Cambridge Centre for Economic and Public Policy, University of Cambridge, UK. Amit Bhaduri is Professor of Economics, University of Pavia, Italy, and Visiting Professor, Council for Social Development, New Delhi, India. Heather Boushey is a Research Economist at the Center for Economic and Policy Research (CEPR), and Research Affiliate with the National Poverty Center at the Gerald R. Ford School of Public Policy, Washington, DC, USA. Sergio Cesaratto is Full Professor of Economic Policy and of Development Economics at the University of Siena, Italy. Eckhard Hein is a Senior Researcher at the Macroeconomic Policy Institute (IMK) in the Hans Boeckler Foundation, Duesseldorf, and Visiting Professor at the University of Hamburg and at Carl von Ossietzky University, Oldenburg, Germany. Arne Heise is Professor of Economics at the University of Hamburg, Germany. Enrico Sergio Levrero is Assistant Professor, University of Roma Tre, Italy. Ozlem Onaran is Associate Professor at Istanbul Technical University, and Visiting Faculty Member at Wirtschaftsuniversitat Wien, Austria. Thomas I. Palley is an independent economic consultant who works in Washington, DC, USA. He can be reached at www.thomaspalley.com. Malcolm Sawyer is Professor of Economics, University of Leeds, UK. Thorsten Schulten is a Senior Researcher at the Institute for Economic and Social Research (WSI) in the Hans Boeckler Foundation, Duesseldorf, Germany. x 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Notes on the Contributors

Notes on the Contributors xi

Antonella Stirati is Associate Professor, University of Roma Tre, Italy.

Achim Truger is a Senior Researcher at the Macroeconomic Policy Institute (IMK) in the Hans Boeckler Foundation, Duesseldorf, Germany. Christian Weller is a Senior Economist at the Center for American Progress and Research Associate at the Economic Policy Institute, Washington, DC, USA.

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Engelbert Stockhammer is Assistant Professor at Wirtschaftsuniversitat Wien, Austria.

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Introduction

The subjects covered in this book are among the most controversial in the history of economics as an academic discipline: the relation between wages and employment, the effects of wages on distribution, and the relation between distribution and growth. However, taking a look at the state of mainstream economics today, all of these debates seem to have been resolved by and large. In New Classical as well as in mainstream New Keynesian Economics there is a clear cut inverse relation between real wages and employment, at least in the long run. This is also true for the 'new consensus' models in macroeconomics.1 Although the New Classical and the New Keynesian schools of thought differ with respect to the determinants of short-run economic activity and also with respect to the effectiveness of macroeconomic policies, in the long run it is the real wage rate which determines employment. Therefore, the mainstream in both schools of thought focuses on structural reforms in the labour market and in the welfare state when it comes to fighting persistent unemployment. To improve labour-market flexibility and to make the social benefit systems more 'employment-friendly' is regarded as the key to raising employment. This usually includes the reduction of employment protection legislation, of benefit replacement rates and durations, and of the tax wedge as well as the decentralization of wage-setting in order to adjust real wages to workplace productivity. Macroeconomic policies are assumed to be ineffective in determining real variables in the long run and should therefore supply a 'stable environment', which means that monetary as well as fiscal policies should aim at assuring price stability. Income distribution and, in particular, functional income distribution is hardly discussed at all in mainstream economics today. Atkinson (2000) speculates that this may be due to the wide acceptance of the 1 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Eckhard Hein, Arne Heise and Achim Truger

hypothesis of constant income shares in the long run, which, however, cannot be observed empirically (Atkinson 1997, 2000). When new growth theories deal with distribution issues, it is personal distribution of income and wealth which can affect accumulation and hence longrun productivity growth through different channels. 2 Under the conditions of imperfect capital markets, unequal distribution of income and wealth may impede accumulation of human capital and R&D investments which determine productivity growth in these models. Unequal distribution may also cause social unrest and state intervention which disrupt the transformation of savings into productive real investment. However, effective demand for goods and effects that functional income distribution may have on effective demand and capital investment do not play a role in these models. The long run growth process is purely supply-side determined. The papers collected in this volume take a different perspective. They challenge the view that unemployment is exclusively determined by structural characteristics of the labour market and the social benefit system. Macroeconomic policies and investment in capital stock are included into the analysis and it is shown that they have a major role to play when it comes to the short and long-run determination of unemployment. Wage-setting in the labour market has no direct impact on employment but nominal wages set in this market rather affect the price level. Following the recommendations of mainstream economics with respect to labour-market reforms, decentralization of wage bargaining and wage moderation in an environment of low growth and serious effective demand problems may therefore contribute to deflationary risks and may hence worsen the economic situation instead of improving it. It is also shown that unemployment and 'structural reforms' aiming at more open and more flexible markets at the national and the international level may have major feedback effects on functional and personal income distribution, causing real wage growth to lag behind productivity growth, falling labour income shares and more unequal personal income distribution. These developments may then also contribute to slow growth and rising unemployment. This is shown in applying growth models which rely on the principle of effective demand also in the long run and which incorporate the effects of distribution struggle into these models. In an introductory chapter Amit Bhaduri analyses why the neoliberal view on labour-market flexibility and restrictive fiscal and monetary policies as a precondition for economic expansion has become the dominant view in academics and in economic policy-making today

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2 Introduction

superseding the Keynesian style of demand management. According to Bhaduri, the latter failed for several internal and external reasons: Keynesian macroeconomic policies were set in the context of a closed economy and did not seem to apply to increasingly open and globalized economies. Full employment orientation lost ground as soon as the competition between capitalist and socialist economic systems had been resolved; and internal contradictions of the success of the 'golden age' of welfare capitalism, that is full employment and increasing inflationary pressure, were not sufficiently taken into account in this approach. However, neo-liberal policies characterized by methodological individualism and a lack of macroeconomic reasoning suffers from some serious fallacies of composition: cutting wages may improve the profit margin of a single firm, but the total volume of sales in an economy is likely to suffer and overall employment may deteriorate. In particular, neoliberal policies do not pay attention to the two-way relationship between the growth rates in real wages and in productivity, in which productivity growth allows for increasing wages through cost and price cutting of firms and rising real wage demands by workers induces firms to increase productivity in order to maintain profit margins. This virtuous circle propelling long-term growth in capitalism may be undermined by neo-liberal policies. In an empirical chapter Thomas I. Palley challenges the conventional wisdom that high European unemployment is the result of rigid and inflexible job markets. The chapter accounts for both micro- and macroeconomic factors and considers cross-country economic spillovers. Palley's estimations show that macroeconomic factors dominate in explaining unemployment. These factors are robust to changes in empirical specification. Labour-market institutions do matter for unemployment, but not in the way conventionally spoken about. Unemployment benefits and union density have no effect. The level of wage bargaining coordination and the extent of union wage coverage both matter, and if properly paired can raise incomes without causing unemployment. Lower tax burdens can also lower unemployment, but a far more cost effective fiscal approach is to increase spending on active labour-market policies. The bottom line is that high unemployment in Western Europe has been the result of self-inflicted dysfunctional macroeconomic policy. European policy makers adopted a course of disinflation, high real interest rates, and slower growth that raised unemployment. Moreover, they all adopted this course at the same time, thereby generating a wave of trade based spillovers that generated a continent wide macroeconomic slowdown and further raised unemployment.

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Eckhard Hein, Arne Heise and Achim Truger 3

Philip Arestis, Michelle Baddeley and Malcolm Sawyer examine the proposition that investment and capital stock can contribute substantially to the determination of the rate of unemployment and real activity, and thereby to the determination of the NAIRU (Non-Accelerating Inflation Rate of Unemployment) in a range of EMU countries. In their model, the effect of demand on unemployment and wages is emphasized. The mechanism works through changes in capacity utilization, which themselves depend on economic activity and the stock of capital. It is argued here that negative demand shocks affect employment and investment adversely. When shocks reverse, unemployment may not fall to previous levels, due to insufficient capital equipment. Their empirical results show that the general rise in the unemployment rate in the countries examined over the past thirty years was to a large and significant extent due to insufficient investment, leading to a lower (than otherwise) capital stock. Based on a post-Keynesian approach concerning the relationship between wages, prices and employment, the chapter by Eckhard Hein, Thorsten Schulten and Achim Truger studies the extent to which unit labour cost trends have been responsible for disinflation and deflationary tendencies in Germany and the European Monetary Union (EMU). According to their view, excessive nominal wage moderation, particularly in Germany, has not only caused deflationary risks but also contributed to falling labour income shares. Weakened trade union bargaining power in a period of sustained mass unemployment and the integration of trade unions into a new 'competitive corporatism' aiming at wage moderation in order to improve international price competitiveness are seen as major reasons for this development. It is concluded that the excessive wage restraint in Germany not only exacerbates stagnation and deflationary tendencies in Germany but might also mean deflationary risks for the other EMU countries. The influence of unemployment, productivity growth and institutions on real wage trends in Italy is analysed in the chapter by Sergio Levrero and Antonella Stirati which is based on a Classical view on the determination of wages. In this view wage trends are affected by a set of historical and current circumstances that can be broadly classified as labour-market conditions, the degree of organization of the bargaining parties involved, and broader economic and political/institutional factors affecting bargaining power. The empirical analysis shows that the primary factor affecting real wage trends in Italy in the 1970-2000 period appears to have been unemployment. Broader economic and political/institutional factors have had an accelerating influence in

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4 Introduction

particular periods. It is argued that the unprecedented vulnerability of real wages to the exogenous increase in prices after the lira devaluation in 1992 was caused by institutional changes, namely the new wagesetting procedures agreed upon in the same year, combined with the unions' inability to ensure the development of firm-level bargaining. The chapter by Heather Boushey and Christian Weller deals with rising inequality of household income in the USA and the macroeconomic consequences. They find that the distribution of national income between capital and labour has become more unequal as has the distribution within labour. At the same time that inequality rose, consumer debt and household economic distress grew, too. The evidence on a positive link between rising inequality and innovation is not supported by the data. The data either suggest no connection or a potential negative link. In comparison, the link between growing inequality and aggregate demand is somewhat ambiguous. One way to clarify this ambiguity is the possibility that debt has increased and that it has increased more among low-income households, particularly in the form of credit cards and non-bank credit. The authors find that credit-card debt is especially sensitive to changes in inequality and that rising inequality may thus have contributed to rising personal bankruptcies. In a panel-data analysis Gerardo Angeles-Castro examines the effects of economic liberalization on income distribution for a set of developing countries. His results are in keeping with the theoretical foundations and expectations that have supported the global liberalization process only insofar that low inflation, fiscal discipline, larger employment and domestic efficiency can benefit income distribution. On the other hand, the results undermine other aspects of these theoretical foundations and expectations, since the benefits of trade on income distribution are weak, foreign direct investment (FDI) worsens inequality, and the export-led growth strategy and the expansion of employment based on the primary sector do not improve income distribution. As for the set of policies underlined in the second stage of the economic liberalization process, domestic efficiency can help to reduce the adverse effect of FDI on income distribution, while it can also help to obtain some benefits from trade liberalization in income distribution. Moreover, a stronger state is important to decrease inequality, and the set of socio-political norms enclosed in the post-Washington Consensus approach improves income distribution. The study also suggests that further supranational mechanisms, beyond the scope of the state, are required to socialize the flow of trade and investment.

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Eckhard Hein, Arne Heise and Achim Truger 5

From a Classical point of view, Sergio Cesaratto explores the economic impact of ageing on the labour market and on the future of social security organized along pay-as-you-go (PAYG) lines. Assuming as a working hypothesis the persistence of employment at the present levels (with output growth resting on productivity growth), it is argued that the falling supply of domestic labour population is not necessarily a constraint on output growth, insofar as it is compensated by higher participation rates (including later retirement), technical progress, immigration and, perhaps, some recovery in fertility. But in any case, there will be a rise in the PAYG burden on social output which, however, can be covered if wages and/or profits share part of the productivity gains with the retirees. The crucial question the chapter asks is, whether the additional sources of labour supply are such as to preserve an industrial reserve army and if capitalism can live without a significant labour reserve army that keeps the whip of competition on the workers. It is in this sense that a shrinking labour supply may affect employment and growth by inducing deflationary policy choices in order to ensure the existence of an industrial reserve army. The relation between distribution, investment and employment is empirically investigated by Ozlem Onaran and Engelbert Stockhammer. They use a Kaleckian-Post-Keynesian macroeconomic model building on the approach by Bhaduri and Marglin (1990). This model is able to generate profit- and wage-led regimes within an aggregate demand framework. Applying a structural vector autoregression (SVAR) approach to three developed and two developing countries the authors confirm the Keynesian/Kaleckian hypotheses about the labour market: accumulation and capacity utilization/growth have a strong impact on employment. Goods-market variables have a strong effect on unemployment and the economy is driven by investment expenditures. The neoclassical hypotheses of the labour market are not validated. There is little evidence of employment reacting to wages, and no evidence for factor substitution. The findings also suggest that productivity growth does play an important role. It is not distributionally neutral and causes unemployment. However, no statistically significant effect of the 'profit share' was found on investment and growth in developed countries, as well as in one of the developing country cases. There is hence no general result in terms of the distinction between wage-led and profit-led growth regimes for the investigated set of countries. In a theoretical paper, Thomas I. Palley expands the CambridgeKaleckian model of income distribution and growth to include a labourmarket class-conflict channel that is distinct from the product-market

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6 Introduction

competition channel. The labour-market channel works through conflict over distribution of the wage-bill, whereas product market competition impacts the mark-up and the profit share. The distinction between wage share and wage-bill distribution has important theoretical and policy implications. At the theoretical level, it explains why economies can simultaneously exhibit both 'wage-led' and 'profit-led' characteristics. Redistributing the wage-bill to workers always raises aggregate demand and economic activity by raising consumption. However, lowering the profit share can retard activity by lowering investment spending in a 'profit-led' regime. At the policy level, it suggests that progressive policy should focus on altering the distribution of the wage-bill, rather than the profit share as has been the traditional focus. Lastly, the dual wage-led-profit-led characteristic helps make sense of developments in the US economy over the last three decades. In the final chapter Amit Bhaduri develops a synthesis of the Kaleckian model of distribution and growth, as presented in Bhaduri and Marglin (1990), which relies on constant distribution and variable capacity utilization in order to allow for an adjustment of savings to investment, and the Kaldorian model assuming full utilisation of capacity and a variable distribution of income. If neither the profit share nor the rate of capacity utilisation is treated as exogenously fixed, the behaviour and the stability of the system will depend on relative speeds of adjustment. Bhaduri shows that neither the profit-led nor the wage-led course of expansion is unambiguously stable. The papers in this volume were presented at the 8th Workshop of the Research Network 'Alternative Conceptions of Macroeconomic Policies under the Conditions of Unemployment, Globalization and High Public Debt' on 'Wages, Distribution and Growth' which took place in Berlin, 29-30 October 2004. Further papers have been published in a book by Metropolis Verlag (Marburg). We would like to thank the contributors to this volume for their cooperation, and the participants in the conference for the stimulating discussions. Special thanks go to Barbara Schnieders for assistance in the editing process and to the Hans Boeckler Foundation for organizational and financial support for the workshop and the publications. Notes 1 On New Classical and New Keynesian models see Snowdon, Vane and Wynarczyk (1994). On the 'new consensus' models see Arestis and Sawyer (2003), Clarida, Gali and Gertler (1999) and Meyer (2001). 2 See Aghion, Caroli and Garcia-Penalosa (1999) or Alesina and Perotti (1996).

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Eckhard Hein, Arne Heise and Achim Truger 7

8 Introduction

Aghion, P., Caroli, E. and Garcia-Penalosa, C. (1999) 'Inequality and Economic Growth: The Perspective of the New Growth Theories', Journal of Economic Literature, 37: 1615-60. Alesina, A. and Perotti, R. (1996) 'Income Distribution, Political Instability, and Investment', European Economic Review, 40: 1203-28. Arestis, P. and Sawyer, M. (2003) ' "New consensus", New Keynesianism and the Economics of the "Third Way" ', in E. Hein, A. Heise and A. Truger (eds), Neu-Keynesianismus - der neue wirtschaftspolitische Mainstream? (Marburg: Metropolis). Atkinson, A.B. (1997) 'Bringing Income Distribution In from the Cold', The Economic Journal, 107: 297-321. Atkinson, A.B. (2000) 'The Changing Distribution of Income: Evidence and Explanations', German Economic Review, 1: 3-18. Bhaduri, A. and Marglin, S. (1990) 'Unemployment and the Real Wage: The Economic Basis for Contesting Political Ideologies', Cambridge Journal of Economics, 14: 375-93. Clarida, R.; Gali, J. and Gertler, M. (1999) 'The Science of Monetary Policy: A New Keynesian Perspective', Journal of Economic Literature, 37: 1661-707. Meyer, L.H. (2001) 'Does Money Matter?', Federal Reserve Bank of St. Louis Review, 83(5): 1-15. Snowdon, B., Vane, H. and Wynarczyk, P. (1994) A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought (Cheltenham: Edward Elgar).

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References

Labour-Market Flexibility and Economic Expansion Amit

Bhaduri

Introduction The major economies of Western Europe have been facing almost chronic unemployment, often hovering around double digits, for nearly two decades now. This is especially true of Germany, which acted as the economic powerhouse in the consolidation of the European Union. It is all the more paradoxical that advanced market democracies can live with high unemployment placing relatively little emphasis on this problem, except perhaps at times of elections. A deep change in the climate of opinion has occurred in striking contrast to the post-Second World War years, when the pursuit of full employment was the agreed policy objective of almost all shades of political opinion. History is seldom mono-causal; several causal factors and processes usually coincide at a particular juncture of time to bring about such a dramatic change in the climate of opinion. To a significant extent, this change of opinion began as a reaction against the Keynesian style of demand management in pursuit of high employment, which gradually lost ground for several interrelated reasons. First, the Keynesian argument was almost self-consciously set in the context of an economy closed to international trade and capital flows. The intention might have been to emphasize the importance of domestically oriented economic policies for fighting unemployment. The disastrous consequences of 'beggar- my- neighbour' policies of trying to export unemployment through competitive devaluation of the national currencies during the interwar period (until the stand-still agreement of 1936) was still fresh in memory. At the same time, the prestige of the City as the financial centre of the world was in jeopardy, and its views propounding the virtues of 'sound finance' was in ruins. 9 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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It was rather natural in that context to look inward for a solution to the problem of unemployment which relied more on domestic industries, and less on 'high finance' (Bhaduri and Steindl 1985). Secondly, although the contest between the competing systems of capitalism and socialism was most visible in the arms race during the cold war, its ideological dimension was essentially economic. The socialist system appeared capable of providing full employment through deliberate state policies, although much of it was neither satisfactory to the employees nor socially useful. (A common joke of the time in these countries was, 'they pretend to pay, we pretend to work'.) The capitalist market economies, where the level of employment depended largely on the decision of private business, had the opposite problem. The employment it provided had to be necessarily gainful, that is profitable for the private employer, even if private and social gain differed. But the level of economic activity was prone to cyclical fluctuations, at times resulting in severe unemployment. Given this visible difference between the two systems, even initiatives like the Marshall Plan tended to be influenced, at least partly, by the economic competition between the two systems (Hobsbawm 1994). It was around this time that the welfare state also found wider political acceptance. Its theoretical rationale derived from Keynesian demand-management policies, whereas the rising real wage with near-full employment, leading to rapidly improving standards of living for the working population under this new style of economic governance in most Western democracies, posed a counter-challenge to the socialist ideology. Thirdly, the very success of demand management, high employment and rising mass consumption, which had ushered in a 'golden age' of welfare capitalism through rapidly expanding domestic markets for nearly a quarter century, came to be troubled by its own contradictions (Marglin and Schor 1990). Years of high employment had reduced the fear of job-loss for the workers leading to higher wage claims. It was in this context that the experiences of the two major oil price shocks of the 1970s served as almost the watershed years. They made it clear that the burden of such shocks could no longer be passed on easily to the workers. The model of cooperative capitalism of the welfare state was giving away to the model of conflictive capitalism, in which conflict over the distribution of income tended to manifest itself through inflationary or stagflationary price rise (Rowthorn 1977). Even more problematically, the fiscal policy of the state itself got entangled in this distributive conflict, as both workers and their employers tended to pass on the additional tax burden to one another (Bhaduri 1986: ch. 6). Understandably,

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targeting inflation rather than unemployment became the new focus of policies under these changed circumstances, and new economic doctrines, at time reviving old ideas that had been pushed aside by the success of Keynesian economic policies, returned in academic circles and policy discussions under the broad heading of Monetarism. Ironically, Monetarism reinvented the Marxian idea that a 'reserve army' of labour is needed to keep a check on the real wage. Kalecki (1943, reprinted in 1971) had already foreseen towards the end of the Second World War that 'political trade cycles' would be imposed deliberately, particularly in the name of sound finance (read, no deficit financing) to inflict unemployment from time to time on the workers, in order to keep control over the workers. These ideas returned in the orthodox monetarist framework of economic theory as the 'natural rate' of unemployment (Friedman 1968), or as the non-accelerating inflation rate of unemployment, NAIRU (Layard, Nickell and Jackman 1991). They all had a common theme insofar as they propounded the view that, keeping inflation and inflationary expectations under control requires accepting a certain, it may even be a fairly high, rate of unemployment. In particular, it requires giving up demand management policies intended at keeping the rate of unemployment lower than that 'natural' or NAIRU rate. Since deficit financing by the government had been the most potent instrument used for demand management, unsurprisingly it came under special attack. The doctrine of the virtues of a balanced budget, and the evils of a fiscal deficit by a self-seeking government in the name of 'public choice theory' were propounded as general truths, applicable to almost all countries under all circumstances. The wider process of globalization that gathered almost irresistible momentum with the deregulation of national capital markets since the mid-1970s in OECD countries also contributed to this change in the climate of opinion to a significant extent. The greater economic opening-up in goods and services trade has meant an increase in the relative importance of the foreign or external market compared to the domestic or internal market. It encourages countries to stimulate demand through export surplus, rather than through demand management by the fiscal policies of the government. As a result, each country tries to be more price competitive compared to its rivals, by cutting unit cost through wage 'flexibility' on the one hand, and raising labour productivity on the other. Yet there is an obvious 'fallacy of composition' in this strategy; because all countries cannot achieve export surplus at the same time as the export surplus of some must be matched by the import surplus of others. But even for any particular country, which does

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manage to achieve an export surplus in this zero-sum game, such policies may turn out to be counter-productive if the contraction in the size of its internal market more than outweighs the expansion of its external market. The danger of over-contraction of domestic demand from such policies is serious in many countries. Wage restraint depresses consumption by the working people, while labour productivity growth brought about by the corporations through the downsizing of the domestic labour force reinforces this depressive effect. Analytically, this may be identified as the wage- or consumption-led regime in which the depressive effect on consumption of wage restraint and downsizing outweigh its possible stimulating effect on investment and export (Bhaduri and Marglin 1990). And yet, this danger of a sharp decline in domestic demand tends to be overlooked in policy discussions, not due to ignorance, but for reasons that have become intrinsic to the current phase of globalization. Successive waves of deregulation and liberalization of capital markets since the mid-1970s has unleashed private trade in foreign exchange on an historically unprecedented level. In comparison to its daily volume of some 1.2 trillion dollars (BIS 2001, 2002), the total foreign exchange reserve of all the central banks is insignificantly small, while foreign trade and investment together do not account for even 4 per cent of it. The economic policies of national governments seem overwhelmed by the power of the financial markets. In particular, this has generally meant that expansionary fiscal policies for fighting serious unemployment through budget deficits are generally not favoured options by financial markets; and therefore by national governments. Similarly, easy money policies with lower interest rates are not favoured either, insofar as they stimulate consumption and investment expenditure (for example hire-purchase, inventory accumulation, housing and so on), and tend to strain the current account of the balance of payments through lower borrowing cost. Moreover, financial markets often read the lowering of the interest rate as signalling the government's intention of embarking on expansionary fiscal policies. The fear that private capital would vote with its feet in the foreign exchange market by crossing borders on a massive scale has crippled fiscal and monetary policies required to fight growing unemployment. However, there has been a significant difference in this respect between the United States and Europe. Due to the reserve currency status of the dollar, the United States manages to run growing currentaccount deficits and a relatively free national demand-management

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policy, while the rest of the world, especially Japan and Germany as important export surplus countries, continues to finance the US. import surplus in the form of capital inflow into the USA. This is no longer because of the international 'store of value' property of the US dollar; these export surplus countries are almost locked into this arrangement, because economically they have come to depend too heavily for their export surplus on the US market for maintaining demand, while politically they perceive their national defence capability as being dependent on the USA. The consequence has been a peculiar paradox about national employment policies which is seldom commented upon. The current strength of the euro has been bought at the cost of restrictive fiscal policies imposed by the Maastricht 'stability pact', and even more restrictive monetary policies pursued by an independent European Central Bank. But if the euro becomes an international 'store of value' through its strength replacing largely the dollar, capital inflows to the USA would be sharply reduced, reducing in turn the export market, particularly for the large export surplus nations like Germany or Japan. As a result, they would face an even more serious unemployment problem. Thus, with the present international financial arrangements and policies, the paradox is that the euro and the yen seem doomed to remain 'strong' currencies without becoming alternative international stores of wealth. Consequently, the privilege to run large trade deficits continuously by issuing paper liabilities accepted by the rest of the world - the privilege based on the international store of value status of a currency - which England had before the First World War, and the USA has enjoyed since the Second World War, needs to be denied to these countries. The wisdom of following restrictive monetary and fiscal policies that inflict high unemployment also needs to be examined in the light of this paradoxical international financial arrangement. Theories and counter-theories for economic policies The macroeconomic perspective justifying restrictive monetary and fiscal policies is neoliberal in its essence. Since its general philosophy is to roll back the economic role of the state, it is natural that it would view adequate employment creation as the job of the private sector, and not of the state. At best, the role of the state is seen as creating the 'right' climate for the private sector by increasing its profitability, so that it offers sufficient employment. In this respect it has three distinguishing characteristics contrary to the Keynesian theory.

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First, unlike Keynes and Kalecki, who identified the lack of effective demand in the product market as the central cause of unemployment, these theories locate the central cause of unemployment in the labour market. In terms of policy, this means demand management in the product market becomes less important than correcting the malfunctioning of the labour market. This deemphasizes the role of demand management on the one hand, and brings to the forefront the importance of labour-market 'flexibility' on the other. Secondly, even the branch of theory relatively sympathetic to the Keynesian view (for example the neo-Keynesians), tends to make a distinction between the 'short run' and the 'long run'. It is claimed that there may be insufficiency of demand in the product market in the short run, but somehow the demand problem is resolved in the long run by the market. This is starkly visible in almost all versions of neo-classical long-run growth theory which assumes away the demand problem as a short-run phenomenon. Thirdly, and perhaps most basic to this neo-liberal way of thinking, is its foundation of 'methodological individualism'. It uses some procedure of optimization by the individual agent as the central organizing principle of macroeconomic theory. Approaching macroeconomic problems exclusively in this way has many serious ramifications, and insofar as the unemployment problem is concerned perhaps its most serious consequence is to blur the distinction between 'voluntary' and 'involuntary' unemployment. Thus, all unemployment, even mass unemployment, begins to look voluntary in this framework, because it has to be explained through some optimizing decision by the individual worker, but not by a failure of the system which requires intervention. This then becomes attributable to the imperfect functioning of the price mechanism for giving wrong signals to the worker. In some cases government interventions, mostly related to the welfare state, are supposed to distort the signals carried by wages. An important case in point is the criticism levelled against social safety nets like unemployment benefits provided by the government. A widely prevalent view, propagated by the media as well as some academic economists, is that it raises the 'reservation wage' so much that the worker chooses voluntarily to be unemployed. Another version with a similar thrust is to claim that the worker refuses to take up employment at the prevailing wage, either because (s)he is misinformed and spends all his or her time in search of a better job, or waits until the wage rate becomes higher. For a noneconomist with some common sense these theories lie only a little distance away from the view that some are unemployed because they are

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lazy or unreasonably ambitious who do not know their 'market worth'. In this framework either the jobless worker becomes responsible for his or her own situation; or the blame is put on government intervention. Neo-liberalism relying on the market rather than the government to deal with problems like unemployment has a different kind of advantage which is seldom recognized. Nothing in economic theory specifies how long it might take to reach 'equilibrium', through the market mechanism, even under the most idealized circumstances of perfect competition, when the competitive equilibrium has all the desirable properties of so-called Pareto-optimality by the 'fundamental theorem' of welfare economics. In democracies, the government and the politicians in power remain accountable to their people at regular time intervals through the elections, but the market mechanism has no such definite time horizon for showing results. And, this ambiguity helps in sustaining the market ideology insofar as it can always be claimed that, given 'sufficient' time and 'sufficiently' wide-ranging pro-market reforms, the desired results would materialize without having to specify how long is sufficiently long. The market mechanism, like a dictator, can always promise without actually delivering! The virtues of sticking adamantly to pro-market policies as the solution to the unemployment problem get further strengthened by the role of the media. The enormous power wielded by electronic media and television images in shaping public opinion was noticed by perceptive commentators even in the very early stage of current globalization (see for example McLuhan 1960). It helps in spreading a sort of a popular culture in economic policy, policies that can be easily comprehended by 'practical' men and women. In this respect, most appealing is the analogy with the individual. Since spending beyond means is considered bad for the individual, a budget deficit of the government is also considered bad; because the demand for apples can be raised by lowering its price, the demand for labour can also be raised by lowering the wage rate; hard work helps, so a corporate manager helps the economy by downsizing its labour force. Underlying these pronouncements, popularized by the media, is the foundation of 'methodological individualism'. Unfortunately, politicians become victims of it, even if some of them understand better, because political expediency often demands that they do not swim against the current of popular 'understanding'. Nevertheless, this popular culture of viewing macroeconomic policies exclusively through the neo-liberal glass of methodological individualism goes against the very logic of having macroeconomics as a distinct branch of enquiry. The latter is justified, precisely in those situations

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when the analogy with the individual is misleading. And, serious unemployment is perhaps the most important example of such a situation, as the Keynesian theory demonstrated. The common mistake in all arguments based on methodological individualism is to fall into the fallacy of composition. Thus, cutting wages may improve the profit margin for one firm, but the total volume of sales in the economy is likely to suffer. Downsizing the labour force may reduce unit cost for one firm, but when followed by many firms it may reduce total employment and the volume of sales in the economy. Even export surplus for one country must be balanced by the import surplus of another; so the strategy of export-led expansion cannot work for all. These familiar examples show why the argument that holds for the individual part may fail to hold for the whole system. Keynesian macroeconomic theory is based precisely on this premise, and the macroeconomic policies to fight unemployment follows from the fundamental insight that, unlike in the case of the individual, the macroeconomy is characterized by a circular flow from expenditure to income. Expenditure by creating demand may determine output and employment in situations of serious unemployment and excess capacity. Policies for high employment It is against this intellectual background that we need to reconsider policies for attaining and sustaining higher employment. However, at the very outset of this policy discussion it is worth pointing out that many different types of projects may be devised for generating employment. By and large these projects would be country-specific, dependent on geography, stage of development, degree of openness, and so on. The purpose of economic theory in this context is not to list a set of such projects irrespective of the country-specificity, but to indicate the direction in which an employment-generating and employment-sustaining programme can become feasible. The problem of servicing debt exists, but it is far from clear why a government cannot take recourse to further borrowing to service its debt, so long as its higher spending is effective in raising the employment level and the rate of growth. The well-known result that so long as the growth rate exceeds the interest rate in real terms, the debt to income ratio tends to stabilize, might be invoked in this context to serve as a guide. On the whole it seems misplaced to argue that a growing debt-servicing burden necessarily strains the credibility of a government under all circumstances. A government's economic credibility might

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indeed suffer more due to persisting high unemployment and low growth. Therefore, the real issue to be faced is whether government spending can be effective in raising productive employment opportunities and growth prospects. This is indeed the crux of the problem, and needs to be decomposed in two parts. First, to the extent the economy faces insufficiency of demand with excess capacity, the traditional Keynesian remedy should be reasonably effective provided the composition of demand, governed mostly by income elasticities, is broadly in line with the pattern of excess capacities in various industries. In that case, until it really begins to overheat the labour market, even the financial markets might not react unfavourably. Anyway, with considerable excess capacity, inaction is no solution in the face of growing unemployment. The second part of the problem is to devise suitable programmes for government spending. Going against received wisdom, it needs to be pointed out that extensive labour training schemes of various sort can not be of much help. Because, although it might improve labour productivity, without strong demand-side policies such training would only raise the bar for entering the labour market. Thus, while the better trained persons would probably have a higher chance of getting a job, macroeconomically it would not be a very effective policy for the entire labour force. It would be rather like changing the positions of the candidates in a long queue for a fixed number of jobs, without being able to shorten the length of the queue. A better policy with respect to training might be to have a government and private sector forum to agree on the types of training needed in view of both the composition of demand and cost-effectiveness. The training programmes would be partly financed by the government on the understanding that the private firms would simultaneously provide on-the-job training as the rest of the financing. Second, instead of large centralized projects, it might be better to decentralize them. This would at least have the advantage of identifying the regions in which government spending has been relatively more effective in fighting unemployment, and would thus introduce an element of competition into the allocation of public funds. Finally, in the post-industrial societies with aging populations, there might be considerable scope for creating innovative services for the aged. Note that better care of the aged is a demand that cannot be easily saturated, and therefore provides a longer-term perspective on the directions of training and public spending. For financially sustaining these programmes, the government and beneficiaries might share the costs

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through voluntary schemes of using part of pension and insurance funds. It is the increased quality and productivity of labour in these socalled non-tradable areas of services, directed at the domestic rather than the external market, in which the future for a better quality of life with higher employment in post-industrial societies may well lie. Beyond this suggested long-term path of development of the service industry, the problem of labour-market flexibility also has another longrun aspect which is overlooked in current policy discussions. Higher labour productivity tends to reduce prices by reducing unit costs in the more competitive industries. For given money wages, this raises the product wage rates in these industries, normally implying an increase in the overall real wage rate. Therefore, unless labour productivity rises more or less in line with increasing real wage, the share of wages in income would tend to increase over time. However, the observed relative stability of the wage share over the longer run suggests that productivity growth itself adjusts to rising real wages, just as the wage claims of workers have to adjust to the growth in labour productivity. In the long run, therefore, a two-way relationship seems exist between the growth rate in wage and in productivity which might be a central driving force of 'endogenous' growth, making technology appear as 'neutral' to distribution in successful market economies (Bhaduri 2006). In this virtuous circle of positive feedbacks or cumulative causation, growth in productivity tends to raise the real wage rate by lowering unit costs and prices due to competition among firms, while rising real wages induces firms to increase productivity for maintaining their profit margins. Viewed from this longer-run perspective, artificially imposed wage restraints might well weaken this complex positive feedback mechanism between productivity and real-wage, generating economywide increasing returns. This process has been recognized as a potent dynamic force in the successful development of capitalism, at least since Adam Smith identified division of labour as a main source of the wealth of nations. To ignore this dynamic force propelling long-term growth in the name of labour-market flexibility might turn out to be counterproductive, and not a sign of wisdom for the successful management of capitalism.

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References Bank for International Settlements (2001) Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, preliminary global data, press release (9 October). Bank for International Settlements (2002) 'Quarterly Review of International Banking and Financial Markets Development', Statistical Annex (March 2002).

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Bhaduri, A. (1986) Macroeconomics: The Dynamics of Commodity Production (London: Palgrave Macmillan). Bhaduri, A. (2006) 'Endogenous Economic Growth: A New Approach', Cambridge Journal of Economics (forthcoming). Bhaduri, A. and Marglin, S. (1990) 'Unemployment and the Real Wage. The Economic Basis of Contesting Political Ideologies', Cambridge Journal of Economics, 14: 375-95. Bhaduri, A. and Steindl, J. (1985) 'The Rise of Monetarism as a Social Doctrine', in P. Arestis and T. Skouras (eds) Post-Keynesian Economic Theory (Sussex: Weatsheaf). Friedman, M. (1968) 'The Role of Monetary Policy', American Economic Review, 58: 1-17. Hobsbawm, E. (1994) The Age of Extremes. A History of the World, 1914-1991 (New York: Pantheon Books). Kalecki, M. (1971) 'Political Aspects of Full Employment' [1943], in M. Kalecki, Selected Essays in the Dynamics of the Capitalist Economy (Cambridge: Cambridge University Press). Layard, R., Nickell, S. and Jackman, R. (1991) Unemployment, Macroeconomic Performance and the Labour Market (Oxford: Oxford University Press). Marglin, S. and Schor, J. (eds) (1990) The Golden Age of Capitalism (Oxford: Oxford University Press). McLuhan, M. (1960) Explorations in Communications (Ontario: University of Toronto Press). Rowthorn, R. (1977) 'Conflict, Inflation and Money', Cambridge Journal of Economics, 1: 215-39.

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The Causes of High Unemployment: Labour-Market Sclerosis v. Macroeconomic Policy* Thomas L Palley

The debate over the causes of high u n e m p l o y m e n t The economies of Western Europe remain afflicted by high and intractable rates of unemployment, with the European Union unemployment rate standing at 8.1 per cent as of August 2004, while the unemployment rate in the 12-country euro-zone area was 9.0 per cent. Moreover, European unemployment rates have been stuck at these levels for several years. In stark contrast, the US unemployment rate touched a 30-year low of 3.9 per cent in September 2000, rose to 6.3 per cent in the most recent recession, and was back down to 5.4 per cent in September 2004. This divergence in performance has opened a great debate that is being especially vigorously pursued in Germany. One side claims that Europe's unemployment is the result of rigid sclerotic labour markets that have rendered it incapable of adjusting to technological advance and change in the international economy. Unemployment benefits are too generous and their duration too long, unions are too strong, and employee protections are such that firms are discouraged from hiring workers. This contrasts with the US economy, which is marked by flexible dynamic labour markets that have adjusted to these developments and used them to create new jobs.

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* This chapter was originally published in Challenging the Market: The Struggle to Regulate Work and Income, Jim Stanford and Leah E Vosko (eds), McGill-Queen's University Press, 2004. My thanks go to McGill-Queen's University Press for permission to reprint this material. 20 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

The other side claims that Europe's unemployment problem is significantly attributable to bad macroeconomic policy (Baker and Schmitt 1998; Palley 1998, 1999; Solow 1994), which has resulted from mistaken adherence to the theory of the natural rate of unemployment. This has prompted policy-makers to adopt austere macroeconomic policies aimed at reducing inflation regardless of the unemployment cost or the underlying cause of inflation. Currency market concerns have also played an adverse role. In the 1980s and 1990s the persistent threat of currency speculation induced European governments to raise rates so as to defend their currencies and guard against imported inflation. Subsequently, arrangements leading up to the introduction of the euro aggravated the problem as countries were forced to satisfy strict fiscal convergence criteria that called for policies of austerity irrespective of economic conditions. The net result has been a persistent contractionary bias to policy, and policy has also exhibited insensitivity to the state of the business cycle. Contrastingly, US macroeconomic policy has been relatively flexible and counter-cyclical (Palley 1999). Both the US budget deficit and Federal Reserve monetary policy have exhibited clear counter-cyclical fluctuation, and in the recession of 1990-91 the Fed lowered short-term nominal rates such that the real rate was zero. Moreover, this sharp difference in macroeconomic policy persists through to the present. Thus, when the last recession began in 2001 the US Federal Reserve slashed its interest rate in the first six months of the year by over 40 per cent, lowering rates from 6.5 per cent in January to 3.75 per cent in June. Side-by-side, fiscal policy shifted into expansionary mode with a significant tax cut, albeit one tilted toward the affluent. And these policy shifts were undertaken despite the fact that the unemployment rate was still below 4.5 per cent and the inflation rate had actually increased above 3 per cent. Moreover, when robust recovery failed to take hold the Fed lowered rates further to 1.25 per cent in November 2002 and has only recently begun a marginal reversal of these rate reductions. In stark contrast, the European Central Bank was slow to lower interest rates as global recession set in, and the ECB has kept its interest rate above that of the Fed despite the fact that Europe's unemployment is significantly higher than that of the United States. The bottom line is that the monetary and fiscal policy have displayed greater ease and counter-cyclicality in the USA than in Europe. These two accounts of unemployment have enormously different policy implications. If the labour-market flexibility hypothesis is correct, Europe needs to adopt the US model and introduce policies of labourmarket flexibility that render wages downwardly flexible, reduce employee protections, and reduce unemployment benefits and other

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Thomas I. Palley 21

social protections. If the macroeconomic policy hypothesis is correct, Europe should adopt expansionary macroeconomic policies predicated on lower real interest rates. It also needs to adopt policy rules that ensure monetary and fiscal policy move in counter-cyclical fashion. The outcome of this controversy is not only germane to the countries of the OECD, it is also relevant for the developing economies which are marked by a parallel debate. Thus, the Washington Consensus which represents the developing-country analogue of the Euro-sclerosis hypothesis - maintains that employment and output growth in the developing world depends upon the adoption of policies of labourmarket flexibility. Supporters of this consensus therefore counsel developing countries to resist calls for international labour standards since such standards would promote worker rights of freedom of association and collective bargaining. These observations spotlight the critical nature of the debate over the causes of unemployment. How it is resolved promises to have deep lasting impacts on policy in both developed and developing countries. This chapter provides some new evidence on the relative contributions of macroeconomic factors and labour market institutions to unemployment in the OECD. The principal empirical innovation here is that we combine macroeconomic time series variables that capture the stance of macroeconomic policy with microeconomic labour-market institution variables. This means that the effects of both labour-market institutions and macroeconomic policy are taken into account in statistical examinations of the causes of higher unemployment. The principal findings are that macroeconomic policy variables consistently and robustly matter for the evolution of country unemployment rates, and that macroeconomic policy affects unemployment rates in the manner expected. High real interest rates and slow growth raise unemployment, as does a slowdown in export growth. With regard to the microeconomic labour market variables the evidence is more problematic. Unemploymentbenefit duration and union density are both consistently insignificant. The level of wage bargaining coordination and the extent of union coverage matter consistently, but they need not raise unemployment if they are appropriately paired with other policies. Finally, the significance of other microeconomic variables (employment protection, unemploymentinsurance wage replacement rate, tax burden) is unstable and not robust to changes in specification. These findings lead to the conclusion that high unemployment in Western Europe is principally the result of self-inflicted dysfunctional macroeconomic policy. European policy-makers adopted a course of disinflation, high real interest rates and slower growth that raised 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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22 The Causes of High Unemployment

unemployment. Moreover, they all adopted this course at the same time, thereby generating a wave of trade-based cross-country spillovers that generated a continent-wide macroeconomic funk and further raised unemployment. A last important finding is that real interest rates have tended to be systematically higher in countries with high union density despite the lack of any evidence that high union density raises inflation. This suggests that central banks have systematically raised interest rates in countries with high union density. Evidence o n the causes of OECD u n e m p l o y m e n t As noted above, the principal contribution of the current study is to fully incorporate both microeconomic labour-market institution variables and macroeconomic variables, thereby allowing for a proper assessment of the relative contributions of labour market institutions and macroeconomic policy to higher unemployment. This section describes the data, the empirical model and the empirical findings. Data Data for the labour market institutional variables were supplied by Nickell, and are described in his widely cited study on the impact of labour market rigidities on unemployment (Nickell 1997). Data for the macroeconomic variables were drawn from the annex tables in the 1999 OECD Economic Outlook, the World Bank CD-ROM, and IMF CD-ROM.1 Further details regarding the data are provided in the Appendix. The macroeconomic variables are annual time series data so that there is one observation per year for each variable for each country. Contrastingly, the labour-market institution variables correspond to fixed effects. For each type of labour-market institution a six-year average measure was constructed for each country covering the periods 1983-88 and 1989-94. Thus, for each institution in each country there are two observations - one for the period 1983-88, and the other for the period 1989-94. Lastly, data for the following countries was used in the regressions: Austria, Belgium, Denmark, Finland, France, Germany, Holland, Ireland, Italy, Norway, Portugal, Spain, Sweden, Switzerland, the UK, Australia, New Zealand, Japan, the USA and Canada (see Table 2.1). Table 2.1 shows average macro data and labour-market institution data for these 20 countries for the periods 1983-88 and 1989-94. The macroeconomic data are average standardized unemployment rate (%), average real GDP growth (%), average inflation rate (%), average shortterm nominal interest rate (%), and average short-term real interest 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Thomas I. Palley 23

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10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

rate (%) defined as the difference between the short-term nominal interest rate and inflation rate. The labour-market institution data are the wage replacement rate (%), unemployment benefit duration (years), an index of employment protections (1-20), union density (%), the overall tax rate (%), index of spending on active labour market programmes, index of union wage coverage (1-3), and an index of coordination in wage bargaining (2-6). There are a number of features worth remarking. First, with regard to unemployment rates the USA is in the bottom half of the distribution, but many countries also had lower unemployment rates over the period 1983-94. Second, inflation rates were much higher in Europe in the first half of the sample, but they fell significantly in the second half. Third, average short-term real interest rates have been very much lower in the USA than in the rest of the world. These two features, disinflation and higher real interest rates in Europe, are indicative of the more difficult macroeconomic conditions that have confronted European economies. With regard to the labour-market institution data, the USA clearly has the most laissez-faire markets as indicated by its low wage replacement rate, low benefit duration, low level of employment protections, low union density, low tax rate, low spending on active labour market programmes, low union wage coverage, and low level of coordination of wage bargaining. Many of these features carry over to the Anglo-Saxon economies of the UK, Canada and New Zealand - particularly regarding employment protection, tax rates, labour market spending, union wage coverage, and coordination of wage bargaining. However, despite having deregulated labour markets, Australia, Canada, New Zealand and the UK all tended to have unemployment rates that clustered at the top of the distribution. An empirical model The empirical model used to estimate the causes of unemployment is given by: UNEMP;-t = a0 + ajUNEMP^! + a2UNEMP;-f_2 + a3EMPROTM + a4REPRATE/t + a5BENDUR;-1 + a6UNIONDEN;-1 + a7UNIONCOV;-1 + a8COORD;-1 + a9TAXRATE;-1 + a10ALMPROG/t + anDINFLATEM + a^REALINT,^ + a13GDPGROW/#t + a14GDPGROW; ^ + a15EUROPEN/t + a16CANUS;-t + a17IREDUM;-f + a18SPADUMM + uj>t (2.1)

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Thomas I. Palley 27

28 The Causes of High Unemployment

UNEMP, t EMPPROT; t REPRATE; t BENDURy1 UNIONDEN;-1 UNIONCOV, t

COORD; t TAXRATE; t ALMPROG;1

DINFLATE; t REALINT; t GDPGROW,- t EUROPEN, t

CANUS7/1

IREDUM SPADUM u7/1

standardized unemployment rate in country / in year t index of employment protection (1-20) in country /. unemployment insurance wage replacement rate (%) in country /. benefit duration (years) in country /. union density (%) in country /. extent that union wage coverage extends to non-union workers (1 = less than 25%, 2 = 25-70%, 3 = greater than 70%) in country /. extent of coordination (index = 2-6) of wage bargaining amongst unions and employers in country /. total tax rate (sum of average payroll, income and consumption tax rates) in country /. measure of active labour market policy (spending per unemployed worker as a per cent of the potential output per worker) in country /. change in the CPI inflation rate (%) in country / in year t. real interest rate (%) in country / in year t rate of real GDP growth (%) in country / in year t. measure of exposure of individual European countries to intra-European trade in year t (0 for non-European countries). measure of exposure of the Canadian economy to trade with the USA in year r (0 for all countries except Canada). dummy variable capturing effects specific to unemployment in Ireland. dummy variable capturing effects specific to unemployment in Spain. residual.

The variables can be broken down into three sets. The microeconomic labour market variables consist of EMPROT, REPRATE, BENDUR, UNIONDEN, UNIONCOV, TAXRATE, COORD and ALMPROG. The macroeconomic variables consist of DINFLATE, REALINT, GDPGROW, EUROPEN and CANUS. The significance of the EUROPEN and CANUS variables is discussed below, and the construction of these variables is described in the Appendix. Lastly, the IREDUM and SPADUM capture 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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The definition of variables is as follows:

fixed effects that are specific to Ireland and Spain. Both of these economies had much higher unemployment rates over the sample period, reflecting their position as quasi-developing economies on the periphery of the European Union.2 With regard to the specification of the empirical model, the inclusion of two lags of the unemployment rate as explanatory variables reflects the fact that adjustment in labour markets tends to be gradual as it takes time for workers to reallocate and for firms to create new jobs. As a result, all economies exhibit considerable persistence to unemployment shocks. With regard to the macroeconomic variables, the effects of macroeconomic policy and conditions is captured by the change in the inflation rate (reduced inflation corresponds to tight policy), the level of real interest rates (high real rates corresponds to tight policy), and the rate of real GDP growth. The inclusion of the economic openness variables, EUROPEN and CANUS, is especially important. These variables capture the cross-country Keynesian multiplier effects that operate through international trade. Within the European economy it is critical to control for cross-country growth spillover effects owing to the high degree of economic integration among countries. Just as an explanation of unemployment in Texas would need to control for developments in the US economy, so too a similar logic holds in Europe where countries are very integrated economically with each other. This same logic also holds for Canada which is highly integrated into the US economy. Such effects are noticeably absent from other studies examining the causes of higher European unemployment (Nickell 1997; Blanchard and Wolfers 2000). The Appendix describes the construction of the EUROPEN and CANUS variables. Empirical findings Table 2.2 reports several regression estimates of equation (2.1) based on a two-stage least-squares analysis for the sample period 1983-94.3 Column (a) reports the benchmark regression equation which contains just two lags of country unemployment rates. In this model there are assumed to be absolutely no differences between countries, and both micro institutions and macro policy and performance factors are absent. Despite this, the model has considerable explanatory power as measured by the adjusted R2 which indicates the goodness of fit of the model with the data. This highlights the fact that persistence in unemployment rates is a feature common to all economies, and it should therefore be incorporated in all models of unemployment. Column (b) expands the benchmark equation to include labourmarket institution variables. The coefficients of the replacement rate 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Thomas I. Palley 29

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10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

-0.014 (-1.56)

-0.029*** (-3.23)

0.959 0.896 240

1.028 (3.07) 2.440 (5.74) 0.964 0.840 239

DINFLATE REALINT(-l) GDPGROW GDPGROW ( - 1 )

-0.002 (-0.230) -0.084*** (-3.54) 0.070*** (3.85) -0.236*** (-10.23) -0.055* (-1.68)

EUROPEN CANUS IREDUM SPADUM Adj.i? 2 S.E. N=

0.956 0.930 240

0.977 0.664 239

-0.006 (-0.81) -0.077*** (-3.27) 0.061*** (3.39) -0.245*** (-9.30) -0.67*** (-2.08) -0.227*** (-2.62) -0.318 (-1.49)

0.978 0.655 239

-0.019*** (-2.73) -0.064*** -0.080*** -0.0861 (-3.51) (-2.86) (-3.58) 0.046*** 0.046*** 0.0401 (2.97) (2.70) (2.41) -0.257*** -0.225*** -0.274' (-10.65) (-9.01) (-10.78) -0.079** -0.103*** -0.040 (-3.31) (-2.48) (-1.21) -0.167** -0.269*** -0.135' (-2.97) (-2.51) (-2.00) -0.057 -0.288 -0.031 (-0.29) (-1.44) (-0.15) 1.332*** 1.196*** (4.87) (4.84) 1.229*** 1.536*** (4.56) (4.49) 0.979 0.976 0.981 0.641 0.682 0.615

239

239

239

Notes: T-statistics are in parenthesis. *** significant at the 1% level; ** significant at the 5% level; * significant at the 10% level. Source: See Appendix.

OO

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ALMPROG

(REPRATE) and the overall tax rate (TAXRATE) are both statistically significant at the 5 per cent level, and both raise unemployment. The extent of wage bargaining coordination (COORD) is significant at the 1 per cent level and lowers unemployment. Employment protections (EMPPROT) and union coverage (UNIONCOV) are both significant at the 10 per cent level, and both raise unemployment. Lastly, benefit duration (BENDUR), union density (UDEN) and active labour market programmes (ALMPROG) are all insignificant at the 10 per cent level. Regression (c) further expands the model to include country-specific effects for Ireland (IREDUM) and Spain (SPADUM). Both of these countryspecific effects are statistically significant and positive at the 1 per cent level, and their inclusion dramatically changes the significance of other explanatory variables. Now, both the employment protection index and replacement rate become statistically insignificant at the 10 per cent level, but union density and spending on active labour market programmes now both become statistically significant at the 1 per cent level. This is indicative of coefficient instability among the microeconomic labour-market institution variables. Regression (d) begins the task of incorporating macroeconomic variables by including the change in inflation (DINFLATE), the lagged real interest rate (REALINT(-l)), and the current and lagged real output growth (GDPGROW and GDPGROW(-l)). Inclusion of these variables dramatically improves the quality of the regression estimate as indicated by the jump in the adjusted R2 statistic and the fall in the standard error of the regression equation. The variables DINFLATE, REALINT(-l) and GDPGROW are all statistically significant at the 1 per cent level, while GDPGROW(-l) is statistically significant at the 10 per cent level. All are signed in a manner consistent with conventional understandings of the impact of macroeconomic policy on unemployment. Disinflation raises unemployment, as do higher real interest rates.4 Faster growth lowers unemployment. As regards the labour-market institution variables, inclusion of the macro variables causes major changes. First, the union density coefficient becomes insignificant - a feature which is examined in greater detail below. Second, the statistical significance and magnitude of the tax coefficient falls considerably. Third, the variables EMPROT and REPRATE now become significant at the 1 per cent level, which is indicative of coefficient instability surrounding these variables. This too is further discussed below. Column (e) further augments the model by including the international trade exposure variables EUROPEN and CANUS. The former is

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32 The Causes of High Unemployment

significant at the 1 per cent level, while the latter is only significant at the 14 per cent level. Both are negatively signed. The large magnitude and clear statistical significance of the coefficient of EUROPEN indicates the importance of interdependence amongst European economies.5 The signs of the other macro variables (DINFLATE, REALINT(-l), GDPGROW, GDPGROW(-l)) remain unchanged, and all coefficients are statistically significant at the 1 per cent level. The coefficients of these macroeconomic variables are robust and stable with regard to changed model specification, lending confidence to their importance for explaining unemployment. With regard to the micro variables, BENDUR, UNIONDEN, TAXRATE and ALMPROG are all statistically insignificant at the 10 per cent level. REPRATE, UNIONCOV and COORD are statistically significant at the 1 per cent level, while EMPROT is significant at the 6 per cent level. Column (f) reports the findings for the full model that includes all labour-market institution variables, all macroeconomic variables, and the Ireland and Spain country fixed effect variables. The coefficients of all the macroeconomic variables remain same-signed, and all except the CANUS variable are statistically significant at the 1 per cent level. The Ireland and Spain country fixed effects are also both positive and statistically significant at the 1 per cent level. However, most of the labourmarket institution variables are statistically insignificant. This holds for the employment protection index (EMPROT), the wage replacement rate (REPRATE), benefit duration (BENDUR) and union density (UDEN). The full model therefore suggests that none of these variables matter for explaining unemployment. Spending on active labour market programmes (ALMPROG) is statistically significant at the 1 per cent level, and it contributes to lower unemployment. The overall tax rate (TAXRATE) is also significant at the 10 per cent level, and higher taxes rates raise unemployment. This fully specified model helps understand a number of features. First, both union wage coverage (UNIONCOV) and the extent of coordination in wage bargaining (COORD) are significant at the 1 per cent level, and both variables are statistically significant in most of the other regressions. These variables have opposite signs with the former being positive, while the latter is negative. The UNIONCOV variable takes values of 1-3, while the COORD variable takes values of 2-6. These two variables are strongly positively correlated, having a correlation coefficient of 0.49, and a regression of COORD on UNIONCOV yields: UNIONCOV = 1.897 + 0.197 COORD, (25.53)

Adj. R2 = 0.235

(2.2)

(11.11)

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Thomas I. Palley 33

Figures in parentheses are t-statistics. Thus, if COORD = 2, the predicted value of UNIONCOV = 2.3: if COORD = 6, the predicted value of UNIONCOV = 3.1. The two variables therefore co-move strongly and systematically, and should best be thought of as a 'system of industrial relations'. Coordination in wage bargaining lowers unemployment, while union wage coverage raises it. As long as these two features are appropriately paired, there need be no negative impact on unemployment. 6 Problems only emerge when there is extensive union wage coverage unaccompanied by wage bargaining coordination. This finding is consistent with the work of Calmfors and Drifill (1988).7 Second, the inclusion of the country dummy variables for Ireland and Spain causes the EMPROT and REPRATE variables to become statistically insignificant. Inspection of Table 2.1 shows that Spain had extremely high unemployment rates, and it also had an extremely high level of employment protection and a very high replacement rate. The statistical significance of these two institutional variables therefore appears to be entirely related to Spain - that is, it is an outlier phenomenon. When a Spain dummy is included, they become insignificant. This phenomenon holds for both the full model (compare regressions (e) and (f)) and for the restricted model with just labour-market institution variables (compare regressions (b) and (c)). The policy implication is that existing employment protections and wage replacement rates have not been a contributory factor to European unemployment, except perhaps in Spain. Finally, regressions (g) and (h) provide estimates of the restricted model with just macroeconomic variables. These regressions are presented to give additional evidence of the significance of macroeconomic factors for explaining unemployment. The coefficients of the macro variables continue to be highly statistically significant, they remain same-signed and their magnitude is little changed. At the same time, the restricted regressions with just macro variables perform very well in terms of adjusted R2 and standard error of the regression, being only marginally worse than the full model which includes the labour-market institutional variables. Further interpreting the results In sum, the regressions reported in Table 2.2 provide clear evidence of the importance of macroeconomic forces for unemployment. This conclusion is robust to empirical specification. Based on regression (f), permanently lowering the inflation rate by 1 percentage point increases unemployment by 0.4 percentage points. An increase in real interest

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34 The Causes of High Unemployment

rates of 1 percentage point increases unemployment by 0.3 percentage points. Lowering the rate of real output growth by 1 percentage point increases unemployment by 2.1 percentage points. This latter finding implies an Okun coefficient of one-half. This is fully in accordance with existing estimates of the Okun coefficient (Palley 1993), which lends additional support to the results presented. For a European country that exports 20 per cent of its GDP, a 1 percentage point increase in the growth rate of other European economies results in a 0.35 percentage point decrease in that country's unemployment rate. Regression (f) indicates that a one hundred basis point increase in the real interest rate increases the unemployment rate by 0.4 percentage points. During the period 1989-94, the US real interest rate averaged 1.80 per cent. In Canada the real interest rate averaged 4.7 per cent, raising the Canadian unemployment rate relative to the USA by 1.2 percentage points. In Germany the real interest rate averaged 4.03 per cent, raising the German unemployment rate relative to the USA by 0.9 percentage points. In France it averaged 6.12 per cent, raising the French unemployment rate relative to the USA by 1.7 percentage points. Finally, in the Scandinavian countries (Denmark, Finland, Norway and Sweden) the real interest rate averaged 5.87 per cent, raising the Scandinavian unemployment rate relative to the USA by 1.6 percentage points. With regard to the labour-market institution variables, the regressions provide no evidence that lowering employment protections, replacement rates or benefit durations will reduce unemployment. Nor will lowering union density. However cutting taxes can. A 10 percentage point reduction in tax burdens (which in most countries means reducing taxes by about one-fifth) lowers the unemployment rate by only 0.8 percentage points. Increasing spending on active labour-market policies has a much bigger bang for buck. Increasing active labour market spending per unemployed worker by an amount equal to 10 per cent of potential output per worker lowers the unemployment rate by 1.2 percentage points. Spending on job training and placement programmes for the unemployed is therefore a more cost-effective fiscal approach to the problem of unemployment. Finally, if properly paired, coordination of wage bargaining and union wage coverage can actually lower unemployment. If both of these institutions were maximally implemented (UNIONCOV = 3, COORD = 6), then the unemployment rate would be reduced by 0.6 percentage points. Of course if there is widespread union wage coverage and no coordinated wage bargaining, then unemployment rates will rise.

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Thomas I. Palley 35

36 The Causes of High Unemployment

The previous section reported several estimates of structural equations determining the causes of unemployment. This section changes the focus of analysis and uses these estimates to identify what caused country unemployment rates to change between 1983 and 1994. For this purpose, the preferred equation is that reported in column (f) of Table 2.2. According to this equation, the contribution of microeconomic institutional factors to unemployment is given by: 0.007 EMPPROT,-1 + 0.007 REPRATE,-1 + 0.007 BENDUR; t + 0.007 UNIONDEN,t MICRO,-1 = /0.154 + 0.541 UNIONCOV; t - 0.286 COORD, \ + 0.012 TAXRATE, t - 0.019 ALMPROG,'t

(2.3)

The change in unemployment rates attributable to changes in labour market institutional factors is then computed as: DMICRO = MICROy - M I C R O y

(2.4)

Table 2.3 reports an analysis that decomposes the actual change in country unemployment rates between 1983 and 1994 into those parts attributable to micro and macro factors. Columns (1) and (2) detail the country unemployment rates ruling in 1983 and 1994 respectively, while column (3) reports the change in country unemployment rates between 1983 and 1994. Column (4) then details that part of the change attributable to changed microeconomic institutional settings. Finally, column (5) details the change in unemployment rates attributable to macroeconomic factors. This macroeconomic component is computed as: DMACRO = DUNEMP - DMICRO

(2.5)

The table has a number of interesting and important findings. First, DMICRO is negative in 13 out of 20 countries, indicating that most countries have pursued policies designed to flexibilize labour markets. Second, DMACRO is positive in 15 out of 20 countries, indicating that over the period 1983-94 most countries experienced negative macroeconomic outcomes that raised unemployment rates. Third, in Europe's three biggest economies (France, Germany, Italy) these negative macro shocks were quantitatively large. In all three economies the direction of microeconomic change was such that unemployment should have

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Quantifying the causes of changed u n e m p l o y m e n t rates

Thomas I. Palley 37

d) Country Austria Belgium Denmark Finland France Germany Holland Ireland Italy Norway Portugal Spain Sweden Switzerland UK Australia New Zealand Canada USA Japan

UNEMP 1983 (%)

(2) UNEMP 1994 (%)

(3) DUNEMP (2) minus (1)

(4) DMICRO 1983-94

(5) DMACRO 1983-94

3.8 11.1 10.3 6.1 8.1 6.9 9.7 14.0 7.7 3.5 7.8 17.5 3.7 0.9 11.1 10.0 5.8 11.9 9.6 2.7

3.8 10.0 8.2 16.8 12.3 8.4 7.1 14.3 11.4 5.5 7.0 24.1 9.4 3.8 9.6 9.7 8.1 10.4 6.1 2.9

0.0 -1.1 -2.1 10.7 4.2 1.5 -2.6 0.3 3.7 2.0 -0.8 6.6 5.7 2.9 -1.5 -0.3 2.3 -1.5 -3.5 0.2

-0.79 -0.51 -0.26 2.29 -0.34 -1.61 -0.89 -0.69 -1.68 -0.77 -1.69 -0.64 0.23 1.63 3.80 -0.38 0.40 0.20 0.05 0.25

0.79 -0.59 -1.84 13.17 4.54 3.11 -1.71 0.99 5.38 2.77 0.89 7.24 5.47 1.27 2.3 0.80 1.90 -1.70 -3.45 0.05

Source: See Appendix.

fallen, but instead unemployment rose owing to the large scale of macroeconomic shocks. Fourth, US unemployment fell by 3.5 percentage points, and this decline was almost entirely due to favourable macroeconomic conditions. Fifth, Finland, Sweden and Spain all suffered large increases in unemployment rates, and in all three instances the increase was almost entirely due to unfavourable macroeconomic forces. Sixth, Belgium, Denmark and Holland experienced reductions in unemployment rates, and favourable macroeconomic developments explain more than 50 per cent of the decline in these three cases. In sum, almost all of the decline in the USA is attributable to positive macro forces, while almost all of the increase in Europe is attributable to negative macro forces. And in those few instances in Europe where unemployment rates fell, macro forces were again primarily responsible. The policy implication is clear. Rather than engaging in a wholesale remaking of labour-market institutions and arrangements, European

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Table 2.3 Decomposition of the causes of changing unemployment rates into factors due to changing labour-market institution (DMICRO) and macroeconomic slowdown (DMACRO)

governments should correct the dysfunctions that have driven macro economic policy over the last two decades. That these dysfunctions remain in place is clearly evident in the different policy responses of the Federal Reserve and the European Central Bank to the economic slowdown of 2001. The political e c o n o m y of monetary policy: have central bankers waged war o n unions? Both Nickell (1997) and Scarpetta (1995) report that union density has a statistically significant positive impact on unemployment rates. This contrasts sharply with the findings reported in the current study, and it is worth enquiring as to the source of this difference. One clue to this difference comes from a comparison of regressions (2.c) and (2.d) in Table 2.2 in which the inclusion of macroeconomic variables appears to undo the unemployment impact of union density. In the regressions reported by Nickell (1997) the only macro variable is the change in inflation rates. This suggests that the effect may be related to the inclusion of real interest rates. To test this hypothesis, union density was regressed against the average measure of country real interest rates shown in Table 2.1. The resulting pooled least-squares regression, with and without a time dummy to capture changes in financial market conditions across the periods 1983-88 and 1989-94, is given by: REALINT, = 3.505 + 0.032 UNIONDEN, (5.33)

(2.27)

2

Adj.R = 0.096 N = 40

(2.6a)

REALINT. = 2.943 + 0.035 UNIONDEN, + 0.923 TIMEDUMMY (4.12)

(2.49)

(1.77)

2

Adj.R = 0.145 N = 40

(2.6b)

Figures in parentheses are t-statistics. In both regressions, with and without a dummy for the period 1989-94, the coefficient of UNIONDEN is positive and statistically significant at the 5 per cent level. According to these regressions, a 10 per cent absolute increase in the union density rate therefore results in a 0.3 percentage point increase in the real interest rate.

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38 The Causes of High Unemployment

Thomas I. Palley 39

REALINT, t = 1.822 + 0.483 REALINT.-1_! + 0.018 UNIONDEN, (4.82)

(10.11)

'

(2.36)

2

Adj.JR = 0.333 N = 238

(2.7)

The union density coefficient is positive and statistically significant at the 5 per cent level, and according to equation (2.7) the net effect of a 10 per cent increase in union density is to raise real interest rates by 0.35 per cent. This almost exactly matches the results from regressions (2.6a) and (2.6b). Prima facie, regressions (2.6a), (2.6b) and (2.7) suggest that central bankers may have raised rates in economies where union density is high. However, it is possible that union density causes inflation and central banks were really aiming to lower inflation. To test this hypothesis union density was regressed on average consumer inflation (as reported in Table 2.1) yielding: INFLATION, = 3.854 + 0.023 UNIONDEN, (3.25)

2

Ad).R =N = 40

(0.89)

0.005 (2.8a)

INFLATION, = 4.839 + 0.019 UNIONDEN, - 1.633 TIMEDUMMY (3.76)

(0.74)

(-1.74)

2

Ad].R = 0.045 N = 40

(2.8b)

Both regressions (2.8a) and (2.8b), with and without a dummy for the period 1989-94, show that there is no statistical relation between inflation and union density. This conclusion was further tested by a simple autoregressive pooled time-series model of country inflation rates given by: INFLATION,, = 0.514 + 0.776 INFLATION,t_t + 0.001 UNIONDEN, (1.59)

(26.69)

'

(0.14)

2

Ad].R = - 0 . 0 0 5 N= 240

(2.9)

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To test for robustness, this union interest rate hypothesis was also tested in a simple time-series model with one lag of the real interest rate and with a union density fixed effect for the period 1983-94. The resulting regression was:

Again, figures in parentheses are t-statistics, and again union density has no explanatory power regarding inflation. In sum, regressions (2.8a), (2.8b) and (2.9) all show no statistical relation between inflation and union density. This challenges the defence that real interest rates were higher in countries with higher union density because unions cause inflation. Instead, it looks as if central banks systematically raised interest rates in countries with high union density. This is fully consistent with the idea that monetary policy is a site of class conflict and policy has largely been captured by interests antagonistic to unions (Palley 1997). Labour-market institutions and income inequality Thus far, attention has focused on the impact of labour-market institutions on unemployment. This section shifts the focus to income inequality, and Table 2.4 presents some data on patterns of cross-country income distribution. Simple pooled regressions using the data in Tables 2.1 and 2.4, appropriately matched by year, yield the following relations between income distribution, union density and employment protection: (In)

= 2

\50/,-

06.04 - 0.581 UDEN, (27.78)

(-3.60)

2

Adj.i? = 0.40 N = 19

(2.10a)

f £ ) = 188.03 - 0.612 EMPPROT, 50//

(22.43)

(-3.60)

Ad].R2 = - 0.02 N = 19

(2.10b)

§£ J = 212.35 - 0.582 UDEN, - 0.621 EMPPROT, 50//

(22.95)

(-3.64)

Ad).R2 = 0.41 N=19

(-1.12)

(2.10c)

(IH) = 4-539 " °- 0 2 3 UDEN, \10//

(12.56)

Adj.£2 = 0.29 N=19

(-2.91)

(2.10d)

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40 The Causes of High Unemployment

Thomas I. Palley 41 Table 2.4

Measures of country income distributions

Country

10th/50th

90th/50th

90th/10th

Gini

1989 1987 1992 1991 1992 1991 1984 1989 1991 1987 1991 1992 1987-88 1991

.45 .56 .58 .47 .54 .57 .55 .54 .57 .50 .56 .46 .54 .56

1.93 1.87 1.63 1.83 1.55 1.58 1.93 1.72 1.73 2.09 1.76 1.92 1.87 1.58

4.3 3.34 2.79 3.9 2.86 2.75 3.48 3.21 3.05 4.18 3.14 4.17 3.46 2.8

0.308

1990 1992 1982 1991 1991

.49 .57 .54 .44 .36

1.98 1.59 1.85 2.06 2.08

4.04 2.78 3.43 4.67 5.78

0.306 0.229 0.311 0.335 0.343

Year

Australia Austria Belgium Canada Denmark Finland France Germany Holland Ireland Italy Japan N.Zealand Norway Portugal Spain Sweden Switzerland UK USA

0.23 0.285 0.239 0.223 0.294 0.263 0.249 0.328 0.255 0.315 0.233

Source: Mishel, Bernstein and Schmitt (2000).

| ^ l = 4.196 - 0.060 EMPPROT, /

Adj.R1 N=

(12.16) 2

(- 2.03)

= 0.15

19

(2.10e)

§-"« j

Adj.ff

(13.11)

2

0.023 UDEN, - 0.061 EMPPROT, (-3.38)

N = 19 10 50/,Adj.R2 N=

19

(-2.59)

0.47 (2.10f)

45.987 + 0.141 UDEN, (-3.38) (i3.ii) = 0.18 (2.10g)

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Ratio

42 The Causes of High Unemployment

s o ) = 46.265 + 0.552 EMPPROT, W

U

//

(19.29)

(2.66)

2

Adj.jR = 0.25

50//

(13.74)

0.141 UDEN, + 0.554 EMPPROT, (2.78)

(3.16)

2

Adj.£ = 0.47 N= 19

(2.10i)

GINI, = 0.332 - 0.001 UDEN, (19.07)

(-3.38)

Adj.£ 2 = 0.39 N= 17

(2.10J)

GINI, = 0.307 - 0.003 EMPPROT, (15.06)

(-1.56)

Adj. JR2 = 0.08 N= 17 GINI, = 0.360 (17.59)

Adj.R2 = 0.51 N=17

(2.10k) 0.001 UDEN, - 0.003 EMPPROT, -3.74)

(-2.12)

(2.101)

where (90/50),

= ratio of income of 90th percentile household to median household in country /. (90/10),= ratio of income of 90th percentile household to 10th percentile in country /. (10/50), = ratio of income of 10th percentile household to median household in country /. GINI = Gini coefficient in country /'. UDEN,= u n i o n density (%) in country /. EMPPROT, = index of employment protections (1-20) in c o u n t r y ; . Figures in parentheses are r-statistics. The regressions show that b o t h union density and employment protections work unambiguously to reduce income inequality. Union density reduces income inequality between the top and the middle (90/50), and the top and the b o t t o m

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(2.10h)

N= 19

(90/10).8 Employment protections reduce inequality between the top and the bottom (90/10), but have no impact on the top and the middle (90/50). Both union density and employment protections reduce income inequality between the bottom and the middle (10/50). In sum, unions appear to equalize income across both left and right tails of the income distribution, while employment protections seem to operate on just the left tail. Beyond the wasteland: towards fair and full employment for all The conventional wisdom is that the cause of high European unemployment lies in a job market that is rigid and inflexible. These rigidities include excessive employment protection, too generous replacement rates, too long benefit durations, and high rates of unionization. The empirical results reported in this chapter challenge this received wisdom. These results are based on an empirical model of unemployment that includes both microeconomic labour-market institution variables and macroeconomic variables. The evidence clearly shows that macroeconomic factors matter for unemployment, and these factors are robust to changes in the empirical specification of the model. However, when it comes to microeconomic factors the evidence is much more problematic. The level of wage-bargaining coordination and the extent of union coverage matter consistently, but they need not raise unemployment if they are appropriately paired. The level of benefit duration and the level of union density are both consistently insignificant. The significance of other microeconomic variables (employment protection, replacement rate, tax burden) is unstable and not robust to changes in specification. Moreover, none of these variables is significant in a fully specified model that takes account of country-specific fixed effects related to Ireland and Spain. This leads to the conclusion that high unemployment in Western Europe is the result of a self-inflicted macroeconomic policy. European policy-makers adopted a course of disinflation, high real interest rates and slower growth that raised unemployment. Moreover, since all adopted this course at the same time, they generated a wave of tradebased cross-country multipliers that further raised unemployment and contributed to a continent-wide macroeconomic funk. The policy implications are clear. Lowering European unemployment will require a period of sustained expansionary macroeconomic policy, and this

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Thomas I. Palley 43

44 The Causes of High Unemployment

(0

c o "55 c

A

B

progressive consensus

USA

C

D

Europe

Laissez-faire consensus

(0 ,0

aoo O (0

[jj

.

>

2 15

Figure 2.1 The economic policy menu policy needs to be pursued by all countries. Flexibilizing labour-market institutions will not lower unemployment as these institutions are not the cause of unemployment. Indeed, if it involves just reducing the extent of wage bargaining coordination, it could raise unemployment. The above analysis of the causes of unemployment and factors influencing income distribution is consistent with the two dimensional macroeconomic-microeconomic policy framework presented by Palley (1998) which is shown in Figure 2.1. 9 In this framework unemployment is caused by macroeconomic factors. Microeconomic labour-market institutions protect workers by giving them voice and bargaining power which impact distributional outcomes. Weakening these institutions therefore worsens income distribution but has little impact on unemployment. In the USA macroeconomic policy has been expansionary but labour-market institutions protecting workers have eroded: the result has been low unemployment and increased income inequality. In Europe macroeconomic policy has been contractionary but labour-market institutions protecting workers remain intact: the result has been high unemployment but relatively unchanged income inequality. Restoring the golden age economic prosperity of the post-Second World War era will require expansionary macroeconomic policy combined with labour-market institutions that protect workers' voice and bargaining power.

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Labour Market Policy Regulate Flexibilize

Thomas I. Palley 45 Unfortunately, the laissez-faire 'Washington' consensus that dominates policy-making recommends the exact opposite combination.

This Appendix details the data that was used in the regression reported in Tables 2.1-2.2. All data for the labour-market institution variables (EMPROT, REPRATE, BENDUR, UNIONDEN, UNIONCOV, COORD, TAXRATE, ALMPROG) were provided by Nickell and are as described in Nickell (1997). The macroeconomic data were taken from OECD Economic Outlook (1999), the World Bank CD-ROM, and the IMF CD-ROM. The series on real GDP growth was taken from the World Bank series of that name on the CD-ROM. Updates for 1998 were taken from the World Bank's homepage. These series match the real GDP growth figures reported in the June 1999 OECD Economic Outlook, Annex table 1. Short-term interest rates are from the IMF CD, series 60B, money market rates. For Ireland, series 60C, Treasury Bills, was used due to the unavailability of the money market series. Missing values for New Zealand 1978-82 and Australia 1996-98 were filled in using 60C values. The measures of inflation are the per cent change in consumer prices drawn from the OECD database's purchasing power parity figures for private consumption, updated to match the OECD's published 1999 figures. DINFLATE is computed as the first difference of the annual inflation rates. The real short-term interest rate was computed as the difference between the short-term nominal interest rate and the CPI inflation rate. Standardized unemployment rates were drawn from the Statwise database where available, and completed manually from the OECD Economic Outlook (1999) Annex table 22, with which these figures are in accordance. To extend the series to include values back to 1977, the June 1999 OECD Economic Outlook numbers were supplemented by values from the June 1994 OECD Economic Outlook. However, these two series are not always identical owing to adjustments made by the OECD. To achieve compatibility, the 1994 figures were adjusted hard copy from the OECD. The series were adjusted for compatibility according to the following: 1979 Adj. std. unemp = 1979 std. unemp OECD June 1994 ^ 1980 std. unemp OECD June 1999 1980 std. unemp OECD June 1994 Thus, earlier measures of the standardized unemployment rate were converted to the new basis by multiplying the old series by an adjustment factor. This adjustment factor was computed as the ratio of the first year of the new series to the old measure of standard unemployment in that year. The first year of the series in Annex table 22 is 1980. A similar scaling method was used to create standard unemployment rate values for countries for which they were unavailable. In these instances, values for the commonly used definition of unemployment rates (Annex table 21) were

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Appendix

46 The Causes of High Unemployment adjusted according to:

where the adjustment factor was calculated for the earliest year for which the standard unemployment series was available. The countries to which this was applied are: Denmark, Austria, Portugal, Ireland; New Zealand had a scalar of 1. The cross-country Keynesian multiplier openness variable is designed to capture the impact of growth in the rest of the European economy on each European country. Canada is especially exposed to growth in the USA, and a similar variable was therefore also constructed for the Canadian economy. The European country openness variable is defined as: n( EMP/f \ EUROPEN,,, = s x ; , t | ( T 5 ^ G Y ,

(

where sx; = export share of GDP for country /; EMPZ = employment in country i(i = /); TOTEMP; = total employment in all European countries excluding country/; and GY, = growth of real output in country i(i = j). The logic of this openness variable is as follows. The sx;- component measures the export openness of a country, while the rest of the term measures real growth outside the country. This real growth component is the employment-weighted average of country growth rates. For all non-European countries EUROPEN takes on a value of zero. The Canadian openness variable is defined as: CANUS, = sxCAN/tGYuv where sxCAN t - Canadian export share of GDP; and GYUS t = US real GDP growth rate. For all countries other than Canada it is zero.

Notes 1 The OECD continually changes its reported measure of standardized unemployment, and as a result the measures used here do not match earlier measures used by Nickell (1997). The current measures are drawn from the OECD's Economic Outlook, December 1999. 2 Over the period 1983-94 Spain had average standardized unemployment of 19.15 per cent, while Ireland had average standardized unemployment of 15.32 per cent. The next country after these two was Belgium with an average standardized unemployment rate of 11.33 per cent. 3 Two-stage least-squares was needed because the ALMPROG variable is defined as the percentage of GDP spent on labour market policies normalized on the unemployment rate. The instrument for this variable was spending as a percentage of GDP normalized on the average unemployment rate in 1977-79 (see Nickell 1997: 64). 4 The statistical significance of REALINT is at odds with results reported by Scarpetta (1995) which have informed much OECD policy analysis. This

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std.unemp t+1 Adj. std.unemp t = common unemp. * — Common unemp f+1

5

6

7 8 9

difference likely stems from differences in the measure of real interest rates. Scarpetta used a measure of world real interest rates based on a GDP-weighted average of domestic long term rates. The current estimate uses the short-run country interest rate which is the appropriate rate for purposes of assessing the impact of country macroeconomic policies on country unemployment rates. Though negatively signed, the Canadian openness variable (CANUS) is only significant at the 14 per cent level. This may be because the impact of the US economy on the Canadian economy is fully incorporated in the domestic GDP growth variable. Indeed, given the coefficients in column (c) of Table 2.2, a properly constructed system of coordinated wage bargaining and extensive union coverage can lower unemployment. The coefficient of COORD is -0.298, while that of UNIONCOV is 0.415. However, the value of COORD is twice that of UNIONCOV. Ireland suffers especially from having high coverage and low coordination (UNIONCOV= 3, COORD- 2). The UK, Canada and New Zealand also suffer, albeit less so (UNIONCOV- 2, COORD- 2). These cross-country findings are consistent with the time-series data for just the USA, which show that union density dramatically lowers US income inequality (Palley 1999). Stanford (2000) uses a similar framework to compare Canadian economic policy with that of other countries.

References Baker, D. and Schmitt, J. (1998) The Macroeconomic Roots of High European Unemployment: The Impact of Foreign Growth (Washington, DC: Economic Policy Institute). Blanchard, O. and Wolfers, J (2000) 'The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence', The Economic Journal, 110: C1-C33. Calmfors, L. and Drifill, J. (1988) 'Bargaining Structure, Corporatism, and Macroeconomic Performance', Economic Policy, 6: 13-61. Mishel, L., Bernstein, J. and Schmitt, J. (2000) The State of Working America, 2000/2001 (Ithaca, NY: Cornell University Press). Nickell, S. (1997) 'Unemployment and Labour Market Rigidities: Europe versus North America,' Journal of Economic Perspectives, 11: 55-74. Organisation for Economic Co-operation and Development (1998) OECD Economic Outlook (Paris: OECD). Palley, T.I. (1993) 'Okun's Law and the Asymmetric and Changing Nature of the U.S. Business Cycle', International Review of Applied Economics, 7: 144-62. Palley, T.I. (1997) 'The Institutionalization of Deflationary Policy Bias', in H. Hagemann and A. Cohen (eds), Advances in Monetary Theory (Kluwer Academic Publishers). Palley, T.I. (1998) 'Restoring Prosperity: Why the US Model is Not the Answer for the US or Europe', Journal of Post Keynesian Economics, 20 (Spring): 337-54. Palley, T.I. (1999) 'Arbeitslosigkeit und makrookonomische Weichenstellung', in S. Lang, M. Meyer and C. Scherrer (eds) Jobwunder USA - Modell fiir Deutschland (Mtinster: Westfalisches Dampfboot).

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Thomas I. Palley 47

Scarpetta, S. (1996) 'Addressing the Role of Labour Market Policies and Institutional Settings on Unemployment: A Cross-Country Study', OECD Economic Studies, 26(1): 44-98. Solow, R. (1994) 'Europe's Unnecessary Unemployment', International Economic Insights (March/April). Stanford, J. (2000) 'Canadian Labour Market Developments in International Context: Flexibility, Regulation, and Demand', Canadian Public Policy 26: 27-58.

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48 The Causes of High Unemployment

Is Capital Stock a Determinant of Unemployment? Philip Arestis, Michelle Baddeley and Malcolm Sawyer

Introduction This chapter seeks further to examine the proposition that the size of the capital stock is an important variable in the determination of the rate of unemployment. The argument is along the lines of recent contributions that are able to confirm the hypothesis that capital stock affects the non-accelerating inflation rate of unemployment (NAIRU) (see, for example, Arestis and Biefang-Frisancho Mariscal 1997, 1998, 2000), but here we focus on EMU countries in our empirical estimations. An important implication of the hypothesis that unemployment and capital stock are closely related, concerns current mainstream macroeconomic thinking. The proposition is made whereby monetary policy is concerned with the nominal side of the economy, and specifically with inflation, and supply-side policies are designed to address the real side of the economy. The supply side of the economy is often represented in terms of an unchanging supply-side equilibrium, with the NAIRU assumed to summarize it. The estimates provided for the NAIRU are often presented as a single (and hence implicitly unchanging) number. A less extreme view would be that the supply-side equilibrium may change over time but not in response to the demand side of the economy. Changes in labour-market institutions and laws, for example, would be predicted to lead to changes in the supply-side equilibrium, and these changes are assumed to take place independently from any variations in the level of economic activity. But when the capital stock is a major influence on the level of the NAIRU, then there is a factor continually changing the NAIRU (since net investment is always causing the capital stock to vary) and the pace and structure of investment will be influenced by the level of economic activity (and by variables such as 49 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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3

profitability which are correlated with economic activity). Hence the variability of the NAIRU will be influenced continually by the path of aggregate demand. The focus of this chapter is to examine the proposition that investment and the capital stock can contribute substantially to the determination of the rate of unemployment and real activity, and thereby to the determination of the NAIRU in a range of EMU countries. We deal first with the existing theoretical and empirical work and attempt to summarize existing literature on the matter. This is followed by estimation and testing of the theoretical model as postulated in Arestis and BiefangFrisancho Mariscal (1997, 1998, 2000). The following four EMU countries were selected for the empirical investigation, solely on the basis of data availability and consistency: Austria, Belgium, Germany and Spain. It is argued here that negative demand shocks affect employment and investment adversely. When shocks reverse, unemployment may not fall to previous levels due to insufficient capital equipment. Our empirical results show that the general rise in the unemployment rate in the countries over the past 30 years was to a large and significant extent due to insufficient investment, leading to a lower (than otherwise) capital stock. A final section summarizes the argument and concludes. Review of the literature Labour market flexibility Rigidities in labour markets (for example employment protection laws, union density and so on), coupled with an inadequately skilled workforce, are widely held to play a key role in the explanation of high unemployment rates, especially in Europe in the 1980s and 1990s (see for example OECD 1994; Nickell 1997; Siebert 1997; Elmeskov, Martin and Scarpetta 1998; Layard et al. 1991; Nickell et al. 2002; IMF 2003). Another branch of literature has focused on the particular labour-market institutions and rigidities that are responsible for high levels of unemployment (representative examples include, Nickell 1997; Layard and Nickell 1999). Related contributions attempt to examine the evolution of unemployment across countries using as their guide the hypothesis that 'flexible' institutions are more adaptable to adverse shocks (for example, Blanchard and Wolfers 2000). The unemployment policy implications that follow from the 'labour-market flexibility' thesis include 'weakening the power of trade unions, cutting taxes on labour, deregulating labour markets, spending on active labour-market policies, cutting the value and duration of unemployment benefits and reducing

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50 Is Capital Stock a Determinant of Unemployment?

the relative value of minimum wages' (Kapadia 2004: 4). Britain and the Netherlands are usually thought of as two examples where labourmarket reforms have worked according to the postulates of the theory. There is, however, a great deal of controversy over the thesis that labour-market reforms lower unemployment, and the OECD (1999) study is actually damning to the thesis of 'labour-market flexibility'. The study covers the period late 1980s to late 1990s and includes new and improved data on employment legislation in 27 OECD countries. It utilizes multiple regression analysis and techniques, in a way that it is able 'to control for other factors that can influence unemployment' (OECD 1999: 88). The study demonstrates that employment protection legislation (a measure of labour-market flexibility) has small or no impact at all on total unemployment. The employment protection legislation is defined broadly and covers all types of employment-protection measures resulting from legislation, court rulings, collective bargaining or customary practices. The OECD study considered a set of 22 indicators, summarized in an overall indicator on the basis of a four-step procedure (OECD 1999: 115-18). This confirms that dismantling employment protection would not solve the current unemployment malaise in the 27 countries considered in the study. There are other studies that are equally, if not more, critical. Ball (1999) concludes that the British and Dutch experience with labourmarket reforms does not constitute a favourable case for the labour-market flexibility thesis. Those reforms were relatively minor compared to the reduction in unemployment these two countries experienced. There are other countries, though, such as Belgium, Canada and Spain, where labour-market reforms were undertaken on a larger scale than the British and Dutch equivalent, but failed to reduce unemployment in the 1990s (although it is true to say that Spain did experience a fall in unemployment, from 18.1 per cent in 1994 to 11.3 per cent in the middle of the 1990s, well before any labour-market reforms were introduced, but unemployment in Spain has stuck at over 10 per cent ever since; the Netherlands experienced a fall in unemployment from 7.6 per cent in 1994 to 2.0 per cent in 2001 but then rose back to 5.0 per cent in 2004 took place). It is also argued in the same study that countries like Portugal and Ireland that did not undertake major changes in their labour-market institutions and laws, were still successful in reducing unemployment (less so it must be said in the case of Portugal, from a peak of 7.2 per cent in 1995 to 4.0 per cent in 2000, followed by a rise to 6.6 per cent to 2004 only because it sought to adhere to the Stability and Growth Pact). The comparison between Portugal and Spain is

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Philip Arestis, Michelle Baddeley and Malcolm Sawyer 51

particularly apt in view of the argument (see Blanchard and Jimeno 1995) that labour-market institutions are very similar in the two countries (see, also, Kapadia 2004). Glyn (2002) compares the 1990s experience of Ireland, where unemployment rates fell in the absence of labour-market reforms, and New Zealand, where despite major reforms only small changes in unemployment took place, and concludes that 'excessive labour-market deregulation is neither a necessary nor a sufficient condition for a radical improvement in employment' (Glyn 2002: 16). The study by Baker et al. (2004) provides empirical evidence that suggests the results of the well-known studies that support the 'labourmarket flexibility' thesis are not robust, especially with respect to the variables employed and the time period utilized. The Baker et al. (2004) study covers 20 OECD countries spanning 40 years, 1960-99. l Different time periods are utilized and different combinations of variables. The most comprehensive measure of labour-market institutions and policies utilized can only account for a minor part of the differences in the evolution of unemployment. An index of the extent of labour-market deregulation in the 1990s is constructed, but this variable too, showed no meaningful relationship between labour-market deregulation and shifts in the NAIRU. The same study poses the question of 'reverse causality' to conclude that 'While clearly not universal, this evidence of reverse causation provides serious grounds for viewing test results showing a correlation between high unemployment and long benefit duration' (Baker et al. 2004: 28) with caution. Consequently, the evidence in Baker et al. (2004) provides little or no support for the thesis that concentrates on labour-market rigidity, and in more general terms on labour-market institutions. Palley (2001) by accounting for micro- and macro-economic factors, and also for cross-country economic spillovers, concludes that unemployment in Europe emanates from 'self-inflicted dysfunctional macroeconomic policy' (Palley 2001: 3), rather than from labour-market 'rigidities'.2 Furthermore, there is the argument (Kapadia 2004) that in many of the more 'successful' countries a more promising relationship might be between high levels of investment and unemployment reduction. The cases of Portugal (following accession to the European Economic Community in 1986), and Ireland (following the large increase in foreign direct investment in the mid-1990s), are very telling on this aspect. The Netherlands, too, experienced increased investment in the early 1990s, from -3.2 per cent in 1990, -4.7 per cent 1991, to +6.9 per cent in 1992 and 1.2 per cent in 1993. Indeed, the British economy experienced strong investment performance in the early to mid-1990s. In all

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52 7s Capital Stock a Determinant of Unemployment?

these cases, increased investment activity was followed by substantial decreases in unemployment. The British example may be particularly relevant in this respect in that increased investment activity in the early parts of the 1990s was associated with falling unemployment in the second half of the 1990s. Similarly, earlier periods in the UK (early 1960s to early 1990s) are characterized by high unemployment rates being accompanied by lower levels of investment (Kitson and Michie 1996). These experiences confirm Hahn's (1995) puzzlement that 'one can only be amazed at the neglect of investment and of the capital stock in theories of the natural rate' (Hahn 1995: 52). They also point to another important consideration, namely that reduction in unemployment in all these cases is sustained even after investment rates have fallen. Capital stock may have some impact in NAIRU. We turn to this aspect next. Degree of substitutability between capital and labour Part of the debate on the relationship between capital shortage and unemployment concerns the degree of substitutability between labour and capital (Bean 1989; Jerger 1991; Rowthorn 1999). A larger capital stock will permit a higher level of aggregate demand, a higher level of employment and a lower rate of unemployment, without inflation tending to rise. But this is not always accepted in the literature. When capital investment takes the form of increasing the average capital stock per enterprise, and where the elasticity of substitution between capital and labour is unity and the wage equation shifts up in line with the rise in output (and hence the labour share in national income remains a constant), then the NAIRU can involve a substantial level of unemployment, and it cannot be shifted through the expansion of the capital stock (see, for example, Layard, Nickell and Jackman 1991: chapter 2). However, when the elasticity of substitution is below unity, or when the wage equation does not shift up in line with the rise in output, or when capital investment takes the form of more enterprises, then the NAIRU could be guided into compatibility with full employment through capital investment. If a Cobb-Douglas production function is assumed, which implies an elasticity of substitution of unity between labour and capital, then a 1 per cent change in relative factor costs is predicted to lead to a 1 per cent change in relative factor use. Furthermore, there is empirical evidence that real wages rise in line with rises in labour productivity, so that the increase in labour productivity due to higher capital intensity tends to lead to higher real wages. Consequently, as argued by the critics of the

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Philip Arestis, Michelle Baddeley and Malcolm Sawyer 53

capital shortage hypothesis, it is the downward inflexibility of real wages that prevents a return to previous employment levels (Lindbeck 1993; Blanchard and Summers 1986). No policy measures discriminating in favour of investment are necessary, for there is no obvious market failure involved (Bean 1989). It follows that unemployment is best viewed as part of labour-market reform given an existing capital stock. However, Rowthorn (1999) shows that the bulk of the empirical evidence suggests that the elasticity of substitution between capital and labour is considerably below unity, and hence a rising capital-labour ratio reduces the equilibrium level of unemployment. Rowthorn (op. cit.) cites 33 studies which show that the elasticity of substitution between labour and capital is well-below one. In these circumstances, capital accumulation can affect the equilibrium level of employment, even when real wages rise following an increase in the capital stock. The rise in capital stock will reduce a firm's ability to increase their profit share and the wage share will rise. Due to the limited substitutability between capital and labour, employment rises with the increase in capital accumulation. Wage models show that a fall in unemployment is accompanied by upward pressure on (real) wages (Layard, Nickell and Jackman 1991). However, since the wage share has increased, trade unions will be less inclined to demand higher (real) wages in response to lower unemployment. Consequently, the economy can operate at a lower level of unemployment. Furthermore, as argued above, slow capital accumulation in the recovery phase prevents unemployment from falling. It also reduces the effective labour supply through hysteresis effects, thereby reinforcing the problem of high unemployment. Therefore, policies that address the speed with which new capital is installed become necessary in order to prevent insider effects in the labour market. Rowthorn (1999) assumes a Constant Elasticity of Substitution (CES) technology. If a Cobb-Douglas production technology is assumed and capacity constraints are introduced, the same result is obtained. Kapadia (2004) actually shows that within a Cobb-Douglas production technology with imperfectly competitive arrangements in the labour market, of the type assumed in, for example, Layard et al. (1991), capital stock would still affect NAIRU. Introducing capacity into the standard CobbDouglas production technology, so that when the capital-labour ratio drops below a certain threshold, the returns on capital increase while those of labour fall by the same amount shows that, over a certain range, NAIRU depends on capital stock. This assumes that capital stock is exogenous. When capital stock is endogenous, the NAIRU depends on the real user cost of capital over a certain range.

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54 Is Capital Stock a Determinant of Unemployment?

Capital stock and unemployment Gordon (1997) finds that countries that experienced the largest slowdown in capital accumulation per labour hour faced the highest unemployment rates in the 1990s. He concluded that the European countries did not have sufficient capital in the 1990s to equip all employees who would have had a job had unemployment rates remained the same as in the 1970s. Bean (1989) predicted a similar result. The work of Dow (1998) can be used to illustrate the effects of recession on the future capital stock and thereby on future employment prospects. He argued that in a major recession underemployment results in the deterioration and premature scrapping of physical equipment, and that disbandment or underemployment of a firm's workforce similarly results in the partial destruction of working practices and working relations. The latter constitute the intangible capital of a firm, the value of which is an important fraction of its market value as a going concern. The capital stock, physical and intangible, takes time to build up, and it cannot be destroyed rapidly; in effect, therefore, the destruction is quasi-permanent. In this way demand shocks impact on supply. A major recession causes a downward displacement of the growth path of productivity (or potential or capacity output); after the recession, the 'stable growth' mechanism described by the first mechanism will in the absence of further shocks start to operate again, i.e. normal growth will be resumed from the low point of the recession. (Dow 1998: 369) Dow produces estimates of the impact of five major recessions in the UK, implying that substantial (negative) changes in capacity can occur as the result of recession, with long lasting effects. These findings are consistent with the views we have outlined above. The increase in the level of unemployment experienced in the 1980s and in the 1990s as compared with say the 1960s (especially in Europe) was substantial. The oil price shock of the mid-1970s could be seen as effectively reducing capacity as heavy energy-using plant and equipment became unprofitable. High levels of unemployment and excess capacity can be expected to have led to a substantial reduction in the capital stock below its full employment level. In some respects, this says little more than enterprises will adjust the capital stock to the prevailing demand for output (and level of employment). But it, nonetheless, suggests a clear mechanism through which the level of (un)employment experienced will be reflected in the estimated NAIRU.

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Philip Arestis, Michelle Baddeley and Malcolm Sawyer 55

Estimates of a NAIRU (or similar) are generally derived from the estimation of wage and price equations from which an 'equilibrium' rate of unemployment is solved (based on expectations being fulfilled and real wages growing in line with productivity). This equilibrium is equivalent to income distribution between wages and profits remaining unchanged, and hence in the absence of pronounced trend in the distribution of income any successful estimation of the NAIRU will fall in the range of observed unemployment. It is, though, often observed that the NAIRU is a 'weak attractor'. For example, Blanchard argues that 'the natural rate is at best a weak attractor' and that 'the natural rate is often as much an attractee as it is an attractor' (Blanchard 1995: xiii), where the term 'natural rate' is used in the way we have used the term NAIRU and that the estimates of the NAIRU tend to follow the actual experience of unemployment (see, for example, Worswick 1985). The variation in the estimated value of the NAIRU, the tendency of estimates of the NAIRU to follow actual unemployment, and the NAIRU being a 'weak attractor' are consistent with the view put forward in the current paper. Sawyer (2004) considers the experience of the 1990s with declining unemployment without inflation in Canada, the UK and the USA, contrasting it with the high levels of unemployment in countries such as France and Germany. He argues that while unemployment of labour was falling in the first group of countries, capacity utilization did not rise substantially as there was something of an investment boom, which led to a rising capital stock. There is evidence to support this view, though the empirical work to which we refer has been undertaken within frameworks that have some similarities to the one outlined here, albeit with some differences as well. Rowthorn finds that 'when manufacturing and services are combined, capital stock has a large, statistically significant impact on employment' (Rowthorn 1995: 33), in equations estimated for a cross-section of OECD countries. So that, Rowthorn concludes, 'The problem of unemployment is ultimately one of investment' (Rowthorn 1995: 38). In an introduction to a recent symposium on unemployment, Dixon concludes that 'although the papers [in the Controversy section] reflect the wide disagreement which exists amongst economists, they suggest that the increase in the real interest rate and the decline in the investment ratio are partly to blame for the high unemployment rate in the OECD countries' (Dixon 1998: 781). Arestis and Biefang-Frisancho Mariscal (1997) conclude from their empirical work for the UK over the period 1966 to 1994 that 'unemployment is significantly determined by capital shortages. Capacity is not fixed and investment depends on expected profitability and the

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56 Is Capital Stock a Determinant of Unemployment?

expected long-term rate of interest' (Arestis and Biefang-Frisancho Mariscal 1997: 191). In a subsequent paper, they find that 'the NAIRU is determined by long-term unemployment, worker militancy and the capital stock' (Arestis and Biefang-Frisancho Mariscal 1998: 202). In work on Germany and the UK those authors conclude that 'adverse demand shocks affect employment and investment. When shocks reverse, unemployment may not fall to previous levels due to insufficient capital' (Arestis and Biefang-Frisancho Mariscal 2000: 487). Miaouli utilizes annual data from the manufacturing sector of five European countries and concludes that 'the empirical analysis verifies that in all countries, accumulated investment in the private sector influences employment in a positive way' (Miaouli 2001: 23). Rowthorn finds that 'when manufacturing and services are combined, capital stock has a large, statistically significant impact on employment' (Rowthorn 1995: 33) in equations estimated for a cross-section of OECD countries. Stockhammer aims 'to contrast and test the NAIRU hypothesis and a Keynesian explanation of unemployment in a time-series context. For the NAIRU explanation, wage push variables are key to explaining the rise of unemployment in Europe, for Keynesians the slowdown in capital accumulation is' (Stockhammer 2004: 21) the key. This proposition is tested using data from the mid-1960s to the mid-1990s for Germany, France, Italy, the UK and the USA. He concludes that 'the NAIRU specification performed poorly, with only the tax wedge having a positive effect on unemployment as predicted. As to the Keynesian approach, the role of capital accumulation was confirmed. Whereas capital accumulation is robust to the specification and can be pooled across countries, the tax wedge is not. In the Keynesian specification the tax wedge has the incorrect sign, however replacement ratios are significant with the predicted sign' (Stockhammer 2004: 21). Further support comes from Alexiou and Pitelis (2003), where a panel-based study is undertaken for the period 1961 to 1998 for a number of European countries. They conclude that their 'analysis and empirical findings suggest that one of the potential factors behind the high and persistent European unemployment is insufficient growth of capital stock and inadequate aggregate demand' (Alexiou and Pitelis 2003: 628). In this chapter we utilize a model that aims to explain the determination of wages and unemployment. Specific to this model is the effect of the capital stock on wages and unemployment, and consequently on the NAIRU. We follow the theoretical framework put forward in Arestis and Biefang-Frisancho Mariscal (1997, 1998, 2000) for the purposes of empirical investigation.

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Philip Arestis, Michelle Baddeley and Malcolm Sawyer 5 7

58 is Capital Stock a Determinant of Unemployment?

Our empirical work concerns the estimation of two relationships, one for real wages and one for unemployment, involving the capital stock, and the basic equations derived in Arestis and Biefang-Frisancho Mariscal (1997, 1998, 2000) will be used throughout. We begin with equation (3.1), where lower-case variables are in logarithms: w = ps + j32s - p3u + p4ltu + psk

(3.1)

where the dependent variable w, defined as w = (wn - p - Ip) with wn being nominal wage, p the GDP price deflator and Ip labour productivity, is the real wage per unit of output, which implies that productivity neutrality with respect to unemployment is assumed. Although the theoretical model (Arestis and Biefang-Frisancho Mariscal 1997, 1998, 2000) itself does not impose this restriction, this assumption is backed by empirical results (Manning 1992; Elmskov 1993). Furthermore, r=(wu- p) is real level of unemployment benefits,3 where wu is unemployment benefits, 5 stands for strike activity, u for unemployment, Itu for longterm unemployment, and k for capital stock. This equation indicates how the rise in capital stock can reduce inflationary conflict over income distribution, and thus affect the real wage per unit of output. This can be explained in the following two ways (Rowthorn 1995). First, a higher capital stock would mean that capacity utilization will be lower for any given level of aggregate demand, and this lower capacity utilization restrains firms' ability to raise prices. Second, the rise in capital stock leads to a fall in conflict over income distribution, which produces lower domestic prices, which may lead to the economy operating with a higher real exchange rate; this increases the amount of resources available for domestic use. Each of these effects allows the real wage to rise and helps to reduce inflationary conflict. The second equation derived is: u =

Jir + Jis ~ 73^ + yJAu

(3.2)

It can be seen that the equilibrium rate of unemployment is a declining function of capital stock. The effect of changes in capital stock on unemployment can be explained as follows. If capital stock is reduced, or taxes or import cost rise, conflict over income distribution rises. Taking as an example the rise in oil prices in the mid-1970s, the resulting conflict over who should bear the cost led to accelerating inflation. In order

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Estimable equations

to bring inflation down, governments introduced policies that curbed demand. As a result, unemployment rose. This can be explained if a fall in demand is accompanied by a fall in capacity utilization. Firms respond by reducing investment, leading to a lower (than otherwise) capital stock, which increases the NAIRU even further. When oil prices return to their previous level, inflationary pressure and unemployment fall. However, due to a lower capital stock, the previous level of employment cannot be attained. Empirical investigation and empirical evidence The first part of the empirical section discusses the data utilized for the four countries concerned. This is followed by the estimation of the cointegrating relationships corresponding to equations (3.1) and (3.2). Variable definition and data The selected countries Austria, Belgium, Germany and Spain exhibit consistency in the data. The model is estimated using quarterly data for different periods in the four countries as indicated in Table 3.1. The definition of variables for all countries are as follows: real hourly average earnings per employee is denoted by (w), deflated by the GDP price deflator (p) and labour productivity (pf); (r) is real benefits, that is nominal benefits (wu) deflated by (p); (5) is the number of strikes; (u) is the number of unemployed; the long-term unemployed (Itu) are those unemployed for more than 52 weeks in relation to the labour force; and capital stock (k) is the business-sector capital stock. As suggested above, all variables are measured in logarithm form. Empirical results We apply the standard Johansen (1988, 1995) maximum likelihood estimation procedure to estimate the number of linearly independent cointegrating vectors (see, also, Johansen and Juselius 1990). Identifying restrictions on the cointegrating vectors are then imposed and tested for lying in the cointegrating space spanned by the cointegrating vectors. The results along with relevant explanatory notes are given in Tables 3.1-3.3. All variables were tested for the level of integration, applying the standard Augmented Dickey-Fuller (ADF) unit-root tests with the result that all variables have unit roots.4 The Akaike (AIC) and Schwarz-Bayesian (SBC) information criteria were applied in order to enable us in the model selection procedure. These criteria are designed to select the

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Philip Arestis, Michelle Baddeley and Malcolm Sawyer 59

o

Table 3.1 Cointegrating vectors Austria 1994Q4 to 2002Q4 Normalized on

Belgium 198SQ4 to 2000Q4 Normalized on

Germany 1983Q4 to 2002Q4 Normalized on

Spain 1979Q4 to 2002Q4 Normalized on

Wages

Unemployment

Wages

Unemployment

Wages

Unemployment

Wages

Unemployment

-0.03 [-2.62] 0.03 [2.34] 0.00 [2.31] 0.04 [5.53] 0.05 [4.38]

n/a n/a -1.04 [-2.46] 0.00 [0.31] -0.16 [-1.51] 0.55 [2.26]

-0.08 [-0.41] -0.41 [-0.50] 0.12 [5.06] 0.18 [0.67] 0.31 [1.45]

n/a n/a 6.40 [1.00] 0.50 [3.14] -2.22 [-1.20] 3.57 [2.11]

-0.02 [-5.25] 0.25 [3.51] n/a n/a 0.001 [5.20] 0.25 [4.37]

nidi nidi

-0.38 [-1.85] 0.29 [ 1.88] 0.22 [1.39] 0.85 [2.31] -0.63 [-5.94]

nidi

3.73 [ 1.41] n/a n/a -0.001 [-1.94] -13.46 [-6.90]

n/a. 0.50 [4.30] -0.87 [-18.07] -1.99 [-17.69] -0.14 [-1.75]

Notes: w=number of unemployed; r = real benefits; s = number of strikes; k = business sector capital stock; Itu = long-term unemployed; all variables are measured in logarithm form, r-ratios are in square brackets. Sources: OECD Quarterly Labour Force Statistics, OECD Business Sector Database, ILO.

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ON

Model specification statistics Belgium

Austria Wages

Unemployment

Wages

0.92 0.10 0.45 Adj.R2 F-statistic F(14,33) = 3.19 F(12,33) = 39.50 F(14,61) = 1.40 -6.42 AIC -2.37 -7.70 -7.11 -1.87 SBC -5.85 430.64(14) 258.71(12) 852.80(14) x2

Germany

Unemployment

Wages

Unemployment

0.38 F(12,61) = 3.47 -2.54 -2.04 638.20(12)

0.20 F(14,71) = 2.32 -6.29 -5.84 -33.84(14)

0.33 F(12,71) = 3.87 1.95 2.38 -310.79(12)

Spain Wages

Unemployment

0.08 0.63 F(14,87) = 1.58 F(12,87) = 14.21 -4.99 -4.62 -4.58 -4.27 1444.84(14) 1179.41(12)

Notes: AIC = Akaike information criterion; SBC = Schwarz-Bayesian information criterion; all variables are in logarithms; numbers in brackets denote the numbers of degrees of freedom. Sources: OECD Quarterly Labour Force Statistics, OECD Business Sector Database, ILO.

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Table 3.2

62 is Capital Stock a Determinant of Unemployment?

w u k s r Itu n/a F-statistic AIC

SBC

^(ri)

\n(w-p-pr), with p being the GDP price deflator and pr labour productivity ln(no. of unemployed), for Germany is the rate of unemployment ln(X) 1995 prices ln(strikes) ln(real unemployment benefits) ln(long-term unemployment) not applicable F-test of explanatory power, with its critical value at 95% confidence interval being approximately equal to 2.0 Akaike Information Criterion is a model selection criterion based around the residual variance which is equal to Tln(RSS)+2iC, where K = number of regressors, T = number of observations, and RSS = residual sum of squares Schwarz-Bayesian Information Criterion; another model selection criterion, which selects the most parsimonious model = Tln(MSE) + iCm(T), where MSE is the mean-square error log-likelihood function, which captures the probability that the model is data consistent. The critical values for a 95% confidence interval are: *2(14) = 23.68 and *2(12) = 21.03

model with the optimal empirical lag length in the specification of the vector error-correction model (VECM). They also require that the resulting model has residuals that correspond to the absence of serial correlation. It is well-known that the SBC is d o m i n a n t w h e n selecting lag length and cointegrating rank. The F(nlf n2) statistic suggests that the explanatory power of the equation is satisfactory. The results of all these tests, along with those of the relevant R2 and ^iri) tests, are reported in Table 3.2. 5 The R2s are reasonable, and the x2(n) is significant in all cases, which suggests that the model conforms with the theoretical priors. Most importantly, the AIC and SBC statistics are remarkably similar and in most cases above their critical values. In fact, all the results of the tests conducted for the purposes of Table 3.2 are satisfactory from the point of view of the model selection aspect of the exercise. The two cointegrating vectors, as discussed in the last sub-section, may not be meaningful in an economic sense. They span a space in which any linear combination is another cointegrating relationship. Since the Johansen's reduced rank regression procedure only determines how m a n y unique cointegration vectors span the cointegration space,

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Table 3.3 Key to variables and statistics/diagnostics as in Tables 3.1 and 3.2

and since any linear combination of the stationary vectors is also a stationary vector, the estimates produced are not necessarily unique. Therefore, it will be necessary to impose restrictions to obtain unique vectors lying within that space (Harris 1995). Consequently, general joint restrictions on the cointegration vectors and the speed-of-adjustment parameters, according to prior theoretical premises, were imposed and tested for significance (see, for example, Harris 1995; Hunter 1992; and Mosconi and Giannini 1992). The resulting equations thereby derived for the four countries are reported in Table 3.1, which should be read in conjunction with Table 3.2.6 In Table 3.1 the values in square brackets are the t-values. The first equation for each country describes the average hourly real wage per unit of output (wn—p-lp), determined by the logarithm of unemployment (u), the logarithm of real benefits (r), strike activity represented by the logarithm of the number of strikes (s), capital stock (k) and the logarithm of long-term unemployment (Itu). The second equation explains unemployment by real benefits, number of strikes, capital stock and by the number of long-term unemployed. Most variables are correctly signed and statistically significant at the conventional levels. In particular, it may be noted that for all the countries in this investigation the real wage per unit of output is negatively related to unemployment, and hence positively related to employment. Furthermore, and for the purposes of this paper, the capital stock variable is correctly signed and significant with varying degrees in the eight relationships reported in Table 3.1. The empirical performance of the rest of the variables support the theoretical contention postulated in this chapter. Summary and conclusions We have employed an aggregate wage model which incorporates a number of ideas on wage determination, and the model is concerned with explaining the (long-run) level of unemployment. In this model, the effect of demand on unemployment and wages is emphasized. The mechanism works through changes in capacity utilization, which themselves depend on economic activity and the stock of capital. Wage and unemployment relationships are estimated and tested with comparable data sets for the four EMU countries included in our sample. The datasets provided two cointegrating vectors, which could be identified as unemployment and wage relationships. The empirical results, based on quarterly time-series data for the four countries, confirm Stiglitz's statement that 'it takes capital and entrepreneurship to create new firms and

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Philip Arestis, Michelle Baddeley and Malcolm Sawyer 63

jobs' (Stiglitz 2002: 59). Consequently, policies to promote investment also help to tackle unemployment. The current focus on labour-market reforms and flexibility is overstated. The policy implications of our findings are that in view of the strong effect of long-term u n e m p l o y m e n t o n the NAIRU, programmes that enhance the skills of displaced workers may allow t h e m to regain access to the labour market. Furthermore, the results suggest that capital stock significantly affects unemployment. This is important since investment-enhancing policies can lead the way in reducing unemployment. Notes 1 It is important to note that this data series covers the late 1990s when unemployment rates fell sharply in the 20 countries included in the study's sample. 2 It is worth commenting on Germany's current labour-market reforms, which do not appear to be delivering a reduction in unemployment, although it should be readily noted that they have not been in place for all that long. Financial Times (20 October 2004) reports that six leading German economic institutes have criticized labour-market reforms. Their critique rests on the failure of the reforms to reduce unemployment, which if anything has been increasing over the period. More importantly, though, the six institutions warn that Germany's labour reforms might fail to curb high unemployment. However, this has not prevented the majority of them from demanding further reforms. 3 We note that the variable real benefits (wu-p) differs from the variable replacement ratio, with the latter being (wu-w). 4 The results of these tests can be obtained from the authors upon request. 5 The results of the vector error-correction model are not reported in the chapter, but can be obtained from the authors upon request. 6 The results reported in Tables 3.1 and 3.2 were estimated using EViews 4.0 © 1994-2000 Quantitative Micro Software, LLS, California, USA. References Alexiou, C. and Pitelis, C. (2003) 'On Capital Shortages and European Unemployment: A Panel Data Investigation', Journal of Post Keynesian Economics, 25(4): 613-31. Arestis, P. and Biefang-Frisancho Mariscal, I. (1997) 'Conflict, Effort and Capital Stock in UK Wage Determination', Empirica, 24(3): 179-93. Arestis, P. and Biefang-Frisancho Mariscal, I. (1998) 'Capital Shortages and Asymmetries in UK Unemployment', Structural Change and Economic Dynamics, 9(2): 189-204. Arestis, P. and Biefang-Frisancho Mariscal, I. (2000) 'Capital Stock, Unemployment and Wages in the UK and Germany', Scottish Journal of Political Economy, 47(5): 487-503. Baker, D., Glyn, A., Howell, D. and Schmitt, D. (2004) 'Labour Market Institutions and Unemployment: A Critical Assessment of the Cross-Country Evidence', in

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64 Is Capital Stock a Determinant of Unemployment?

D. Howell (ed.), Fighting Unemployment: The Limits of Free Market Orthodoxy (Oxford: Oxford University Press). Ball, L. (1999) 'Aggregate Demand and Long-run Unemployment', Brookings Papers on Economic Activity, 2: 89-251. Bean, C.R. (1989) 'Capital Shortage and Persistent Unemployment', Economic Policy, 4(1): 12-53. Bean, C.R., Layard, R.G. and Nickell, SJ. (1986) 'The Rise in Unemployment: A Multi-Country Study', Economica, Supplement, 53(210): Sl-22. Blanchard, D.G. (1995) 'Preface', in R. Cross (ed.), The Natural Rate of Unemployment: Reflections on 25 Years of the Hypothesis (Cambridge: Cambridge University Press). Blanchard, OJ. and Jimeno, J.F. (1995) 'Structural Unemployment: Spain versus Portugal', American Economic Review, 85(2): 212-18. Blanchard, OJ. and Summers, L.H. (1986) 'Hysteresis and the European Unemployment Problem', in S. Fischer (ed.), NBER Macroeconomics Annual 1986 (Cambridge, Mass.: MIT Press). Blanchard, O.J. and Wolfers, J. (2000) 'The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence', Economic Journal, 110(462): C1-C33. Dixon, H. (1998) 'Controversy: The Macroeconomics of Unemployment in the OECD', Economic Journal, 108(448): 779-81. Dow, J.C.R. (1998) Major Recessions: Britain and the World, 1920-1995 (London and New York: Oxford University Press). Elmskov, J. (1993) 'High and Persistent Unemployment: Assessment of the Problem and its Causes', Economics Department Working Paper, 132 (Paris: OECD). Elmeskov, J., Martin, J. and Scarpetta, S. (1998) 'Key Lessons for Labour Market Reforms: Evidence from OECD Countries Experience', Swedish Economic Policy Review, 5(2): 205-52. Glyn, A. (2002), 'Labour Market Success and Labour Market Reform: Lessons from Ireland and New Zealand', mimeo, Oxford University, http:/www.economics.ox. ac.uk/Members/andrew.glyn/IrelandandNZ4.pdf. Gordon, RJ. (1997) 'Is there a Trade-off Between Unemployment and Productivity Growth?', in D.J. Snower and G. De la Dehesa (eds), Unemployment Policy: Government Options for the Labour Market (Cambridge: Cambridge University Press). Hahn, F. (1995) 'Theoretical Reflections on the "Natural Rate of Unemployment" ', in R. Cross (ed.), The Natural Rate of Unemployment: Reflections on 25 Years of the Hypothesis (Cambridge: Cambridge University Press). Harris, R.I.D. (1995) Using Cointegration Analysis in Econometric Modelling (London: Prentice Hall). Hunter, J. (1992) 'Cointegrating Exogeneity', Economics Letters, 34: 33-5. IMF (2003) 'Unemployment and Labour Market Institutions: Why Reforms Pay Off, World Economic Outlook (April, chapter IV): 129-50 (Washington, DC: International Monetary Fund). Jerger, J. (1991) 'Wage Gaps, Capital Formation and Unemployment', Jahrbuecher fuer Nationaloekonomie und Statisik, 208(3): 264-71. Johansen, S. (1988) 'Statistical Analysis of Cointegrating Vectors', Journal of Economic Dynamics and Control, 12: 231-54. Johansen, S. (1995) Likelihood-based Inference in Cointegrated Vector Autoregressive Models (Oxford: Oxford University Press).

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Johansen, S. and Juselius, K. (1990) 'Maximum Likelihood Estimation and Inference on Cointegration with Applications to the Demand for Money', Oxford Bulletin of Economics and Statistics, 52: 169-210. Kapadia, S. (2004) 'The Capital Stock and Equilibrium Unemployment: A New Theoretical Perspective', mimeo (Balliol College, Oxford University). Kitson, M. and Michie, J. (1996) 'Britain's Industrial Performance Since 1960: Underinvestment and Relative Decline', Economic Journal, 106: 196-212. Layard, R., Nickell, S. and Jackman, R. (1991) Unemployment (Oxford: Oxford University Press). Layard, R. and Nickell, S. (1999) 'Labour Market Institutions and Economic Performance', in O. Ashenfelter and D. Card (eds), Handbook of Labour Economics, 3C: 3029-86. Lindbeck, A. (1993) Unemployment and Macroeconomics (Cambridge, Mass.: MIT). Manning, A. (1992) 'Productivity Growth, Wage Setting and the Equilibrium Rate of Unemployment', CEP Discussion Paper no. 63 (London: London School of Economics). Miaouli, N. (2001) 'Employment and Capital Accumulation in Unionised Labour Markets', International Review of Applied Economics, 15(1): 5-30. Mosconi, R. and Giannini, C. (1992) 'Non-causality in Cointegrated System: Representation, Estimation and Testing', Oxford Bulletin of Economics and Statistics, 48:300-417. Nickell, S. (1987) 'Why is Wage Inflation in Britain so High?', Oxford Bulletin of Economics and Statistics, 49: 103-29. Nickell, S. (1997) 'Unemployment and Labour Market Rigidities: Europe Versus North America', lournal of Economic Perspectives, 11(3): 55-74. Nickell, S., Nunziata, L. and Ochel, W. (2002) Unemployment in the OECD since the 1960s. What Do We Know (London: Bank of England). http:/www.nuff.ox. ac.uk/users/nunziata/publications_files/nicknun02.pdf. OECD (1994) OECD Jobs Study, Evidence and Explanations, Part I: Labour Market Trends and Underlying Forces of Change (Paris: OECD). OECD (1999) OECD Employment Outlook, June (Paris: OECD). Palley, T.I. (2001) 'The Role of Institutions and Policies in Creating High European Unemployment: The Evidence', Levy Economics Institute of Bard College Working Paper Series, 336 (August). Rowthorn, R.E. (1995) 'Capital Formation and Unemployment', Oxford Review of Economic Policy, 11(1): 26-39. Rowthorn, R.E. (1999) 'Unemployment, Wage Bargaining and Capital-labour Substitution', Cambridge Journal of Economics, 23(4): 413-26. Sawyer, M. (2004) 'The NAIRU, Labour Market "Flexibility" and Full Employment', in J. Stanford and L. Vosko (eds), Challenging the Market: The Struggle to Regulate Work and Income (McGill: Queen's University Press), 33-50. Siebert, H. (1997) 'Labour Market Rigidities: At the Root of Unemployment Problem', Journal of Economic Perspectives, 11(3): 37-54. Stiglitz, J.E. (2002) Globalisation and its Discontents (London: Allen Lane). Stockhammer, E. (2004) 'Explaining European Unemployment: Testing the NAIRU Hypothesis and a Keynesian Approach', International Review of Applied Economics, 18(1): 3-24. Worswick, D. (1985) 'Jobs for All?', Economic Journal, 95(1): 1-15.

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66 Is Capital Stock a Determinant of Unemployment?

Deflation Risks in Germany and the EMU: The Role of Wages and Wage Bargaining* Eckhard Hein, Thorsten Schulten and Achim Truger

Introduction In late 2003 the deflationary dangers in Germany could hardly be denied. The GDP deflator for Germany rose by 1.0 per cent in 2003 and the forecast rise for 2004 was 0.8 per cent. Meanwhile, the consumer price index rose by 0.9 per cent in 2003 and was forecast to rise by 1.2 per cent in 2004 (Institute 2003). These figures mean that inflation in Germany has in principle already reached the level considered by the European Central Bank (ECB) to be the minimum safety margin against deflation in its reformulated monetary policy strategy for the whole of the European Monetary Union (EMU) (ECB 2003). A further fall in inflation would therefore significantly increase the danger of deflation and a cumulative deflationary spiral. In its April 2003 Task Force Report, the IMF named Germany alongside Japan, Taiwan and Hong Kong as one of the economies most at risk from deflation worldwide (IMF 2003).l Not least because of Japan's experiences in the 1990s, there is currently a broad consensus among economists that once a deflationary spiral is underway it has very negative consequences for growth and employment and is extremely difficult to stop. The causes of deflationary processes can be found both on the supply side and the demand side * An earlier version of this chapter was presented at the 8th International PostKeynesian Conference, 26-29 June, 2004, Center for Full Employment and Price Stability, University of Missouri, Kansas City. For helpful comments we would like to thank the participants in this conference and in the 8th Workshop of the Research Network Alternative Macroeconomic Policies on 'Wages, Distribution and Growth', 29-30 October, 2004, Berlin. 67 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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4

(IMF 2003). However, while the price falls resulting from positive supply shocks (such as innovations that boost productivity) are usually associated with an increase in economic activity, deflationary processes caused by negative demand shocks go hand in hand with an overall fall in economic activity. The real problem posed by deflation thus results from a combination of falling demand and output with falling prices. This leads to an expectation of further price cuts, an increase in the value of real debts, falling share prices and stricter lending policies on the part of commercial banks and financial intermediaries, all of which ultimately may cause debtors to become insolvent and go bankrupt. Owing to the risk of cumulative effects, there is also a broad consensus that economic policy should take timely and decisive steps to combat deflation, ideally as soon as the first signs of it emerge. This is particularly important because as the nominal interest rate heads towards zero, less and less can be achieved by monetary policy.2 However, there is a clear lack of consensus among economists with regard to which instruments should be used to tackle (incipient) deflation. While (post-)Keynesian authors have always stressed the key role of wages policy as the nominal anchor for combating both inflationary and deflationary tendencies, wages policy as an instrument in mainstream new-Keynesian thinking is either non-existent or at best allocated a highly ambivalent and ultimately contradictory role. For example, the IMF (2003) study ranks the key indicators of deflation risks as follows: (1) consumer and producer prices, (2) overcapacity and output gaps, (3) share prices and property prices, and (4) credit and money aggregates. Wages or unit-labour-cost trends are not explicitly mentioned at all. This is hardly surprising, since at times of sustained demand-led deflation, rigid nominal wages are considered to be an additional destabilizing factor that can lead to an increase in real wages and a fall in employment and should therefore be avoided, according to the IMF. On the other hand, during temporary demand shocks, rigid nominal wages are considered to be a tried and tested means of preventing pricecut expectations and their associated deflationary consequences from arising in the first place. However, the point at which a temporary shock becomes a sustained shock requiring nominal wages to be lowered is by no means clear, nor is it evident how lowering nominal wages can halt and reverse a deflationary process as described above once it is already underway. Similar inconsistencies with regard to the relationship between nominal wage rigidity, low inflation or deflation and employment are to be found in a number of standard works on the problems of low inflation

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68 Deflation Risks in Germany and the EMU

and deflation. For example, Akerlof, Dickens and Perry (1996) show that because of employees' perceptions of what is fair and morally right, nominal wage rigidities are inevitable, irrespective of what the existing labour market institutions are. In their view, when inflation is low and demand is falling these rigidities act as an obstacle to the necessary downward adjustment of real wages, thereby destabilizing the whole economy.3 At the same time, however, they also view downward nominal wage rigidities as a means of braking cumulative deflationary processes and consequently as something that promotes overall economic stability! Also Bernanke (1995) blames insufficient downward nominal wage flexibility together with debt deflation for the severity of the Great Depression starting in 1929 which was characterized by major deflationary processes without even acknowledging that downward nominal wage rigidity might have stopped deflation. Finally, in an otherwise highly informative study for the Board of Governors of the US Federal Reserve System on the ultimate failure of Japan's economic policy measures to prevent deflation in the 1990s, Ahearne et al. (2002) make no mention whatsoever of wage trends or wages policy. In contrast to these predominantly new-Keynesian analyses, more recent studies of deflation risks in Germany have pointed to the destabilizing effects of German wages policy (Flassbeck and Maier-Rigaud 2003; Kromphardt 2003).4 According to this approach, a policy of excessive wage restraint has led to low increases in unit labour costs and consequently to low inflation. To place wage trends at the core of the analysis of deflation risks is to follow the line of reasoning outlined by Keynes (1936: 257-71) in his General Theory, and at present it is only post-Keynesian authors who continue to take this approach to its ultimate conclusion. In contrast to the predominantly new-Keynesian studies alluded to above, Keynes and post-Keynesian theory view rigid nominal wages and stable unit labour costs as the indispensable basis for price stability in a monetary production economy. Consequently, rather than disturbing the market system and threatening to prevent it from functioning optimally, rigid nominal wages resulting from trade union wages policy or statutory minimum wages are in actual fact considered to be a requirement for the functioning of capitalist monetary economies. This is because to remove the wage anchor is to remove the last barrier against cumulative and disruptive deflationary processes. Of course, in the post-Keynesian view the wage anchor also prevents cumulative inflationary processes. This chapter will follow Keynes's or the post-Keynesian line of reasoning in order to demonstrate that wages policy especially in Germany but

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Eckhard Hein, Thorsten Schulten and Achim Truger 69

also in the rest of the EMU is in danger of not fulfilling its stabilizing role and that wage trends are causing deflationary risks. The second section will summarize the key theoretical links between wages, prices and employment from Keynes's and the post-Keynesian perspective. The third section will present an empirical study of the relationship between unit labour cost trends and inflation in Germany and the EMU, and this will be followed in the fourth section by an analysis of the causes of the observed unit labour cost trends. The final section will discuss the macroeconomic risks arising from the current wages policy in the context of the EMU's monetary and fiscal policies. Wages, prices and employment The post-Keynesian approach to analysing prices and employment that underpins this chapter differs fundamentally from mainstream thinking. In the neoclassical, neoclassical synthesis, monetarist and new classical models, Say's Law and the classical dichotomy between the real and the monetary sphere apply in the long term (and also in the short term in new classical models) (Snowdon, Vane and Wynarczyk 1994). Nominal wage settlements in the labour market affect real wages and hence determine employment and output levels. Price levels are determined by the money supply, which is controlled by the central bank, and inflation and deflation are purely monetary phenomena attributable to the central bank's monetary policy. The new-Keynesian models (Snowdon, Vane and Wynarcyk 1994), and in particular the 'new consensus models' (Arestis and Sawyer 2003; Clarida, Gali and Gertler 1999; Meyer 2001), do abandon the assumption that the central bank can control the money supply. More realistically, it is assumed that for a credit money economy the action parameter of monetary policy is the money interest rate.5 Monetary policies may have a short-term real effect on output and employment. In the long term, however, unemployment is determined by the NAIRU (non-accelerating inflation rate of unemployment) which itself depends on structural factors of the labour market, the wage bargaining and the social security system. As such, the NAIRU describes the unemployment rate at which, in imperfect labour and commodity markets, the distribution claims by employees and employers do not result in any increase or decrease in the inflation rate. When unemployment falls below the NAIRU, inflation always rises, and when unemployment climbs above the NAIRU the result is disinflation and finally deflation. By resorting to the interest-rate tool, monetary policy is always able to stop both

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70 Deflation Risks in Germany and the EMU

cumulative inflationary and deflationary processes and to bring about a stable inflation rate, according to this view. The post-Keynesian approach presented in this chapter has for several decades already been arguing the case for the endogeneity of money in a modern credit money economy as recently 'discovered' by the newKeynesian consensus models (Kaldor 1970, 1982, 1985; Lavoie 1984, 1992: 149-216, 1996; Moore 1988, 1989): the central bank's control instrument in a credit money economy is the key interest rate, and the money supply arises endogenously through commercial banks supplying creditworthy credit demand at a given rate of interest and the central bank accommodating the required cash. In such a model, the price level and hence inflation or deflation cannot be determined by the quantity of money supply. In an imperfect commodity-market scenario, the price level is instead the result of mark-up pricing on unit costs. Post-Keynesian research has put forward various theories with regard to the underlying unit costs (full costs or variable costs) and the factors determining the mark-up (competition, internal finance requirements, interest rate).6 One simple version of this approach, which draws on the work of Kalecki (1954: 11-27), suggests that businesses in the industrial sector of a closed economy set their prices by charging a mark-up on unit labour costs, which are taken to be constant until full capacity output (Hein 2004: 178-87). The size of the mark-up is determined on the one hand by the degree of price competition on the commodity markets and on the other by the extent to which the trade unions are able to achieve significant nominal wage increases when profit levels are high. If the size of the mark-up is fixed, then it is unit labour costs that determine price levels. Cumulative inflationary processes come about if the trade unions attempt to increase employees' share of the national product by negotiating nominal wage increases that exceed the neutral scope for distribution given by the sum of productivity growth and inflation, and when businesses are able to pass these increased unit costs on to consumers by raising prices. However, upward pressure on inflation also arises when businesses attempt to increase their mark-ups7 or when the bargaining parties fail to foresee a fall in productivity growth. Disinflation or deflation arise if wages policy is either unwilling or unable to make full use of the growth in productivity plus inflation. Nominal wage growth will now be affected by the employment or unemployment rate, in particular, and also by the degree of wagebargaining coordination with a higher degree of coordination being conducive to stable unit labour costs in the face of upward but also

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Eckhard Hein, Thorsten Schulten and Achim Truger 71

downward movements in employment. 8 In post-Keynesian models, the employment rate depends in both the short and long term on effective demand for goods, which is governed mainly by private investment, the level of which is in turn determined by the ratio of the expected profit rate to the monetary interest rate. In contrast to the new-Keynesian 'new consensus models', the post-Keynesian approach sees no reason to assume that the unemployment rate determined by the commodity market will adjust to the NAIRU (Sawyer 2001, 2002). On the contrary, the post-Keynesian model implies that at best the NAIRU constitutes a short-term employment barrier enforced by monetary policy. But if unemployment exceeds the NAIRU, there is no guarantee that expansive monetary policies are sufficient to stimulate the economy when profit expectations are low and firms are hit by debt-deflation.9 According to Keynes (1936: 262-71), price levels can be expected to drop, albeit not necessarily to the same extent owing to specific price rigidities in the commodity market, if sustained high unemployment results in falling nominal wages or unit labour costs.10 If reductions in unit labour costs are not fully passed on to consumers in the shape of price cuts, the result is also a redistribution at the expense of wage earners and a concomitant fall in this group's consumption demand. However, if domestic prices fall in an open economy, the balance of trade improves assuming the Marshall-Lerner condition to be fulfilled. But this short-run improvement is likely to be counteracted by a nominal appreciation of the domestic currency or by nominal wage moderation and hence real devaluation abroad, so that the overall effect of falling unit labour costs on foreign demand is quite uncertain in the medium run. In order to assess the effects of disinflation or deflation on investment, the development of interest rates, debt and profit expectations have to be taken into account. Here, the effect of falling wages and prices on the interest rate postulated by Keynes (1936: 263) as a result of falling transactions demand for money can only come about if the money supply is largely exogenously determined and does not adjust endogenously to the demand for money through credit creation or destruction and therefore constitutes net wealth.11 However, this is not the case in modern credit money economies where money is largely created by creditor-debtor relationships and every asset therefore has a corresponding liability. In this scenario, falling wages and prices can only affect interest rates in the event of a discretionary key interest rate cut by the central bank. Even in such cases, however, the potentially expansive effect on investment (and consumption) is counteracted by

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72 Deflation Risks in Germany and the EMU

the fact that in a credit money economy where prices are falling, there is a redistribution of wealth from debtors to creditors with the associated risk of over-indebtedness. This debt deflation effect that was accorded central importance by Fisher (1933) and as well by Keynes (1936: 264) serves to dampen investment (and consumption) if the realistic assumption is made that creditors are less inclined to spend than are debtors. Furthermore, it is more difficult to obtain credit to finance spending in a debt deflation scenario, since banks' and financial intermediaries' lending policy is determined by the creditworthiness of firms (and households) applying for loans, and their indebtedness is an important indicator of how creditworthy they are.12 Taking these considerations into account, the new-Keynesian view of a symmetrically effective monetary policy which is always capable of adjusting actual unemployment to the NAIRU seems to be overly optimistic and the neglect of the stabilizing role of nominal wage rigidities seems to be unwarranted. If one realistically assumes the characteristics of a modern credit money economy as described in the post-Keynesian approach to hold, it can thus be said that in times of recession, rigid nominal wages are the anchor to prevent deflationary processes, even if the monetary policy response also favours growth and employment. Consequently, any study of deflationary tendencies should pay particular attention to wages policy and unit-labour-cost trends. This does not mean, however, that monetary and fiscal policy are completely off the hook. On the one hand, they should be used preventively to ensure that cumulative downturns and the associated danger of the removal of the wage anchor never come about in the first place. Moreover, decisive use of monetary and fiscal policy should be made to combat downturns that are already underway, thereby helping wages policy to fulfil its role as a nominal stabilizer. Inflation and unit-labour-cost growth The previous section described how post-Keynesian models work on the assumption that in imperfect commodity markets, prices come about principally as a result of a mark-up being added to unit variable costs with unit labour costs being a major part of these costs. If we accept this as true, then the inflation rate ought to be mainly determined by unit-labour-cost growth. Of course, starting from a theory of conflict inflation, we do not expect that unit-labour-cost growth is the only determinant of inflation, because in this view inflation in a real-world economy will also be affected by distribution claims of the state through

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Eckhard Hein, Thorsten Schulten and Achim Truger 73

variations in the net tax rate, of foreign producers through changing import prices or exchange rates, and of domestic firms through variations in the mark-up.13 However, in this section it will be briefly demonstrated that a close - but incomplete - relation between unit-labour-costs growth and inflation is in fact backed up by the empirical data between 1961 and 2003 for Germany and for the member countries of the EMU. Following on from this, the consequences for functional income distribution will be assessed as well and differences between Germany and the EMU countries in the 1990s when the process towards EMU was completed are highlighted. Figures 4.1 and 4.2 show the percentage increase in unit labour costs and the inflation rate in Germany and the EMU countries for the period between 1961 and 2003. There is clearly a relatively close correlation between the two values, in particular for the EMU countries but also for Germany. Although the unit-labour-cost growth curve seems to show more pronounced fluctuations than the fairly smooth inflation curve, both curves nevertheless exhibit a rising trend until the mid-1970s and a downward trend since then or since the early 1980s. The fluctuations of unit-labour-cost growth are around the inflation rate. The deviations of unit-labour-cost growth from inflation are more pronounced in the upwards direction until the mid-1970s and more pronounced in the downward direction since the early 1980s. Sylos-Labini (1979) has presented a rationale for this partial adjustment in an oligopolistic pricing framework for a specific industry characterized by uniform output prices: Unit labour costs are not only affected by variations in nominal wages which are uniform for all firms

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Figure 4.1 Unit-labour-cost growth and inflation rate (consumer prices) in Germany, 1961-2003 (per cent) Source: OECD (2003).

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74 Deflation Risks in Germany and the EMU

Eckhard Hein, Thorsten Schulten and Achim Truger 75

o- - Unit-labour-cost growth

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within an industry, but also by productivity which is different between firms, the price-setting firm being the one with the highest rate of productivity growth. When nominal wage increases are completely shifted to prices by the price-setting firm, the other firms and therefore the industry as a whole cannot completely shift due to inferior productivity growth. In a dynamic context of increasing unit-labour-cost growth, the average growth rate of unit labour costs will therefore exceed inflation. On the other hand, when nominal wages fall, the price-setting firm will only have to decrease prices according to the lower productivity growth of its competitors. In a dynamic context of falling unit-labour-cost growth, this implies that average unit-labour-cost growth will now be lower than inflation. We therefore get a partial adjustment of prices to changes in unit labour costs for the industry as a whole based on an asymmetric adjustment of the price-setting firm.14 In the case of Germany and the countries of the EMU, this partial adjustment also seems to be valid for the economy as a whole and has had an impact on functional income distribution which is shown in Figure 4.3. In the period of high and accelerating unit-labour-cost growth-under the conditions of high employment - from the early 1960s until the recession in the mid-1970s, partial adjustment of inflation meant a rising tendency of the labour income share,15 in Germany as well as in the other EMU countries. Profit margins declined and so did the profit share. Since the early 1980s when under the conditions of high and rising unemployment unit-labour-cost growth started to decline considerably, partial adjustment of inflation has meant a

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•*— Inflation rate (consumer prices)

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Deflation Risks in Germany and the EMU 78.0 76.0 74.0 72.0 70.0 68.0 66.0 64.0 62.0 60.0

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tendency of the labour income share to fall, in Germany and also in the EMU. Profit margins have increased and the profit share has recovered. The close but imperfect correlation between the unit-labour-cost growth rate and the inflation rate suggested by purely graphical analysis can be confirmed statistically using regression analyses. If the inflation rate is regressed on the unit-labour-cost growth rate it can be seen that unit-labour-cost growth exerts a statistically significant positive influence on inflation both in Germany and the EMU. This influence is greater in the case of the EMU than for Germany alone, since while in Germany a 1 percentage point increase in unit-labour-cost growth leads to a 0.39 percentage point rise in inflation, it leads to a 0.82 percentage point rise in inflation in the EMU. The coefficient of determination (r2) for Germany stands at 45 per cent, while it is as high as 85 per cent for the EMU. If the previous year's unit-labour-cost growth rate is used as an independent variable (this is a theoretically valid approach owing to delays in the cost-based price adjustment by businesses), the impact of unit-labour-cost growth on inflation is confirmed. For Germany a 1 percentage point increase in unit-labour-cost growth leads on average to a 0.44 percentage point rise in inflation in the following year. For the EMU the figure becomes 0.79 percentage points. The extent to which increases in unit labour costs explain increases in inflation is significantly higher for Germany if the previous year's figure is taken into account, since this gives an r2 coefficient of determination of 58 per cent. For the EMU the figure becomes only slightly worse and amounts to 78 per cent. The differences in adjustment of inflation to unit-labour-cost growth between Germany and the EMU countries as a whole may be due to the

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76

different degrees of openness to foreign competition (Sylos-Labini 1979). Firstly, the more open an economy is, the higher will be the proportion of imported raw materials and unfinished goods costs in unit variable costs so that changes in unit labour costs have a smaller impact on inflation than in closed economies with a smaller share of imported raw materials and unfinished goods. Secondly, the more open an economy to foreign competition, the more difficult it is for domestic producers to shift domestic cost increases to prices without loosing international market shares. In the case of rising domestic unit labour costs, foreign competition therefore acts as a brake upon prices. Since the EMU economies as a whole are less open than the German economy it comes with no surprise that we find a closer relation between unitlabour-cost growth and inflation in the former than in the latter. The statistically close correlation described between unit-labour-cost growth and inflation clearly does not yet establish that it is increases in unit labour costs that cause inflation to rise. It would in principle be possible to imagine that the correlation could be the other way round, that is that unit-labour-cost growth is driven by inflation. Indeed, the regression analysis for Germany and the EMU does show a significant degree of inverse correlation, although it is also true that the r2 value is substantially lower. However, it is our belief that this inverse correlation can be ruled out for two reasons. Firstly, it would cause theoretical problems in the framework of the post-Keynesian approach pursued in this chapter, since if money is endogenous the model would no longer have an explanation for price levels. Secondly, the results of a Granger causality test,16 even if we accept all the limitations of such tests, offer much stronger support for the assertion that unit-labour-cost growth does in fact influence inflation and not vice versa.17 It can thus be claimed both theoretically and on the basis of empirical data that in both Germany and Europe, an overall downward trend in unit-labour-cost growth since the mid-1970s led to a similar downward trend in inflation. If we take a closer look at the development since the early 1990s, the final phase of European monetary integration, it can be noted that after a brief period of more rapid growth at the beginning of this decade, since 1995 unit labour costs in Germany have risen by consistently less than in the EMU, with their annual growth remaining on average some 1.5 percentage points below the EMU average (see Figure 4.4). A similarly clear difference is evident in Germany's inflation rate, which has remained consistently below that of the EMU by an average of 0.6 percentage points per year (see Figure 4.5). In absolute terms, the average inflation rate in Germany over the whole period in question was

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Eckhard Hein, Thorsten Schulten and Achim Truger 77

78 Deflation Risks in Germany and the EMU -»-EMU

Figure 4.4 Unit-labour-cost growth in Germany and the EMU, 1991-2003 (per cent) Source: OECD (2003).

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approximately 2 per cent, but this figure includes the unusually high rates of 4 per cent experienced during the boom following reunification, and the average figure since 1995 has been just 1.4 per cent. In contrast to this, the average EMU inflation rate for the whole of the period being examined was 2.8 per cent, reaching a high of almost 6 per cent at the beginning of the 1990s, but falling to an average of just 2.1 per cent since 1995. As will be argued below, the differences in unit-labour-cost growth and inflation between Germany and the EMU as a whole cause major macroeconomic problems and deflationary risks under the present conditions of slow growth and low inflation in the currency union. 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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A-Germany

Eckhard Hein, Thorsten Schulten and Achim Truger

79

The downward trend in the annual unit-labour-cost growth rate observed in the EMU during the 1990s could theoretically be explained either by particularly stringent wage restraint or by increasing productivity growth. However, since the average annual productivity growth rate in the EMU during the 1990s stood at 1.5 per cent compared with 1.7 per cent during the 1980s (European Commission 2003: 52), it can be seen that this figure has changed very little, and consequently it is to wages policy that we should look for an explanation of this trend. There has in fact been a clear downward trend in labour cost growth. While during the 1980s the nominal remuneration per employee18 in the EMU rose by an annual average of 6.9 per cent, the figure during the 1990s was only 3.6 per cent (European Commission 2003: 88). During the course of the 1990s, the employee remuneration growth rate fell almost continuously and it was only at the end of the decade that a slight upward trend emerged once more (see Figure 4.6). This downward trend in the employee remuneration growth rate indicates that in many European countries, against a background of sustained mass unemployment, the collective bargaining power of trade unions was substantially weakened. The most visible indicators of this were falling trade union membership and a significantly lower number of strikes and industrial disputes (Boeri et al. 2001; Schulten 2004). In addition, the 1990s saw the emergence in many European countries of new corporatist competitive structures which, as a result of national social pacts and 'alliances for jobs', led to the trade unions becoming

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Figure 4.6 Remuneration per employee* in Germany and the EMU, 1991-2003 (annual increase in per cent) * Wages and salaries plus employers' contribution to social security Source: European Commission (2003).

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Wage trends and collective bargaining

firmly tied into the political agenda and committed to a competitive wages policy (Fajertag and Pochet 2000). Since the mid-1990s, the annual nominal collectively agreed hourly wage increases in the EMU have remained constantly below 3 per cent (see Table 4.1). Interestingly, in most years actual hourly earnings rose more rapidly than collectively agreed wages, resulting in a positive wage drift for the EMU as a whole. In general, the scope for distribution derived from the sum of productivity gains and inflation was clearly not fully exploited by the growth of employee remuneration in the EMU during the second half of the 1990s, and this resulted in disinflationary tendencies. In contrast, labour cost trends in the EMU at the start of the twenty-first century are typical for a cyclical downturn, since, owing to the sharp fall in productivity growth, they are increasing at a rate that is slightly higher than the scope for distribution.19 It should be pointed out, however, that wage trends in the individual EMU countries were by no means uniform during the 1990s, and in fact reflected the occasionally major differences in economic growth and employment trends between countries. Wage increases were distinctly higher than the EMU average principally in some of the smaller EMU countries that achieved especially dynamic economic growth, such as Ireland, the Netherlands and recently also Spain. This contributed to higher than average inflation as a result of these countries exceeding the national scopes for distribution, in some cases by a considerable margin (Schulten 2002). The situation was somewhat different in the larger EMU countries, that is in France, Italy and Germany. While overall wage increases in Italy were slightly higher than the EMU average and slightly lower than the EMU average in France, in Germany they have remained consistently below the EMU average since 1996 (see Figure 4.6). Germany has thus been pursuing the most moderate wages policy in the EMU for some eight years, and given that it is the largest economy in the EMU, this has exerted a downward pressure on EMU average wage increases. The particularly low wage increases in Germany can firstly be attributed to a lessening of the trade unions' bargaining power. While at the start of the 1990s the trade unions were still able to achieve exceptionally high collectively agreed wage settlements on the back of the boom following German reunification, since 1996 at the latest their collective bargaining policy has been plunged into a major crisis and they have been forced to accept collectively agreed wage increases of under 3 per cent and on occasion even under 2 per cent (see Table 4.2).20

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80 Deflation Risks in Germany and the EMU

Scope for distribution^ inflation +producitivity growth1

Indicators of wage trends1

1996 1997 1998 1999 2000 2001 2002 2003

Collectively agreed wages per employee hour

Actual earnings per employee hour

Wage drift2

Remuneration per employee

2.7 2.3 2.1 2.3 2.2 2.6 2.7 2.4

3.0 2.6 1.9 2.5 3.3 3.5 3.3 2.8

+0.3 +0.3 -0.2 +0.2 + 1.1 +0.9 +0.6 +0.4

2.3 1.9 1.2 2.0 2.7 2.8 2.5 2.4

Prices3

Labour productivity per employee

Scope for distribution4

Extent to which scope for distribution is exploited by employee remuneration5

2.2 1.6 1.1 1.1 2.1 2.3 2.3 2.1

1.1 1.5 1.1 1.0 1.3 0.2 0.3 0.2

3.3 3.1 2.2 2.1 3.4 2.5 2.6 2.3

-1.0 -1.2 -1.0 -0.1 -0.7 +0.3 -0.1 +0.1

Notes: x increase to previous year in per cent; 2 difference between growth rate of actual earnings and growth rate of collectively agreed wages in percentage points; 3 harmonized consumer price index (HCPI), 4 inflation rate + productivity growth rate; 5 difference between growth rate of employee remuneration and growth rate of labour productivity plus inflation rate in percentage points. Sources: ECB, authors' own calculations.

oo

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Table 4.1 Wage trends and extent to which the scope for distribution is exploited in the EMU

Scope for distribution^inflation +productivity growth1

Indicators ofwage trends1

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Collectively agreed wages3

Actual earnings3

Wage drift4

Employee remuneration3

Prices5

Labour productivity3

12.0 7.5 3.4 4.9 2.6 1.5 1.9 2.9 2.0 2.0 2.7 2.0

9.1 6.1 2.1 4.5 3.0 1.0 1.4 2.3 2.8 2.7 2.1 1.2

-2.9 -1.4 -1.3 -0.4 +0.4 -0.5 -0.5 -0.6 +0.8 +0.7 -0.6 -0.8

9.2 5.8 3.1 4.9 2.8 1.6 1.5 2.0 3.3 2.5 2.2 1.5

5.1 4.4 2.7 1.7 1.5 1.9 0.9 0.6 1.4 2.0 1.4 1.1

2.7 1.6 2.6 2.5 2.3 2.0 1.3 1.5 2.2 1.4 1.3 0.8

00

Extent to which scope for distribution is exploited2

Scope for distribution6

By collectively agreed wages

By actual earnings

By employee remuneration

7.8 6.0 5.3 4.2 3.8 3.9 2.2 2.1 3.6 3.4 2.7 1.9

+4.2 + 1.5 -1.9 +0.7 -1.2 -2.4 -0.3 +0.8 -1.6 -1.4 0.0 +0.1

+ 1.3 +0.1 -3.2 +0.3 -0.8 -2.9 -0.8 +0.2 -0.8 -0.7 -0.6 -0.1

+ 1.4 -0.2 -2.2 +0.7 -1.0 -2.3 -0.7 -0.1 -0.3 -0.9 -0.5 -0.4

Notes:x increase to previous year in per cent, 2 percentage points, 3 per employee hour; 4 difference between growth rate of actual earnings and growth rate of collectively agreed wages in percentage points; 5 Federal Statistical Office consumer price index, 6 inflation rate + productivity growth rate. Sources: Bundesbank, Federal Statistical Office, authors' own calculations.

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Table 4.2 Wage trends and extent to which the scope for distribution is exploited in Germany

The crisis of trade unions' collective bargaining policy is shown even more clearly by actual earnings trends than it is by collectively agreed wage trends. In contrast to most other EMU countries, wage trends in Germany in the 1990s were mainly characterized by a negative wage drift, with actual earnings growing even more slowly than collectively agreed wages. This means that the trade unions were unable to ensure that the wage increases they had negotiated were actually implemented in all companies. In addition to the trade unions' loss of political power, the negative wage drift in Germany is also a consequence of fundamental changes in the structure and operation of the German collective bargaining system.21 One clear sign of this is the decline in the number of companies and employees covered by collective agreements that has been observed since the mid1990s (Schnabel 2003). According to the IAB (Institut fur Arbeitsmarktund Berufsforschung) figures for 2001, only 48 per cent of all companies in western Germany and 71 per cent of all employees were bound by collective agreements, while in eastern Germany the figures were as low as 28 per cent of companies and 56 per cent of employees (Bispinck 2003: 395). The negative wage drift seems to suggest that wage increases in companies not bound by collective agreements were significantly lower. Furthermore, even within the German collective bargaining system there are numerous signs to suggest that the binding nature of collective agreements is being eroded, making negotiated collective wage increases harder to implement in practice and consequently favouring a negative wage drift. There is now a significant number of companies that are formally bound by collective agreements but which in practice do not comply with them. According to the results of the 2002 WSI Works Council Survey, which probably only covers part of the problem, 10 per cent of companies occasionally failed to comply with the terms of current collective agreements, and a further 5 per cent did so frequently. In the majority of these cases, the non-compliance involved failure to pay the collectively agreed wages (Bispinck and Schulten 2003: 159). In addition to the above, 'hardship' and 'opening-clauses' were introduced into virtually all of the major sectoral collective agreements in the 1990s, allowing companies to deviate from the terms contained in collective agreements under certain circumstances.22 Opening-clauses are now used by more than a third of all companies, although it is true that in the majority of cases these relate to the divergence of working time organization from the collective agreement, and the use of openingclauses with regard to remuneration is for the time being still not very widespread (Bispinck and Schulten 2003: 160).23

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Eckhard Hein, Thorsten Schulten and Achim Truger 83

One final significant cause of the negative wage drift is the reduction of payments that are above the collectively agreed rate. A large number of companies in Germany continue to pay wages that are higher than those established in their collective agreement. The results of the IAB company panel show that although the number of companies paying more than the collectively agreed rate did decline in the 1990s, it still stood at 48 per cent in 2000 (Schnabel 2003: 95). The wage spread, that is the absolute difference between collectively agreed wages and actual wages was on average found to be approximately 11 per cent (Schnabel 2003: 95). Nevertheless, during the course of the 1990s, several companies began to use 'company alliances for jobs' to 'compensate for' the wage increases negotiated in collective agreements by cutting back on payments above the collectively agreed rate. This led to the emergence of a new form of concession bargaining in which employees agree to give up established benefits in exchange for limited job security, thereby contributing to a substantial reduction in labour costs. Since the mid-1990s, the collectively agreed wage settlements achieved in practice by Germany's trade unions have no longer been sufficient in most years to fully exploit the scope for distribution (see Table 4.2). The negative wage drift also indicates that the significance of trade union collective bargaining policy has waned considerably, with the result that actual wage increases have fallen still further behind the sum of inflation and productivity increases. Even if overall employee remuneration in the 1990s rose by slightly more than actual wages did, there can be little question that on the whole wages policy developments in Germany had clear disinflationary repercussions and must as such take a large part of the responsibility for the low inflation rate in the largest economy in the EMU. Conclusion: the dilemma of wage policies in Germany and Europe Despite the sluggish growth currently being experienced in the EMU, wages policy and trends have not yet caused acute deflationary risks. However, there is no guarantee that this will continue to be the case if the restrictive macroeconomic policy mix of the past continues to be pursued.24 One of the main causes of the sluggish economic growth is the 'anti-growth bias' in the ECB's monetary policy with its inflation target of 'below, but close to 2 per cent' (ECB 2003: 89) which is far too low for a heterogeneous currency area with markedly different growth and inflation rates - not to mention the fact that it is asymmetrical in nature

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84 Deflation Risks in Germany and the EMU

and is exclusively geared towards ensuring that the inflation target is not exceeded. The growth-unfriendly effect of this monetary policy is magnified by the Stability and Growth Pact that forces the European fiscal policy to be pro-cyclical and to target budgetary consolidation via spending cuts, something that is ultimately to the detriment of public investment. If the economic stagnation resulting from these monetary and fiscal policies persists, it is quite possible that the associated high unemployment could increase the pressure on wages policy, leading in turn to an increase in wages policy-driven deflationary risks. The danger of deflation is already considerably higher in Germany than in the EMU as a whole, since the stagnation caused by monetary and fiscal policy is aggravated by Germany's excessive wage restraint.25 The unit-labour-cost growth rate has for some time now been significantly lower than the EMU average, and this is to a large extent responsible for an inflation rate that is also much lower than average. Consequently, even a monetary policy that might be suitable for the EMU as a whole is too restrictive for a country where growth is as low as in Germany. Furthermore, the fact that nominal interest rates are the same across the EMU and inflation in Germany is below average means that German consumers and investors are faced with real interest rates that are higher than the EMU average. On top of this, excessive wage restraint has led to a falling labour income share, which has in turn further weakened domestic demand. The combination of a pronounced trend towards stagnation and significant deflation risks - not yet actual deflation - in the largest EMU country together with the ECB's overly ambitious inflation target for the EMU as a whole represents a major challenge for wages policy in Germany and in the rest of Europe.26 If Germany is to achieve an economic recovery with the aid of wages policy, both the unit-labour-cost growth rate and inflation will need to rise. However, if such a rise leads to an EMU inflation rate that is higher than the ECB's inflation target owing to the fact that other EMU countries have inflation rates that exceed the ECB target by a considerable margin, then restrictive monetary policy intervention is always going to be on the cards. What this means is that if the ECB is not prepared to raise its inflation target substantially in order to allow the slowly growing larger economies more room to achieve a recovery, then it will be necessary to reduce inflation in the other EMU countries. It is therefore important for the bargaining parties and in particular the trade unions to intensify their efforts towards European-level effective coordination of wages policy. The aim of this process should be for each country to increase wages on the basis

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Eckhard Hein, Thorsten Schulten and Achim Truger 85

of its long-term domestic productivity growth figures plus the ECB's target inflation rate.27 If it proves impossible either to convince the ECB to raise its inflation target or to coordinate wages policy in the EMU countries as described above, then in the medium to long run Germany's stagnation and deflation risks are likely to spread increasingly to the other EMU countries. Excessive wage restraint in Germany will not only fuel national economic stagnation, but will also put pressure on wages policy in the other EMU countries in the medium term. The fact that inflation in Germany is lower than the EMU average means that price competitiveness of German producers in the European market is constantly increasing. It is true that in recent years, growing export surpluses have prevented Germany from sliding into a deep recession. However, it also means rising import surpluses for the other EMU countries, something that cannot be sustained for any length of time owing to the negative effects on income and employment. Since the EMU countries can no longer resort to a currency devaluation, it is inevitable that sooner or later there will be a wages policy response, as witnessed in the Netherlands, where the recent wage bargaining round ended with a zero wage increase (Schulten and Muhlhaupt 2003). However, if wages policy starts to be widely used to improve price competitiveness, then further redistribution at the expense of labour, rising effective demand problems and the threat of deflation will spread accordingly. If this happens, then even a more growth-friendly monetary policy by the ECB might be ineffective and in the next downturn the deflationary risks may become actual deflation. Notes 1 The report defined deflation as a sustained fall in the consumer price index or GDP deflator. The common technical definition of deflation as a fall over the course of two consecutive quarters was not considered to be sufficient (IMF 2003: 6). 2 For a contrasting position on the powerlessness of monetary policy to combat deflation, see for example Buiter (2003). 3 Consequently, monetary policy should aim for a positive inflation rate, albeit a low one, rather than zero inflation. 4 While the Bundesbank (2003) does not believe that Germany is experiencing deflation risks, it nevertheless includes unit labour cost trends in its considerations. 5 At the simplest level, the 'new consensus models' are based on three equations: an aggregate demand function derived from optimization calculations of consumers and businesses, which describes the output gap as an inverse function of the real interest rate, a Phillips curve in which the inflation rate

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86 Deflation Risks in Germany and the EMU

6 7 8

9 10 11

12

13

14 15 16 17

has a positive correlation with the output gap, and a central bank reaction function, which relates the nominal interest rate set by the central bank to the equilibrium real interest rate, the output gap and the deviation of inflation from the inflation target (Taylor rule). See, among others, Eichner (1976), Wood (1975), Harcourt and Kenyon (1976), Sylos-Labini (1969, 1979). For surveys of post-Keynesian price theories see: Lavoie (1992: 129-48, 2001) and Lee (1998, 2003). One cause of this can be a monetary policy decision to raise interest rates. This leaves businesses facing higher interest costs, which they attempt to pass on by increasing their mark-ups (Hein 2004a). See Hein (2002, 2004a) for an attempt to integrate wage bargaining institutions into a post-Keynesian model of wages, employment and inflation. This attempt relies on the work of institutional political economists deriving the beneficial effects of effective wage bargaining coordination on macroeconomic performance, in particular in interaction with independent central banks (Soskice 1990; Hall and Franzese 1998; Franzese 2001, 2001a; Kittel and Traxler 2001; Hein 2002a). Post-Keynesians have also argued that in the long term the NAIRU adjusts endogenously to the actual unemployment rate through different channels (Hein 2002, 2004). See also Kalecki (1969: 55-9). The same is true of the positive effect of falling prices on real wealth and consumer demand proposed by neoclassical theory: in order for the Pigou effect to come about, it is necessary for the monetary wealth of the economy as a whole to be exogenously determined net wealth. This has already been made clear by Kalecki (1937, 1954: 91-5) in his 'principle of increasing risk' according to which the firm's access to external capital on capital markets is largely determined by its entrepreneurial capital. Investment is therefore limited by finance which is in turn inversely affected by the degree of indebtedness. A similar view was taken by Robinson (1962: 86) and Steindl (1952: 107-38). Recent empirical work has shown that business investment is strongly influenced by internal funds which determine the access to external borrowing on imperfect capital markets (see Fazzari, Hubbard and Petersen 1988; Hubbard 1998; Schiantarelli 1996). Changes in the mark-up may either be caused by changes in the intensity of price competition in the goods market or changing power relations between capital and labour in the labour market, on the one hand. Or changes in the mark-up may be due to changing overhead costs, i.e. variations in salaries or in capital costs, on the other hand. On the relation between unemployment, wages and functional income distribution in the European Union, see more explicitly Hein and Schulten (2004). The labour income share is calculated as compensation per employee as percentage of GDP at factor costs per person employed. See Gujarati (1995: 620-4). In our Granger test, for a lag of 1, the growth rate of unit labour costs for Germany had a significance level of 1 per cent and the significance level for the EMU was still 25 per cent, making it Granger-causal for inflation.

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18 19

20 21

22 23 24 25 26 27

In contrast, the inflation rate was not Granger-causal for the unit-labour-cost growth rate in either Germany or the EMU. The remuneration per employee figure includes gross earnings and salaries as well as non-wage labour costs, i.e. employer social security contributions. Since the ECB data for collectively agreed and actual wage increase is calculated on an hourly basis but the data for labour productivity is calculated on the basis per employee, it is unfortunately not possible to discuss to what extend the scope for distribution was exploited by collectively agreed wage increases. See also Flassbeck and Maier-Rigaud (2003). When calculating the even higher overall figure for the negative wage drift per employee, changes in actual working time (e.g. overtime or short-time working) are of particular importance. However, these factors are not taken into account in the figure for wage drift per employee hour used here, in order to enable us to concentrate purely on the structural aspects of collective bargaining policy. For more on the current debate concerning developments in the German collective bargaining system, see for example Bispinck (2003), Bispinck and Schulten (2003), Schnabel (2003) and the contributions in Wagner and Schild (2003). For a more detailed analysis and description of the main hardship and opening-clauses, see Bispinck and WSI Tarifarchiv (2003). For more on the debate surrounding 'Company Alliances for Jobs', see the contributions in Seifert (2002). See Hein (2003) and Hein and Truger (2005, 2005a) for a detailed analysis of the EMU's restrictive policy mix. For a more detailed analysis of the causes of stagnation in Germany see Hein and Truger (2005b). On the interaction of the ECB's monetary policy with wage bargaining in Europe see Hein (2002). For more detailed information on the current status and future prospects of the various trade union coordination initiatives, see Schulten (2003, 2004) and Traxler and Mehrmet (2003).

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88 Deflation Risks in Germany and the EMU

References Ahearne, A. et al. (2002) Preventing Deflation: Lessons from Japan's Experience in the 1990s, Board of Governors of the Federal Reserve System, International Finance Discussion Papers no. 729. Akerlof, G.A., Dickens, W.T. and Perry, G.L. (1996) 'The Macroeconomics of Low Inflation', Brooking Papers on Economic Activity, 1: 1-76. Arestis, P. and Sawyer, M. (2003) 'New Consensus', New Keynesianism and the Economics of the "Third Way" ', in E. Hein, A. Heise and A. Truger (eds), Neu-Keynesianismus - der neue wirtschaftspolitische Mainstream? (Marburg: Metropolis). Bernanke, B. (1995) 'The Macroeconomics of the Great Depression: A Comparative Approach', Journal of Money, Credit and Banking, 27: 1-28. Bispinck, R. (2003) 'Das deutsche Tarifsystem in Zeiten der Krise - Streit um Flachentarif, Differenzierung und Mindeststandards', WSI-Mitteilungen, 56: 395-404.

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Bispinck, R. and Schulten, T. (2003) 'Decentralization of German Collective Bargaining - Current Trends and Assessments from a Works and Staff Council Perspective', WSI-Mitteilungen, special English issue, 56: 24-33. Bispinck, R. and WSI-Tarifarchiv (2003) Tarifliche Oeffnungsklauseln. Fine Analyse von Regelungen aus 80 Tarifbereichen, Reihe Elemente qualitativer Tarifpolitik 52 (Diisseldorf: Haus Boeckler Foundation). Boeri, T., Brugiavini, A. and Calmfors, L. (eds) (2001) The Role of Unions in the Twenty-First Century: A Report for the Fondazione Rodolfo Debenedetti (Oxford: Oxford University Press). Buiter, W. (2003) Deflation: Prevention and Cure, NBER Working Paper Series no. 9,623 (Cambridge, Mass.: National Bureau of Economic Research). Clarida, R., Gali, J. and Gertler, M. (1999) 'The Science of Monetary Policy: A New Keynesian Perspective', Journal of Economic Literature, 37: 1661-707. Deutsche Bundesbank (2003) 'Zur Diskussion liber Deflationsgefahren in Deutschland', Monatsbericht, 55(6): 15-28. ECB (2003) 'The Outcome of the ECB's Evaluation of its Monetary Policy Strategy', Monthly Bulletin (June): 79-92. Eichner, A. (1976) TheMegacorp and Oligopoly (Cambridge: Cambridge University Press). European Commission (2003) European Economy, Autumn 2003 (Brussels: DG Economy and Finances). European Commission (2004) AMECO Database, DG Economy and Finances, http://europa.eu.int/comm/economy_finance/indicators/annual_macro_ economic_database/ameco_en.htm. Fajertag, G. and Pochet, P. (eds) (2000) Social Pacts in Europe - New Dynamics (Brussels: ETUI). Fazzari, S.M., Hubbard, R.G. and Petersen, B.C. (1988) 'Financing Constraints and Corporate Investment', Brooking Papers on Economic Activity, 1: 141-95. Fisher, I. (1933) 'The Debt-Deflation Theory of Great Depressions', Econometrica, 1: 337-57. Flassbeck, H. and Maier-Rigaud, R. (2003), 'Auf der schiefen Bahn - Die deutsche Lohnpolitik verscharft die Krise', Wirtschaftsdienst, 83: 170-7. Franzese, R.J. (2001) 'Institutions and Sectoral Interactions in Monetary Policy and Wage/Price-Bargaining', in PA. Hall and D. Soskice (eds) Varieties of Capitalism. Institutional Foundations of Comparative Advantage (Oxford: Oxford University Press). Franzese, R.J. (2001a) 'Strategic Interaction of Monetary Policymakers and Wage/Price Bargainers: A Review with Implications for the European CommonCurrency Area', Empirica, 28: 457-86. Gujarati, D.N. (1995) Basic Econometrics, 3rd edn (New York etal.: McGraw-Hill). Hall, PA. and Franzese, R.J. (1998) 'Mixed Signals: Central Bank Independence, Coordinated Wage Bargaining, and European Monetary Union', International Organization, 52: 505-35. Harcourt, G. and Kenyon, P. (1976) 'Prices and the Investment Decision', Kyklos, 29: 449-77. Hein, E. (2002) 'Monetary Policy and Wage Bargaining in the EMU: Restrictive ECB Policies, High Unemployment, Nominal Wage Restraint and Inflation Above the Target', Banca Nazionale del Lavoro Quarterly Review, 55: 299-337.

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Hein, E. (2002a) 'Central Bank Independence, Labour Market Institutions and the Perspectives for Inflation and Employment in the European Monetary Union', Political Economy. Review of Political Economy and Social Sciences, 10: 37-64. Hein, E. (2003) Voraussetzungen und Notwendigkeiten einer europaischen Makrokoordinierung, in: Angelo, S., Mesch, M. (eds) Wirtschaftspolitische Koordination in der Europaischen Wahrungsunion, Wirtschaftswissenschaftliche Tagungen der Arbeiterkammer Wien, 7 (Vienna: LexixNexis). Hein, E. (2004) 'Die NAIRU - eine post-keynesianische Interpretation', Intervention. Journal of Economics, 1: 43-66. Hein, E. (2004a) Verteilung und Wachstum. Eine paradigmenorientierte Einfuhrung unter besonderer Berucksichtigung der post-keynesianischen Theorie (Marburg: Metropolis). Hein, E. and Schulten, T. (2004) 'Unemployment, Wages and Collective Bargaining in the European Union', Transfer. European Review of Labour and Research, 10: 532-51. Hein, E. and Truger, A. (2005) 'Macroeconomic Co-ordination as an Economic Policy Concept - Opportunities and Obstacles in the EMU', in E. Hein, T. Niechoj, T. Schulten and A. Truger (eds) Macroeconomic Policy Coordination in Europe and the Role of the Trade Unions (Brussels: ETUI). Hein, E. and Truger, A. (2005a) 'European Monetary Union: Nominal Convergence, Real Divergence and Slow Growth?', Structural Change and Economic Dynamics, 16: 7-33. Hein, E. and Truger, A. (2005b) 'What Ever Happened to Germany? Is the Decline of the Former European Key Currency Country Caused by Structural Sclerosis or by Macroeconomic Mismanagement?', International Review of Applied Economics, 19: 3-28. Hubbard, R.G. (1998) 'Capital-market Imperfections and Investment', Journal of Economic Literature, 36: 193-225. Institute (2003) Arbeitsgemeinschaft deutscher wirtschaftswissenschaftlicher Forschungsinstitute, 'Die Lage der Weltwirtschaft und der deutschen Wirtschaft im Herbst 2003', DIW Wochenbericht, 70: 643-86. International Monetary Fund (2003) Deflation: Determinants, Risks and Policy Options - Findings of an Interdepartmental Task Force (Washington, DC: IMF). Kaldor, N. (1970) 'The New Monetarism', Lloyds Bank Review, 97 (July): 1-17. Kaldor, N. (1982) The Scourge of Monetarism (Oxford: Oxford University Press). Kaldor, N. (1985) 'How Monetarism Failed', Challenge (May/June): 4-13. Kalecki, M. (1937) 'The Principle of Increasing Risk', Economica, 4: 440-7. Kalecki, M. (1954) The Theory of Economic Dynamics (London: George Allen & Unwin). Kalecki, M. (1969) Studies in the Theory of Business Cycles, 1933-1939 (London: Basil Blackwell). Keynes, J.M. (1936) The General Theory of Employment, Interest, and Money, The Collected Writings of J.M. Keynes, Vol. VII, 1973 (London, Basingstoke: Macmillan - now Palgrave Macmillan). Kittel, B. and Traxler, F. (2001) 'Lohnverhandlungssysteme und Geldpolitik', Wirtschaft und Gesellschaft, 27: 11-40. Kromphardt, J. (2003) 'Lohnpolitik bei moglicher Deflation', Wirtschaftsdienst, 83: 501-8.

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Lavoie, M. (1984) 'The Endogenous Flow of Credit and the Post Keynesian Theory of Money', Journal of Economic Issues, 18: 771-97. Lavoie, M. (1992) Foundations of Post Keynesian Economic Analysis (Aldershot: Edward Elgar). Lavoie, M. (1996) 'Horizontalism, Structuralism, Liquidity Preference and the Principle of Increasing Risk', Scottish Journal of Political Economy, 43: 275-300. Lavoie, M. (2001) 'Pricing', in R.P.F. Holt and S. Pressman (eds), A New Guide to Post Keynesian Economics (London, New York: Routledge). Lee, F. (1998) Post Keynesian Price Theory (Cambridge: Cambridge University Press). Lee, F. (2003) 'Pricing and Prices', in J.E. King (ed.), The Elgar Companion to Post Keynesian Economics (Cheltenham: Edward Elgar). Meyer, L.H. (2001) 'Does Money Matter?', Federal Reserve Bank of St. Louis Review, 83(5): 1-15. Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money (Cambridge: Cambridge University Press). Moore, B.J. (1989) 'The Endogeneity of Credit Money', Review of Political Economy, 1: 65-93. OECD (2003) Economic Outlook, 73, Data from CD-ROM (Paris: OECD). Robinson, J. (1962) Essays in the Theory of Economic Growth (London: Macmillan now Palgrave Macmillan). Sawyer, M. (2001) 'The NAIRU: A Critical Appraisal', in P. Arestis and M. Sawyer (eds), Money, Finance and Capitalist Development (Cheltenham: Edward Elgar). Sawyer, M. (2002) 'The NAIRU, Aggregate Demand and Investment', Metroeconomica, 53: 66-94. Schiantarelli, F. (1996) 'Financial Constraints and Investment: Methodological Issues and International Evidence', Oxford Review of Economic Policy, 12: 70-89. Schnabel, C. (2003) Tarifpolitik unter Reformdruck, Benchmarking Deutschland Aktuell (Giitersloh: Bertelsmann Foundation). Schulten, T. (2002) Tarifpolitik in Europa 2001/2002 - 2. Europdischer Tarifbericht des WSI, Reihe WSI Informationen zur Tarifpolitik (Duesseldorf: Hans Boeckler Foundation). Schulten, T. (2003) 'Europeanization of Collective Bargaining: Trade Union Initiatives for the Transnational Coordination of Collective Bargaining', in H.-W. Platzer and B. Keller (eds), Industrial Relations and European Integration. Trans- and Supranational Developments and Prospects (Aldershot, Hampshire: Ashgate). Schulten, T. (2004) Solidarische Lohnpolitik in Europa. Zur Politischen Oekonomie der Gewerkschaften (Hamburg: VSA). Schulten, T. and Muhlhaupt, B. (2003) 'Nullrunden in den Niederlanden', Die Mitbestimmung, 49(12): 44-7. Seifert, H. (ed.) (2002) Betriebliche Buendnisse fur Arbeit (Berlin: Edition Sigma). Snowdon, B., Vane, H. and Wynarczyk, P. (1994) A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought (Cheltenham: Edward Elgar). Soskice, D. (1990) 'Wage Determination: The Changing Role of Institutions in Advanced Industrialized Countries', Oxford Review of Economic Policy, 4: 36-61.

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Steindl, J. (1952) Maturity and Stagnation in American Capitalism, 2nd edn. 1976 (New York, London: Monthly Review Press). Sylos-Labini, P. (1969) Oligopoly and Technical Progress, 2nd edn (Cambridge: Cambridge University Press). Sylos-Labini, P. (1979) 'Prices and Income Distribution in Manufacturing Industry', Journal of Post Keynesian Economics, 11: 3-25. Traxler, F. and Mehrmet, E. (2003) 'Coordination of Collective Bargaining: The Case of Europe', Transfer. European Review of Labour and Research, 9: 229-46. Wagner, H. and Schild, A. (eds) (2003) Der Flaechentarif unter Druck. DieFolgen von Verbetrieblichung und Vermarktlichung (Hamburg: VSA). Wood, A. (1995) A Theory of Profits (Cambridge: Cambridge University Press).

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92 Deflation Risks in Germany and the EMU

The Influence of Unemployment, Productivity and Institutions on Real Wage Trends: The Case of Italy 1970-2000* Enrico Sergio Levrero and Antonella Stirati

Introduction The aim of this chapter is to describe and attempt to interpret the trends of wages in Italy in the period 1970-2000. While it is an applied work, it may be useful to provide at the beginning a brief clarification of the broader framework implicit in the analysis. On consideration of the analytical faults found in neoclassical substitution mechanisms as a foundation for decreasing factor demand schedules, we do not approach the explanation of wages by assuming that the economic forces underlying their determination can be described by the interaction between labour demand and supply functions. More generally, we envisage no tendency of the economy towards full employment or NAIRU (non-accelerating inflation rate of unemployment) equilibria, such as is still assumed in the models that replace the traditional labour demand and supply curves with 'pseudo-curves' based respectively on firm pricing rules and models of wage determination. 1 In line with the classical approach and its modern revival, we instead expect wage trends to be affected by a set of historical and current circumstances that can be broadly classified as labour-market conditions, the degree of organization of the parties *A longer and partially different version of this chapter was published in Economia & Lavoro, 2004, 1. We wish to thank S. Cesaratto, G. Olini, M. Pivetti and P. Vicard for their comments as well as the participants at the 2003 annual International Working Party on Labour Market Segmentation (IWPLMS) conference, the conference 'Sraffa o un'altra economia' (Rome 2003), and the conference 'Wages, Distribution and Growth' (Berlin 2004). The usual disclaimer applies. 93 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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5

involved, and broader economic and political/institutional factors. All these circumstances affect wage determination through the same channel, that is their influence on the ability of the parties involved to establish favourable conditions for themselves in the distribution of income (Stirati 1992; Levrero 2006). There is thus no a priori hierarchy in their respective role, although empirical and historical analysis may obviously show that in specific contexts certain factors have been more important than others, and can also indicate their reciprocal influences.2 An emphasis on the role of those circumstances can be found in various streams of current economic literature, even though the analytical standpoints adopted often differ greatly from the one just outlined. This suggests that they are empirically relevant in affecting wages. For example, the empirical literature on the 'wage curve' (Blanchflower and Oswald 1994) shows the connection between labour market conditions, the unemployment rate in particular, and real wages across regions and industries within a country; changes in the 'bargaining strength' of the parties involved (in the form of shifts in the pseudo demand and supply curves) have been indicated as one possible explanation of changes in income distribution in Europe (Blanchard 1997); and the political situation has been regarded as a central factor in determining the unemployment rate and income distribution across countries (Korpi 1991). Adoption of the classical standpoint implies, however, that such factors as institutional changes are not expected to have only transitory effects and are not regarded as 'disturbances' with respect to the underlying forces of 'supply and demand'. For the same reason, institutional factors determining wage stickiness cannot be seen as the causes of unemployment (the latter depending essentially on effective demand and technical change, given labour supply). The structure of the chapter is as follows. In the next section we describe the trends of contractual wages and earnings, both gross and net of taxes and employees' contributions, and discuss some regression results as a means of assessing the major influences on wage trends. In this connection, we also comment upon the observed scarce influence of labour productivity and terms of trade on wages. In the following two sections we first analyze in greater detail labour market conditions at particular junctures and then broaden the analysis to look at the influence of institutional and economic changes. In the final section we summarize our results and discuss some open questions in connection with the literature.

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94 Unemployment, Productivity and Institutions: Italy

Enrico Sergio Levrero and Antonella Stirati 95

Although the rest of the chapter focuses solely on the period 1970-2000, we shall look here at the data available on contractual wages since 1956 so as to provide some longer-term perspective and ground for comparison. We are primarily interested in the real wages of production workers in the business sector. Within the latter, we focus on Industry and Trade, since they account together for about 70 per cent of all employees and appear to be reasonably homogeneous in terms of types of activities and of employees.3 Examination of Figure 5.1 clearly shows the drive towards higher wage increases in industry and trade in 1962-65, a subsequent slowdown caused by a cyclical downturn, and then sustained growth in 1970-77 at an annual average rate of about 7 per cent. The average growth rates then decline sharply, approaching zero in the 1990s (1.3 per cent per annum in 1978-88 and 0.3 per cent in 1989-2000). They were thus similar in the 1980s and lower in the 1990s with respect to the 1955-61 period, usually regarded as one of trade-union weakness and large labour reserves in backward agriculture and in the southern regions. Changes in gross earnings (which are an average of the earnings of all employees, including white collars) in both Industry and Trade closely Trade -•— Industry

Figure 5.1 Annual rates of change of real hourly wages of production workers in trade and industry, 1956-2000 Sources: ISTAT, Sommario di statistiche storiche 1926-1985, and Lavoro e Retribuzioni (various years).

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Description of trends and some quantitative analysis

96 Unemployment, Productivity and Institutions: Italy 180 160 H

120 100 H 80 60 H 40

Real gross wages, industry Real net wages, industry

20 0

n—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i C

M

^

C

O

C

O

O

C

M

^

C

O

O

O

O

C

M

^

-

C

D

C

O

O

r ^ h « . i ^ i ^ c o o o o o c o c o a > a > o > a ) o > o

Figure 5.2 Real gross and net wages in industry (1972 = 100), 1972-2000 Sources: OECD, The Tax-Benefit Position of Production Workers (various years), and ISTAT, Contabilita Nazionale (2002b) (see also note 4).

follow those in contractual wages. Considering Industry alone, the change in the trend occurring after 1977 is, however, even more marked if we look at earnings net of income taxes and employees' contributions, as shown in Figure 5.2.4 Net earnings rose about six points less than gross earnings between 1976 and 1979 owing to the increasing incidence of employee contributions and income-tax rates and to the phenomenon of fiscal drag. Subsequently they even fell (10 points in 1979-83), regaining their 1979 value only in 1988. After a very slight recovery, net earnings have again performed worse than gross since 1992. They fell three percentage points more than gross earnings in 1992-95 (the aim of fulfilling the 'Maastricht parameters' led to an increase in taxes on labour at a time when real gross earnings were falling) and, unlike the latter, had not yet regained the 1990 level in 2000 (see also Banca d'ltalia, 2001a).5 In order to assess possible explanations of the trends described above, we have explored the correlation between (gross) wages and earnings in Industry and Trade and a number of variables that could be expected to prove influential, particularly productivity growth and labour-market conditions. The latter in turn may be general, reflected in indicators such as the unemployment rate,6 or specific to given groups of workers, reflected in the unemployment rates of sub-sets of employees or in sector employment trends.

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140

There are two aspects to be noted at the start of this empirical exploration. First, since simple correlation analysis shows that the moving averages of actual earning rates of change in each sector are strongly correlated with those of contractual wages (the Pearson correlation coefficients are R = 0.92 and R = 0.89 in Industry and Trade respectively), we have chosen to discuss here the main factors affecting the rates of change of contractual wages. Second, as can be gathered from Figure 5.1 above, there is a very close correlation between changes in contractual wages in Industry and Trade (R = 0.96 for moving averages). This correlation is greater than, and cannot therefore be simply attributed to, correlation with a third factor (such as the general unemployment rate) influencing both variables, and suggests a direct link between the two. Since both are the result of national contracts, this link indicates that there is harmonization between wage demands or wage concessions made by the parties involved in the two sectors. Both data analysis and historical experience suggest, however, that the industrial sector has played a dominant role in wage determination. As regards the data, the Pearson correlation coefficient between contractual wages and rates of change in the sector's employees7 is in fact relatively high in Industry (R = 0.7), while it is almost zero in the Trade sector (R = 0.03).8 Together with the very high correlation between wages in Industry and Trade, this suggests a leading role played by wage setting in Industry (see also Brunello 1996). We can therefore regard industrial wages as our pivot variable, affecting wages and earnings of employees in the business sector as a whole. Focusing thus on Industry, Table 5.1 shows the results obtained by regressing the rates of change in real wages in Industry on the rate of change in productivity and employees in the same sector, the general unemployment rate, and two dummies for the years 1979 and 1993-95, three-year moving averages being taken for all the variables.9 The overall unemployment rate appears to have played the major role in affecting real wages in the 1970-2000 period (a similar influence being found also in the previous decade).10 As discussed above, changes in industrial employment also play a less important but still significant role. By contrast, changes in productivity have a small and statistically non-significant coefficient, while the 1979 dummy has a coefficient of -1.8 and is statistically significant: in that year there was a downward movement in the rate of change in wages not fully accounted for by unemployment and industrial employment trends. After 1977 wages also began to grow less than industrial sector productivity, having grown (on average) more than productivity as from 1969. Another change with respect to

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Enrico Sergio Levrero and Antonella Stirati 97

98 Unemployment, Productivity and Institutions: Italy Table 5.1 Determinants of rates of change in industrial wages

Adjusted R square Standard error Observations F D.W.

Intercept Productivity5 1993-95d 1979d Unemployment0 Employees5

0.86 1.00 28 33.10 2.61

Coefficients

Standard error

t-stat

P-value

9.71 0.10 -1.51 -1.80 -0.78 0.44

1.03 0.10 0.61 0.99 0.10 0.13

9.41 0.99 -2.47 -1.81 -7.73 3.26

0.00 0.34 0.02 0.08 0.00 0.00

Notes: a three years moving average; b three years moving averages of annual rates of change: Employees measured in 'heads'; c three years moving average; d assumes value one in 1993-95, zero otherwise; assumes value one in 1979, zero otherwise. Sources: ISTAT, Contabilitd Nazionale (2002b) for productivity and employees; ISTAT, Rilevazioni delle Forze di Lavoro (various years) for unemployment; ISTAT, Sommario di Statistiche storiche 1926-1985 and Lavoro e Retribuzioni (various years) for wages (see also notes 3 and 16).

previous trends emerges in the early 1990s, namely a fall in contractual real wages for the first time since the 1950s followed by stagnation. Again, the coefficient on the 1993-95 dummy is negative (-1.5), and statistically significant. Such decline in real wages, albeit moderate, is quite a new phenomenon in the postwar period, and calls for enquiry. Some of the factors discussed are clearly described by the scatter diagram in Figure 5.3, which illustrates with immediacy the relationship between (moving averages of) unemployment and real wage growth and its changes in 1979 and 1993-95. The diagram also shows that the relation tends to become non-linear as growth in real wages approaches zero for the well-known reason that decreases in real wages are generally difficult to bring about and, if they take place, tend to be very gradual.11 In the next section we shall look more closely at labour-market conditions at those particular junctures. Before that, however, we shall discuss the question of the influence of productivity on real wage trends a little further. In this connection, it is advisable to extend the analysis to the business sector as a whole. Actually, wage increases might not match productivity growth in individual sectors, but productivity gains might

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Dependent variable: rates of change in industrial real wagesa

Figure 5.3 Unemployment and rate of growth of real wages in industry, 1960-99 (moving averages) Sources: ISTAT, Rilevazioni delle Forze di Lavoro (various years) for the unemployment rate; ISTAT, Sommario di Statistiche storiche 1926-1985 and Lavoro e Retribuzioni (various years) for wages (see also notes 3 and 16).

be redistributed from workers in sectors with high productivity growth to workers in other sectors, for example owing to a centralized bargaining system ensuring equal wage increases across industries. It is worth examining this point. Productivity growth evidently 'makes room' for wage increases at a given rate of profit, and it has often been argued, on different grounds, that changes in productivity tend to determine changes in real wages.12 However, since the same effect upon the 'margins' for wage increases arises also from improvements in the terms of trade, we should in fact ascertain whether productivity and terms of trade have played a joint direct role in determining wage trends. 13 Table 5.2 shows the results of a regression similar to the one estimated for Industry but referring to the Business sector as a whole and with rates of change in actual real earnings as the dependent variable and terms of trade as one of the independent variables. Changes in terms of trade have a very small and statistically non-significant coefficient. The coefficient of productivity is now statistically significant, albeit not very large (one percentage point change in productivity is on average associated with a half-percentage-point increase in real wages, other things remaining constant). Indeed, in the Business sector as a whole, as in Industry, until 1977, with a comparatively low unemployment rate, wages tended to rise systematically more than productivity, despite a

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Enrico Sergio Levrero and Antonella Stirati 99

100 Unemployment, Productivity and Institutions: Italy Table 5.2 Determinants of rates of change in real earnings in the business sector Dependent variable: rates of change in real earnings in the business sector a

Adjusted R square Standard error Observations F D.W.

Intercept 1993-95 d Unemployment 3 1979 d Productivity 15 Terms of trade c Employment (economy) 3

0.80 0.93 28 19.05 1.55

Coefficients

Standard error

t-stat

P-value

7.39 -0.14 -0.70 -2.42 0.47 0.05 0.82

1.43 1.03 0.14 0.97 0.17 0.12 0.38

5.15 -0.14 -4.86 -2.49 2.85 0.39 2.18

0.00 0.89 0.00 0.02 0.01 0.70 0.04

Notes: a three years moving average; b three years moving averages of annual rates of change; c three years moving average of annual rates of change of terms of trade index; d assumes value one in 1979, zero otherwise; assumes value one in 1993-95, zero otherwise. Sources: ISTAT, Contabilita Nazionale (2002b) for productivity, employees and earnings; ISTAT, Rilevazioni delle Forze di Lavoro (various years) for unemployment; European Commission (2002) for terms of trade (see also notes 3 and 16).

worsening of the terms of trade, while they rose systematically less afterwards, when the unemployment rates were rising, notwithstanding the improvement in the terms of trade during the 1980s.14 This does not mean, of course, that the trends in labour productivity and the terms of trade are irrelevant in accounting for the movements in money and real wages. It does mean, however, that no mechanical ox a priori link can be claimed between those variables and that the distribution of gains from productivity growth or changes in the terms of trade actually depends on the workers' bargaining position (Levrero 1999). Broader view of labour-market conditions As we have seen, the overall unemployment rate is the most relevant variable affecting real wage changes in Industry as well as in Trade and the private sector as a whole. We have also seen that in 1979 and 1993-94 there were changes in real wages that must be explained by

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Regression statistics

other circumstances besides the variables included in the regression. For reasons that will become clear in this and the next sections, these circumstances had also an influence on subsequent wage and (particularly after 1979) unemployment trends. In this section we shall take into consideration the possible influence of changes in aspects of the labour market not captured by the variables included in the regression, while the following section will examine the broader economic and institutional situation. There is one aspect of the labour market situation in particular that may have played a role in the changes in industrial relations that took place around 1979, namely, the process of restructuring underway in the large firms, which were at the core of union militancy and action, and where employment was declining (in contrast with the still positive trend for the sector as a whole) and many workers were made temporarily redundant under the CIG (Cassa integrazione guadagui) (see note 8). Employment fell, albeit moderately, in firms with more than 200 employees in the period 1978-80 (-1.2 per cent), continuing the slightly negative trend of the period 1974-77 (-0.4). Similarly, employment fell in firms with more than 500 employees at annual rates of about 1 per cent between 1975 and 1978, while total hours worked (net of temporary redundancies) dropped by 4 per cent between 1977 and 1979 is This was due to technical innovations and the development of what was called the strategy of 'decentralization of production', which assigned some phases of production to smaller units that were only nominally independent of the larger firms and characterized by greater labour flexibility and a lower degree of conflict. Changes in employment and redundancies in large firms after the mid-1970s therefore probably contributed to the changes in wage trends and industrial relations observed after 1977. Nor should we overlook the fact that while employment growth was still positive, general unemployment did increase between 1975 and 1977. While the figure involved may appear moderate nowadays, it caused alarm at the time and may have contributed to the changes in trade-union attitudes described in the next section. As regards the fall in real wages in the 1990s following the devaluation of the lira in 1992, it should be noted that the unemployment rate in 1992-93 and the subsequent years may not be a good indicator of what was happening in the labour market for two reasons. One is a break in the statistical series caused by a restrictive change in the definition of the unemployed;16 the other is the very significant decrease in the number of employees for the economy as a whole in 1993-94 associated with a drop of two percentage points in both male and female activity rates.

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Enrico Sergio Levrero and Antonella Stirati 101

It should also be noted that the Italian labour market underwent other important changes in the 1990s that may have played a role in the general weakening of the workers' position and the stagnation of real wages and earnings during this period. First, there was an increase in the number of jobs characterized by limited duration, made possible by changes in legislation and accounting at the end of the 1990s for about 18 per cent of all employees in Trade and Industry. Second, there were increasing flows of immigrant workers, accounting for about 4.8 per cent of the total labour force, including irregular jobs, in the year 2000 (ISTAT 2002a). While these changes in the composition of the labour force have a direct effect on average actual labour costs and earnings,17 it is not easy to evaluate their impact on union bargaining and contractual wages, especially in Industry and Trade. Combined with high juvenile unemployment rates, the particular high incidence of temporary jobs among the youngest segment of the labour force has very probably inhibited the young workers' potential for union militancy. On the other hand, a union report suggests that the availability of immigrant labour during the 1990s had no negative effect on contractual wages except in Agriculture and, to a lesser extent, Construction (Olini 2003). All in all, given that the changes described intensified in the second part of the decade, it appears that they may have played more of a role in the slow growth of wages in this latter period than in the fall in wages between 1993 and 1995. To sum up, labour market conditions not captured by changes in rates of unemployment and employment growth appear to have contributed to triggering the fall in real wage growth taking place in the late 1970s and early 1990s, thus confirming the influence of the labour market situation on real wages. Their downward movement between (moving averages centred in) 1978 and 1979 appears to have been favoured by negative trends in employment in large firms, while the fall in real wages after 1992 by a fall in the overall employment level and activity rates. Both in 1977-79 and in 1992-95, however, broader changes in industrial relations and the general institutional and economic framework were also taking place, as discussed in the next section. External constraints, macroeconomic policies and institutional changes Let us thus look first at the social and political situation, the pressure of international competition, and economic policy decisions around the years 1978-79, which facilitated the emergence of policies that to some

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102 Unemployment, Productivity and Institutions: Italy

extent contributed to the increase in unemployment and the reduction in industrial employment in the subsequent years, and of a dramatic change in industrial relations. The fact that wages begin to grow less than productivity as early as 1978 and that the rate of increase in wages feel sharply at the very beginning of the recession in 1980, despite the good economic performance of the previous year, suggest that the roots of the fall in real wage growth are to be sought before 1979. In particular, it appears possible to trace them back to the period of the so-called 'consensual stabilization' (Salvati 2000) in 1977-79, that is to the years that saw the end of the previous phase beginning in 1969 characterized by real wages increasing more than productivity and a sharp fall in the lira's nominal exchange rate. As regards wage bargaining, the 'consensual stabilization' was characterized by the trade unions' acceptance of restraints in wage claims. An initial reduction of the coverage of the wage-indexation clauses set up in 1975 was introduced in 1977 (severance pay was excluded from wage indexation and some wage-goods were eliminated from the basket of the cost of living index). Furthermore, the congress of the major workers' organization (the CGIL) substantially accepted the idea that wages cannot be an 'independent variable' and that high wages could conflict with the aim of full employment and growth. With reference mainly to the experience of other countries, an 'exchange' was thus proposed by the CGIL (and accepted in 1978 by all the three major trade unions) between wage moderation and the workers' participation in private and public investment decisions. Whatever the reason for the trade unions' new strategy - whether it was the political prospect of the Communist Party's full participation in government after its electoral peak in 1975-76 or the belief that wage moderation would lead to an increase in the amount of employment 18 it substantially failed. On the one hand, owing to the vagueness of the proposal and Italy's different political and historical context with respect to countries like Austria, Germany and Sweden, no 'exchange' actually took place to reward moderation in real wages.19 On the other, by reducing conflicts at the workplace level, that new strategy permitted a faster increase in productivity and employment fell in the large firms forming the 'core' of the workers' organizations. Together with an increase in the number of small firms (to which the larger firms increasingly subcontracted certain phases of production) and in outsourcing (see Heimler and Milana 1986), these processes undermined the trade unions' strength precisely when a government plan ('Documento

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Enrico Sergio Levrero and Antonella Stirati 103

Pandolfi') explicitly advocated restrictive monetary and fiscal policies. Moreover, as in the case of income policy in the United Kingdom (Tarling and Wilkinson 1977), wage restraint undermined worker militancy at the very time of mounting dissatisfaction with the trade unions on the part of the social groups and workers less protected against price inflation.20 One consequence of this phase of 'consensual stabilization' was to facilitate Italian adherence to the Franco-German architecture of the European Monetary System (EMS), which helped in turn to place organized labour under further pressure. First, the worsening of the real exchange rate in the years 1979-80 in terms of export prices (whose index rose from 89.8 to 93.5) and the second 'oil shock' in 1979 contributed greatly to the fall in exports and industrial production in 1980. This fall and the new exchange rate regime set up in 1979 were regarded by Confindustria (the national association of entrepreneurs) as calling for a sharp change in industrial relations. Its first significant manifestation was in Fiat's new industrial policy and anti-union attitude (Romiti and Pansa 1988; Lama 1987), which led to the defeat of the metalworkers' trade unions (the leading force in wage bargaining) in 1980 during the strike at the Fiat factories against the dismissal of 14,000 workers. After the defeat, which marked a turning point in industrial relations and highlighted the abovementioned difficulties of organized labour, the membership of the metalworking trade unions fell sharply,21 as did the numbers of working hours lost through strikes (ISTAT 2002a). Second, the monetary regime established by the EMS and the rise in the real rates of interest in the United States necessitated an abrupt halt in the rate of inflation, which was higher than in other countries (12 percentage points higher than Germany in 1978 and 20 in 1979). In line with suggestions put forward in OECD documents, 22 the Governor of the Bank of Italy thus stressed the need for a change in the 'monetary constitution' (Banca d'ltalia 1981 and 1982) and implemented restrictive monetary and credit policies associated with high nominal interest rates. Together with the substantial fall in exports in 1980, this led to a sharp decrease in gross private fixed investment in the years 1981-83 and a standstill in real GDP in the period 1980-83. In spite of this, not only were the deflationary monetary policies continued but restrictive fiscal measures were also implemented after 1981 and to a greater extent than in 1976. The growth rate of public expenditure dropped and reached a minimum in 1984 and 1985 (Giarda 1986), thus contributing to the continuing decrease in industrial employment and the rise in unemployment (see Figure 5.4).23

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104 Unemployment, Productivity and Institutions: Italy

Enrico Sergio Levrero and Antonella Stirati 105

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Figure 5.4 Unemployment rates* and annual rates of change in industrial and total employees, 1971-2000 Notes: * Since 1993 the new definition of unemployment gives rise to a lower estimated unemployment rate (see note 16). Sources: ISTAT, Rilevazioni delle Forze di Lavoro (various years) for the unemployment rates; ISTAT Contabilita Nazionale (2002b), for employees.

In addition to these, other measures were also introduced with the same aim of slowing down the rate of inflation and helping firms to cope with the pressure of international competition (the real exchange rates worsened again in 1982-84). In order to increase labour productivity, public subsidies to firms were reduced and recourse was facilitated to early retirement and temporary redundancy under the CIG. More importantly, an agreement reducing wage-indexation by 15 per cent and linking it during the first half of 1984 to a government-targeted inflation rate was signed in 1983 by Confindustria and some of the unions, but not by the CGIL, thus causing a deep rift in the trade-union movement. The CGIL and the Communist Party called a referendum against that agreement, and were defeated in 1985. Anti-union practices and individual benefits and premiums became widespread in the following years,24 while the divisions among the trade unions persisted (as shown by several 'separate agreements' signed by them). As a result of this situation and the rise in unemployment, high real rates of interest and a change in distribution favourable to profits were able to persist. After being negative for most of the 1970s and becoming positive in 1981, the long-term real rate of interest rose to 3 per cent in 1983 and 6.5 per cent in 1987. As regards the period 1992-96 (which marked another change in the trend of real wages as shown in Figure 5.1), it can be said that the fall in

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-+- Unemployment rate - * - Male unemployment rate - • - Industrial employees (heads), - A - Total employees (heads), annual rate of change annual rates of change

real wages during these years reflects the worsening of the workers' bargaining position during the 1980s as a result of the social and political factors mentioned above and the increase in the average rate of unemployment (which rose to 10 per cent). Other factors also appear to have been relevant, however. The 1992 devaluation of the lira occurred after the fixed exchange rate regime in 1988-92 (Italy's adherence to the 'narrow band' of the European Monetary System) designed to discipline wage bargaining (Pivetti 1999). As is known, the regime proved only partially successful in this regard. On the one hand, there was a growing gap with respect to France and Germany in the rate of change in the unit labour costs of the private sector, arising both from a recovery of money wages in 1989-91 (fostered by a cyclical increase in industrial employment) and from lower productivity growth than in other countries (see Table 5.3). On the other, the money costs of production were increased also by the rise in nominal interest rates decided upon by the Bank of Italy in order to guarantee a surplus in the overall balance of payments after the full liberalization of capital movements in 1988. There was thus a real appreciation of the lira (in terms both of unit labour costs and of export prices) and the balance of trade became negative in 1987-91. Manufacturing firms were accordingly under increasing pressure not to raise their prices and the situation led to an increase in the wage-income share of industrial value-added and to Confindustria's unilateral suspension of the price-indexation clauses. The stringent fiscal measures introduced by the Amato government in 1992 to reduce the domestic product failed to prevent the currency crisis brought about by these causes and fuelled by Germany's monetary policy. (The Bundesbank had raised the interest rates and did not intervene to defend the lira, which depreciated by 58 per cent with respect to the mark and 30 per cent with respect to sterling.) Those measures favoured, however, the fall in the unit labour cost even in terms of the national currency, which was greater than in other countries. The real exchange rates thus improved sharply, albeit more in terms of unit-labour-cost rate than of export prices. Firms used the depreciation to some extent to increase their profit margins (see Banca d'ltalia 1999a). It can be stated that, as in other periods (see for example Graziani and Meloni 1980), currency depreciation and deflationary policies were the tools used to boost profits and improve the competitiveness of Italian industry. Unlike the period 1971-76,25 both these aims were now

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106 Unemployment, Productivity and Institutions: Italy

Enrico Sergio Levrero and Antonella Stirati 107 Table 5.3 Rates of change (%) in hourly productivity, hourly labour costs, real exchanges rates in manufacturing in the main industrialized countries

USA FRA GER ITA UK

3.4 3.7 2.5 2.2 3.6

USA FRA GER ITA UK

4.6 5.9 5.0 7.7 7.9

USA FRA GER ITA UK

1.2 2.2 2.4 5.4 4.1

FRA GER ITA UK

-0.3 1.6 0.9 2.3

1979-85

1985-90

Productivity per manhour 2.4 3.5 3.4 3.0 2.1 2.1 1.9 3.5 4.4 4.6

1990-95

1995-2000

3.3 4.0 3.3 2.4 3.3

4.7 4.6 2.6 0.9 2.4

3.5 3.9 6.4 4.9 5.4

4.0 1.9 2.6 2.8 4.6

Unit labour cost in national currency 0.2 1.4 3.6 -0.1 1.0 9.5 3.1 3.8 2.8 2.4 4.8 12.0 2.1 4.5 7.5

-0.7 -2.6 -0.1 1.9 2.2

Hourly labour costs 3.9 7.2 4.5 12.8 5.0 6.0 15.9 6.8 9.4 12.2

Real exchange rates 11.6 -3.3 -4.1 15.9 15.1 -2.5 11.4 -1.0

1.7 5.6 -3.7 -0.4

-9.2 -7.6 -3.1 1.3

Source: US Department of Labor (2002).

achieved. The depreciation of the currency was not accompanied by a wage-price spiral; on the contrary, the rate of inflation decreased slightly in 1992-94, and money wages rose less than prices. Although the decrease in industrial and total employment during the period 1992-96 certainly helped to keep money wages in check, the inability of the latter to respond to price increases resulted also from the reforms of wage settlements introduced by Amato in 1992 and 1993. With the new wage-setting procedures, nominal wages were linked to the target inflation rate, which was usually fixed at a level lower than the actual (see Banca d'ltalia 2000a), while the task of linking wages to productivity was assigned to firm-level bargaining, which never

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1979-2001

developed extensively (it covered only 39 per cent of employees in firms with more than 10 employees and 62 per cent of employees in firms with more than 500 employees in the period 1995-96). Thus, the fact that trade unions accepted the need to restrain wage claims on the grounds of the Maastricht Treaty signed in 1992 appears to have played a role in bringing about the fall in real wages in the years 1992-96, as well as in keeping their rise at a lower rate than productivity in the years 1996-2000.26 Some final remarks We shall now summarize our main results, comment briefly on some of these, and indicate some open questions. Our empirical analysis shows that the primary factor affecting real wage trends in Italy in the 1970-2000 period appears to have been unemployment, while productivity growth played no role in directly affecting the rates of change of industrial wages and a minor one in the trends of earnings in the business sector as a whole. There were, however, also broader factors involved in affecting wage trends. In particular, the fall in wage growth after 1977 precedes the dramatic decline in industrial production and industrial employment (and the parallel rise in the unemployment rate) beginning respectively in 1980 and 1981. Its roots lie in a weakening of the trade unions related both to the decrease in employment in large industrial firms between 1975 and 1979 and to the broader social and political context of the phase of 'consensual stabilization'. After 1979 the decline in wage growth reflects, besides the worsening of labour market conditions, the changes in the institutional and socio-political situation in the previous years as well as the increasing pressures to reduce inflation generated by the exchange rate agreements in Europe and the rise in US interest rates. In the 1990s we observe an unprecedented (in the postwar period) vulnerability of real wages to the exogenous increase in prices after the lira devaluation in 1992. This also must be seen in connection with institutional changes, namely the new wage-setting procedures agreed upon in the same year, combined with the unions' inability to ensure the development of firm-level bargaining. This new wage-setting procedures and the overall economic situation, characterized in particular by the government aim of fulfilling the 'Maastricht parameters', contributed to the stagnation of wages during the 1990s. It may be worth commenting on some of the above points in the light of the existing literature, namely the changes in wage behaviour in the

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108 Unemployment, Productivity and Institutions: Italy

Enrico Sergio Levrero and Antonella Stirati 109

• Changes in the characteristic behaviour of real wages. According to Boyer (1979) the characteristic feature of the period from the end of the Second World War to the mid-1970s (but already beginning to establish itself in the first decades of the century) was the absence of even transitory downward movements in real wage levels and their tendency to grow at a fairly stable annual rate. In this respect, the Italian experience in the 1990s may suggest the appearance of a new scenario - or rather perhaps the return to an older one - in which real wages, or their annual rates of change, may decrease during the negative phases of the economic cycle or as a consequence of changes in the price level. Further investigation might establish whether this pattern is common to other industrialised economies. • A real-wage Phillips curve? The scatter diagram in Figure 5.3 suggests a 'real wage Phillips curve'. There are in fact some obvious analogies with the original Phillips curve, namely the fact that it was also concerned with average values of the variables (albeit derived with a different procedure) rather then cyclical changes, and the non-linear nature of the relationship, associated with a downward stickiness of wages even with high unemployment. A further analogy is that the relationship between unemployment and real wages, like that between unemployment and money wages, can be interpreted as a consequence of the influence of the former on the bargaining position of the parties involved (Rothschild 1993: 129-30). It is, however, interesting that the relationship holds for real wages, since it suggests that changes in the bargaining position of workers related to labour market conditions affected distribution, despite the ability of employers to respond to money wage increases with price inflation, at least in some phases.27 In general, however, we do not believe that quantitative relations should be sought for predictive purposes (that is, to predict the rate of change of wages associated with particular values of the unemployment rate or other variables). The shape and position of such a relation actually depend on the broader institutional and economic setting and are bound to change when changes take place in the latter. Moreover, such changes in the broader context may be triggered by changes in unemployment itself. Generally speaking, one would not expect the effect of the unemployment rate on the growth of real wages to be independent of the previous path of these and other relevant variables.28 In addition to this, great care

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1990s, the relationship between unemployment and real wages, and the role of institutional factors.

should of course be taken not to generalize from a relation found to hold in Italy over a certain period, which may not hold in different countries or different periods. Further investigation in this direction should contribute to a better understanding of the channels through which unemployment may actually affect wage determination in specific institutional settings. Having said that, we believe that the strong correlation we have found between average values of the unemployment rate and real wage growth is an interesting result of our work. As regards Italy, it actually contradicts the apparently widespread view that wages are not affected by unemployment levels, which is probably based on the results of some cross-regional studies.29 • An independent role for political and institutional factors? It has been maintained that institutional factors play no role in real wage trends in the very long run because the latter must reflect the underlying forces of 'supply and demand' (see for example Phelps-Brown 1968 and Levrero 1999, for critical discussion). Apart from the theoretical difference between the traditional view (shared by Phelps-Brown) and our approach as regards the way in which labour market conditions and institutional factors affect wages, our study suggests that such an independent role was played in Italy, for example, by the broad political and union situation in the years between 1976-79 and that the effects of the changed institutional context and political climate were largely felt in the following years through the high unemployment generated by unconditional adherence to the EMS, the more restrictive approach in fiscal and monetary policy, and industrial restructuring. This is in agreement with a stream of contributions, mainly from political scientists, maintaining that political factors affect unemployment levels and income distribution (Hibbs 1977 and Alt 1985, among others). But the case of Italy also appears to lend support to Korpi's (1991) warning that, while the political context is a very relevant factor, a number of political and institutional circumstances must be taken into account in addition to the political orientation of government parties. Notes 1 For recent critical discussion of neoclassical substitution mechanisms, see Garegnani (2003); for analytical criticism of the tendency to the NAIRU, see Petri (2003) and Petri (2004: chapter 7 and appendix 2). 2 Worsening labour-market conditions, for example, may trigger broader changes in the institutional framework, such as a weakening of trade unions, while on the other hand labour market conditions themselves are not

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110 Unemployment, Productivity and Institutions: Italy

3

4

5

6

7

8

9

111

independent of economic policies, which are influenced by the social and political climate. In some instances, labour market conditions can also be affected by the employers' direct response to conflict, the large-firm restructuring and 'decentralization of production' carried out in Italy in the 1970s being a case in point (see pp. 100-8). Industry includes Manufacturing and Energy production but not Construction; Trade includes Catering and Hotels. Wages are contractual hourly wages based on national collective agreements between unions and employers. We shall use the series of contractual wages for production workers only (not including white-collars). The source for aggregate earnings is national account data on gross incomes of employees. Earnings are then divided by 'standard labour units' defined as the normal working hours of a full-time employee. Wages and earnings are deflated by the cost-of-living index based on the typical consumption bundle of employees. The real net earnings per standard labour unit in industry are derived by applying to gross earnings the percentage of taxes and contributions paid by an average Italian production worker as estimated by the OECD (various years). Similar results can be obtained from the data of the Bureau of Labour Statistics and also from the Bank of Italy's J Bilanci delle Famiglie Italiane (1989-2002). Notice also that the increasing weight of contributions and income tax on labour incomes was not compensated by greater social expenditure or structural changes in the Italian fiscal system towards higher de facto progressiveness. Social expenditure in real terms has stagnated in the last decade in particular, and there has been a worsening of the tax-benefit position for workers. In spite of rising fiscal pressure (attenuated after 1998, but more to the advantage of employers than employees) there has been a tendency to reduce the progressive nature of the tax system, and the real social expenditure index increased only from 100 in 1990 to 117.2 in 1999, having doubled every decade during the 1960s and the 1970s (OECD 1985; EUROSTAT 2000). Activity rates and employment rates are also interesting indicators of labourmarket conditions given their ability to pinpoint changes in disguised rather than explicit unemployment. Systematic use has not been made of these indicators due to some breaks in the statistical series. We have chosen to measure employment in 'heads' here because the relevant point for the bargaining strength of the parties involved appears to be the number of actual people getting or losing jobs (rather than the total hours worked). The drawback of this measurement is that it is gross of workers temporarily made redundant under the CIG (a national fund financed by the state and by contributions of employers and employees: the workers made redundant maintain their employment relationship and receive a subsidy). Similar indications can be obtained from regression analyses, which show that along with unemployment the other statistically significant influence on real wage rates of change in the Trade sector comes from the rate of change in industrial employment. Employment and productivity in the Trade sector are instead not statistically significant. We use moving averages because we expect the impact of economic factors on wages to be greater if they persist over time. On the other hand, we are not interested in very short-term variations in wage growth.

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Enrico Sergio Levrero and Antonella Stirati

10 Data not reported here show that wage changes are more correlated with the overall unemployment rate than with the unemployment rates for specific groups (male workers, north-central regions) and the rates of growth of employment for the economy as a whole. It is worth noting, however, that the correlation with the latter becomes very strong in the last decade. This role of unemployment is almost surprising, as it might have been expected that the high female and southern component of unemployment would have a limited influence on union action, largely carried out in large firms concentrated in the north of Italy. It is possible that this influence was indirect, at least to some extent, that is related to a tendency on the part of unions to regard unemployment as the result of the country's economic difficulties and wage moderation as a factor that could help to overcome those difficulties (see also pp. 102-8). 11 We have kept to the linear specification of our regressions for the sake of greater simplicity and easier interpretation of the coefficients. The fit of the equations is good also in this form, and the improvements to be obtained by considering non-linearity are modest. 12 According to the traditional Marginalist theory, for example, an increase in labour productivity due to technical innovation, with a given labour supply, would be associated with an increase in the equilibrium wage level (unless it were due to pervasive 'very labour-saving' technical change, according to Hicks' classification). Again according to this theory, an increase in labour productivity due to the change in the proportion of capital to labour, with given technical knowledge, would determine an increase in real wages. This would be the same size as that in productivity if the elasticity of substitution between labour and capital were equal to one (see Blanchard 1997 for a recent discussion of the latter properties). The same conclusions would derive from standard current models of wage determination, combining a 'wage curve' with a price equation, while in a different analytical context, a tendency of wages to grow in step with productivity has been attributed to specific institutional arrangements, characterizing the period from the end of the Second World War to the mid-1970s (Boyer 1979, among others). 13 To avoid misunderstandings, it should be noted that those 'margins' set no rigid limit to an increase in real wages, since the rate of profit can fall. Technological progress and improvements in the terms of trade only 'make room' for those increases by determining a rise in the rate of profit for a given wage (or vice versa). 14 See Levrero and Stirati (2004: 71-4). For the 1970s and early 1980s, see also OECD (1983). 15 Barca and Magnani (1989: 115), Banca d'ltalia (1977a, 1980a). In the Industrial sector as a whole (firms of all sizes), the number of workers made redundant under the CIG peaked in 1972, 1975 and 1978, and again, more markedly, in 1980, while in 1979 there was a strong rise in employment. 16 The unemployment rate figures are taken from historical series reconstructed by ISTAT for the period until 1985 and between 1994 and 2000. The annual estimates from the Rilevazioni della Forze di Lavoro are used for the other years. Because of a restrictive change in the definition of unemployment, since October 1992 the statistical figures for the unemployment rate tend to be

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112 Unemployment, Productivity and Institutions: Italy

17

18

19

20

21 22 23 24 25

lower than with the previous definition. The difference between the unemployment rate statistics based on the new and old definition was estimated to be of 3.3 percentage points in 1993 (Banca d'ltalia, 1994a). Limited duration contracts (including collaborations) entail as a rule lower contributions and in some instances also lower pay. Immigrant workers tend to be paid between 5 and 10 per cent less than the Italians, after controlling for worker and job characteristics (Brandolini et al. 2003). In a difficult political climate, the Communist Party put pressure on the CGIL between 1977 and the first part of 1979 to accept wage moderation and gave its 'external' backing to the Christian Democrat government. The CGIL in turn regarded the experience of 'national solidarity' as a 'political' result capable (at least in the following years) of opening up a phase of social improvements for workers (CGIL 1981: 96-7). With respect to opinions as regards the effects of wage moderation on employment, see Trentin (1980) according to whom those years had already seen a 'cultural and political hegemony' of the 'laissez-faire' tendencies influencing the policies of the workers' organisations. The trade unions did in fact agree on the need for a ceiling to the public deficit and for a wage policy 'coherent with the aim of full employment' (CGIL 1981: 183 and 186-7). It could be argued that wage restraint actually brought about an increase in employment thanks to the rise in exports. This was, however, partly offset by restrictive domestic policy (de Vivo and Pivetti 1980). Moreover, the trade unions even failed in their attempt to make fiscal and financial provisions for firms conditional upon their acceptance of an industrial policy based on sector investment plans. Apart from the effects of inflation on the real wealth of the middle class, the 'egalitarian' wage-indexation clauses of 1975 combined with non-uniformity in the timing of wage negotiations and the different bargaining strength of workers in the various sectors of the economy to generate dissatisfaction with the three main trade unions (CGIL, CISL and UIL) amongst skilled workers, white-collar workers and public-sector employees (whose real wages had fallen in the period 1975-77). Similarly, the overall rate of worker unionization fell from 49.3 in 1980 to 39.7 in 1986, 38.8 in 1990 and 35.8 in 1997. See for example OECD (1977). See also Kaldor (1984: 113-69), who shows that the explicit aim of the deflationary policies in the United Kingdom was to weaken the workers' bargaining position. The character of fiscal policies was instead not restrictive in 1979-81, due among other things to the increase in family subsidies and the salaries of public employees. This is reflected by the emergence of a 'wage drift' in industry between 1983 and 1988 and its disappearance in the 1990s, when the trade unions were already weakened. The fall in the lira's nominal exchange rate between 1971 and 1976 helped to avoid deterioration of the competitive position of Italian industry. The real exchange rate thus decreased slightly despite an increase in unit labour costs in terms of national currency that was greater than in the other industrialized countries (see Aquino 1986; European Commission 2002). The depreciation of the currency and the worsening of labour-market conditions did not

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Enrico Sergio Levrero and Antonella Stirati 113

26

27 28

29

stop the growth of real wages, however, owing to the ever-increasing strength and militancy of the trade unions and to price indexation. It should be noted that no increase in employment or social expenditure could have been expected by the trade unions. The Maastricht parameters imposed a primary budget surplus and overall budget corrections amounted to 430 trillion lira between 1992 and 1998. The trade unions' strategy might thus have been guided by the idea that it was the 'lesser evil' and that lower interest rates might then help to change the restrictive character of fiscal policies. See Stirati (2001), for a more general perspective. It is very common in the literature to describe 'shifts' that remain largely unexplained in some functional relations (for example the traditional Phillips curve, or the pseudo demand and supply curves). Our position may be regarded as assuming that 'shifts' in empirical relations are only to be expected because wages are affected by changes in the institutional framework, but the causes of the 'shifts' should be explained as much as possible and not left outside the realm of economic analysis. See Lucifora and Origo (1999), who also provide a survey of previous results.

References Alt, J.E. (1985) 'Political Parties, World Demand and Unemployment: Domestic and International Sources of Economic Activity', American Political Science Review, 79: 1016-40. Aquino, A. (1986) Dinamica dei prezzi relativi nell'economia internazionale: Lineamenti teorici ed esperienze deipaesi industriali (Bologna: II Mulino). Banca d'ltalia (1978-2001a) Relazione Annuale (Rome: Banca d'ltalia). Banca d'ltalia (1989-2002b) I Bilanci delle Famiglie Italiane, Supplemento al Bollettino Statistico (Rome: Banca d'ltalia). Barca, F. and Magnani, M. (1989) L'Industria fra Capitale e Lavoro (Bologna: II Mulino). Blanchard, OJ. (1997) 'The Medium Run', Brookings Papers on Economic Activity, 2: 89-158. Blanchflower, D.G. and Oswald, J. (1994) The Wage Curve (Cambridge and London: MIT Press). Boyer, R. (1979) 'Wage Formation in Historical Perspective: The French Experience', Cambridge Journal of Economics, 3(2): 99-118. Brandolini, A., Cipollone, P. and Rosolia, A. (2003) 'Immigrazione e mercato del lavoro in Italia', paper presented at the conference 'L'incidenza economica dell'immigrazione' Florence, December. Brunello, G. (1996) 'L'interazione tra salari pubblici e privati nell'economia Italiana del dopoguerra', Politica Economica, 12(1): 85-114. CGIL (1981), La CGIL dal 9th al 10th Congresso. Atti e Documenti CGIL e documenti unitari, in L. Frisino (ed.) (Rome: Editrice Sindacale Italiana). de Vivo, G. and Pivetti, M. (1980) 'International Integration and the Balance of Payments Constraint: The Case of Italy', Cambridge Journal ofEconomics, 4:1-22. European Commission (2002) European Economy, 6 (Brussels: European Commission). Eurostat (2000) Annuaire. Le guide statistique de VEurope (Luxembourg: Eurostat).

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114 Unemployment, Productivity and Institutions: Italy

Garegnani, P. (2003) 'Saving, Investment and the Quantity of Capital in General Intertemporal Equilibrium', in F. Hahn and F. Petri (eds), General Equilibrium. Problems and Prospect (London: Routledge). Giarda, P.D. (1986) 'L'evoluzione della spesa pubblica in Italia: Alcuni fatti e qualche proposta', in Ente per gli Studi Monetari, Bancari e Finanziari Luigi Einaudi, Oltre la crisi. Le prospettive dell'economia italiana e il contributo del sistema finanziario (Bologna: II Mulino). Graziani, A. and Meloni, F. (1980) 'Inflazione e fluttuazione della lira', in G. Nardozzi (ed.), I difpcili Anni '70, (Milan: Etas Libri). Heimler, A. and Milana, C. (1986) Prezzi Relativi Ristrutturazione e Produttivita: le Trasformazioni dell'Industria Italiana (Bologna: II Mulino). Hibbs, D.A. Jr (1977) 'Political Parties and Macroeconomic Policy', American Political Science Review, 71(4): 1467-87. IMF (2002) International Financial Statistics Year Book (Washington: IMF). Instituto Nazionale di Statistica (ISTAT) (1989) Sommario di statistiche storiche, 1926-1985 (Rome: ISTAT). ISTAT (various years)(a) Rilevazione delle Forze di Lavoro (Rome: ISTAT). ISTAT (various years)(b) Lavoro e Retribuzioni (Rome: ISTAT). ISTAT (2002a) Rapporto annuale sulla situazione del paese (Rome: ISTAT). ISTAT (2002b) Contabilitd Nazionale. Conti Economici Nazionali Anni 1970-2000 (Rome: ISTAT). Kaldor, N. (1984) // flagello del monetarismo (Turin: Loescher editore). Korpi, W. (1991) 'Political and Economic Explanations for Unemployment: A Crossnational and Long-term Analysis', British Journal ofPolitical Science, 21 (3): 315-48. Lama, L. (1987) Intervista sul mio partito (Rome, Bari: Laterza). Levrero, E.S. (1999) 'Worker Bargaining Power and Real Wages from 1870 to 1913: Phelps Brown Reconsidered', Review of Political Economy, 11(2): 183-203 (with Errata, Review of Political Economy, 11(4): 484). Levrero, E.S. (2006) 'Some Notes on Wages and Competition in the Labour Market', in R. Ciccone, C. Gehrke and G. Mongiovi (eds), Sraffa and Modern Economics (London: Routledge), forthcoming. Levrero, E.S. and Stirati, A. (2004) 'Real Wages in Italy 1970-2000: Elements for an Interpretation', Economia & Lavoro, xxxvm (1): 65-89. Lucifora, C. and Origo, F. (1999) 'Alia ricerca della flessibilita: un'analisi della curva dei salari in Italia', Rivista italiana degli economisti, iv (1): 3-35. Organisation for Economic Co-operation and Development (OECD) (1977) Towards Full Employment and Price Stability (Paris: OECD). OECD (1981, 1983) Economic Outlook (Paris: OECD). OECD (1985) Social Expenditures: 1960-1990. Problems of Growth and Control (Paris: OECD). OECD (2002) Revenue Statistics 1965-2001 (Paris: OECD). OECD (various years) The Tax-Benefit Position of Production Workers (Paris: OECD). Olini, G. (2003) Retribuzioni e produttivita in Italia dal 1993 al 2001, Studi e ricerche CISL, Rome, October. Petri, F. (2003) 'Should the Endogenous Theory of Growth be Based on Say's Law and the Full Employment of Resources?', in N. Salvadori (ed.), The Theory of Economic Growth-A Classical Perspective (Cheltenham: Edward Elgar). Petri, F. (2004) General Equilibrium, Capital and Macroeconomics (Cheltenham: Edward Elgar).

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Enrico Sergio Levrero and Antonella Stirati 115

Phelps-Brown, E.H. (1968) A Century of Pay (London: Macmillan - now Palgrave Macmillan). Pivetti, M. (1999) 'High Public Debt and Inflation: On the Disciplinary View of European Monetary Union', in G. Mongiovi and F. Petri (eds), Value, Distribution and Capital. Essays in Honour of Pierangelo Garegnani (London: Routledge). Romiti, C. and Pansa, G. (1988) Questi anni alia Fiat (Milan: Rizzoli). Rothschild, K.W. (1993) 'The Phillips Curve and All That', in K.W Rothschild (ed.), Employment, Wages and Income Distribution (London: Routledge), 125-61. Salvati, M. (2000) Occasioni Mancate. Economia e Politica in Italia dagli Anni 60 a Oggi (Rome-Bari: Laterza). Stirati, A. (1992) 'Unemployment, Institutions and the Living Standard in the Classical Theory of Wages', Contributions to Political Economy, 11: 41-66. Stirati, A. (2001), 'Inflation, Unemployment and Hysteresis. An Alternative View', Review of Political Economy, 13(4): 427-51. Tarling, R. and Wilkinson, F. (1977) 'The Social Contract', Cambridge Journal of Economics, 1(4): 395-414. Trentin, B. (1980), II Sindacato dei Consigli, interview with Bruno Ugolini (Rome: Editori Riuniti). US Department of Labor (2000) Comparative Real Gross Domestic Product per Capita and per Employed Person. Fourteen Countries 1960-1998 (Washington, DC: US Department of Labor). US Department of Labor (2002) International Comparisons of Hourly Compensation Costs for Production Workers in Manufacturing, 1975-2001 (Washington, DC: US Department of Labor).

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116 Unemployment, Productivity and Institutions: Italy

Unequal Fortunes, Unstable Households: Has Rising Inequality Contributed to Economic Troubles for Households in the USA? Heather Boushey and Christian E. Weller

Introduction For the better part of the past three decades, the US economy has been characterized by a growing income disparity. Rising inequality has taken two forms. The share of national income that has gone to employee compensation has tended to decline, and the distribution of this shrinking share of the pie has become more unequal. Rising inequality may also have impacted the economy in the aggregate. While the link between rising inequality and productivity growth is hard to substantiate, the connection between greater inequality and aggregate demand finds more support. However, despite rising inequality demand growth has remained relatively strong. One resolution to this ambiguity may have been a rise in more consumer borrowing, especially for low-income households. In turn, this may have increased economic distress for households, particularly if economic mobility was limited. The rest of the chapter proceeds as follows. In the next section we present background data on inequality as well as on household indebtedness and household economic distress. This is followed by a discussion of the causes of the rising inequality in the USA, followed by an overview over the macro economic consequences of rising inequality. We then discuss the evidence on the link between inequality and innovation and aggregate demand, and present our evidence on the link between inequality, consumer indebtedness and economic distress. The final section contains concluding remarks. 117 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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6

118 Rising Inequality in the USA

Inequality between capital and labour and within labour has been on the rise in the USA for the past decades. A striking characteristic of the last economic recovery in the USA was a rapidly growing gap between supply and demand; economic growth and employment diverged because historically weak demand growth did not keep pace with productivity growth,1 resulting in rising profits and laggard employee compensation (Bivens and Weller 2005; Weller 2004a). In response, households borrowed more to maintain their consumption (Weller 2004a) and businesses, not expecting strong sales growth, did not ratchet up investment quickly (Weller et al. 2004; Weller 2004b). Instead, much of the additional resources went for uses other than productive investments, such as share repurchases and dividends (Bivens and Weller 2005). The 'job-loss' recovery, though, was the culmination of long-run trends. Since the mid-1970s, productivity growth has outpaced compensation growth. Over the period from 1947 to the middle of 1975, productivity and real hour compensation grew apart by a total of 6.0 per cent. From the middle of 1975 to early 2004, productivity grew 25.7 per cent faster than real compensation. Consequently, profits rose, too. The profit share grew more rapidly after 1975 than before (Table 6.1) (Bivens and Weller 2004, Wolff 2003).2 The trends of profit shares are reflected in the trends of labour shares. Although the averages do not differ or are even greater in the latter period, the trends tell a different story. Regardless of how the labour share is measured, it declined in the latter period, whereas it grew in the earlier period. The declines were especially pronounced after 2001 (Table 6.1). Since the 1970s, inequality within the distribution of labour income has also increased, regardless of how it is measured, relatively or absolutely. We focus first on wage inequality because wages and salaries make up the bulk of family income. However, research has found that shifts in the distribution of earnings are not necessarily the most important factor in explaining changes in the income distribution. Over the past 25 years, changes in the distribution of other kinds of income (interest, dividends and rent) have played just as an important role. The severity of the inequality problem is heightened by decreases in economic mobility at the same time. Overall, the past few decades have seen a dramatic shift of income away from labour and away from low-wage earners and low-income families. The sharpest increases occurred during the 1980s: from the

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Inequality trends

Average - earlier period (1947-75) Average monthly rate of change (percentage points) - earlier period Average - later period (1975-2004) Average monthly rate of change (percentage points) - later period Average - 2002-04 Average monthly rate of change (percentage points) - 2002-04

After tax profit share with net interest

After tax profit share without net interest

9.3(1.4)

6.7(1.0)

0.05

0.01

Before tax profit share with net interest 14.2(1.1)

0.03

Before tax profit share without net interest 11.6(1.4)

-0.01

Compensation share

62.9(1.82)

0.05

Compensation and proprietors' income share 73.2(1.14)

0.00

13.6 (1.2)

6.4 (1.0)

16.7 (1.0)

9.5 (1.2)

65.6 (0.88)

73.3 (0.88)

0.04 14.4 (0.7)

0.04 8.3 (0.9)

0.03 16.7 (0.8)

0.03 10.6(1.0)

-0.02 65.2 (0.71)

-0.01 73.7 (0.58)

-0.18

-0.17

0.17

0.23

0.23

0.29

Notes: All figures are in per cent. Figures in parentheses are standard errors. The entire sample for profit shares spans from 1947 to the first quarter of 2004 and is split at the second quarter of 1975. Source: Bivens and Weller (2005).

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Table 6.1 Levels and changes of profit shares and labour shares of national income

economic peak in 1979 to the next peak in 1989, workers in the bottom 10th percentile saw their wages fall by 14.1 per cent while those in the 95th percentile saw their wages rise by 8.1 per cent. Inequality also increased between workers at the median and those at the top, as wages for the median worker grew by 0.0 per cent over that same period (Mishel et al. 2003). The overall trend was for the top and bottom to pull away from each other, while the middle saw little change. Over the 1990s, the growth in wage inequality slowed. Between 1989 and 2000, wages increased by 13.1 per cent for those in the bottom 10th percentile and increased by 16.6 per cent for those in the 95th percentile. Inequality between the top and the middle increased more so than between those at the top and bottom, as the median worker saw their wages rise by only 5.9 per cent. Much of the slowing of inequality occurred during the latter half of the 1990s, as unemployment dipped below 5 per cent. Between 1995 and 2000, wages for those at the bottom of the wage distribution actually saw their wages rise faster than those at the top for the first time in decades (Mishel et al. 2003). If overall inequality rose primarily because of across-group inequality, then it would be due to factors specific to particular groups, such as discrimination or increasing returns to skills. But if inequality has been primarily driven by within-group differences, then the problems are more generalized and cannot be evaluated with microeconomic, human capital based models. The general consensus is that there has been an increase in both across- and within-group inequality. While acrossgroup inequality has increased in terms of educational attainment, it has not increased substantially across African Americans and whites, and gender inequality has actually attenuated. Across-group wage inequality declined among male and female workers over the past three decades, mostly because male wages fell during the 1970s and 1980s. Over the period from 1975 to 1996, average male wages stagnated, while average female wages rose by about one-fifth. Even once wages are regression-adjusted to control for education and experience, the gender gap closed from 47 per cent in 1975 to 27 per cent in 1993. However, since 1993, the gender pay gap has remained unchanged, hovering at around 25 per cent (Gottschalk and Danziger 2003). The inequality gap between African-American and white workers stayed relatively constant over the past three decades. Controlling for personal characteristics, among women, the black/white gap was virtually non-existent in the late 1970s, however it increased to 4 per cent by 2001. Among men, the black/white gap was 14 per cent in 1975, rising

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120 Rising Inequality in the USA

to about 20 per cent in the early 1980s. It came back down to 15 per cent by 2001. Inequality has increased, however, across educational attainment levels. Economists think that human capital, that is the education and training experiences of the worker, is correlated with a worker's productivity which, in turn, determines their wage. Thus, there is an expectation of inequality across educational attainment levels. However, there is not an expectation of an increase in this inequality over time, which is what has happened. In 2003, college-educated men earned 41.5 per cent more than high-school-educated men, compared to a college premium of only 25.3 per cent in 1973. For women, the increase was less dramatic: in 2003, college-educated women earned 46.1 per cent more than high-school-educated women, compared to a 37.7 per cent premium in 1973 (Mishel et al. 2005). Most of the increase in educational inequality occurred between the late 1970s and the early 1990s. Since 1992, the gap between high-school and college-educated workers has been relatively flat among both men and women, although there is slight upward trend, more so for men than women (Gottschalk and Danziger 2003). Another way of evaluating wage inequality is to examine the withingroup differences. Changes in within-group inequality indicate that something has fundamentally changed about the economy that affects all kinds of workers, rather than only affecting some workers based on their educational attainment level or other identifying characteristics. Over the past few decades, this kind of inequality has increased alongside across-group inequality. As with across-group inequality, the largest increases in within-group inequality occurred during the 1970s and 1980s. Among both men and women, the residual wage inequality in hourly wages at the 10th percentile fell precipitously between 1975 and the late 1990s. A person at the 10th percentile of the distribution where 10 per cent of households have income below that level and 90 per cent have income above that level-in the late 1980s had earnings roughly 25 per cent lower than a similar person in 1975. For individuals at the 90th percentile, wages were about 10 per cent higher in the mid-1980s, compared to 1975, but stopped increasing during the 1990s (Gottschalk and Danziger 2003). Since most American families derive the majority of their income from wages, trends in income inequality closely mirror wage inequality. Over the period from 1947 to 1979, annual growth in inflation-adjusted family income was similar across quintiles. However, during the period from 1979 to 2003, those in the top quintile, and in particular the top

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Heather Boushey and Christian E. Weller 121

5 per cent, saw their family income grow significantly faster than those in the lower income quintiles. As with wage inequality, the largest increases in income inequality occurred during the 1980s. Between 1979 and 1989, rising inequality was the result of large increases in income among high-income families and declining income among lower-income families. During the 1990s, income among lower-income families started to rise, but higher-income families saw their incomes rise even faster. Between 1989 and 2000, among married-couple families with children, income of those in the bottom fifth of the income distribution rose by 8.8 per cent, compared to 14.1 per cent among those in the top fifth (Mishel et al. 2005). Analysis of percentiles does not allow us to see just how much those at the very top of the income distribution have gained over the past three decades. To see this, we need to look at data on tax returns that does not top-code the incomes of those at the very top. Top-coded data has all values over a certain threshold recoded as a common number in order to protect the privacy of the very wealthy. Recent research using tax returns has found that between 1973 and 2000, the average real income of the bottom 90 per cent of American taxpayers fell by 7 per cent while the income of the top 1 per cent grew by 148 per cent (Piketty and Saez 2001). While the top has pulled away from the bottom, the top has also been pulling away from the middle. Households at the 80th percentile now have over twice the income (2.01 times) of households at the 50th percentile. Back in 1967, this ratio was only 1.66. The gap between households at the bottom and middle has remained relatively constant, at 0.42 in both 1967 and 2003. Similarly, the ratio of the income limit for the top 5 per cent of income earners to the bottom 20 per cent rose from 6.3 in 1967 to 8.6 in 2003. Also, the annual increases almost doubled after 1980. From 1967 to 1980, the ratio of income cut-offs increased annually by 0.6 per cent, whereas it rose by 1.0 per cent on average each year from 1980 to 2003. In comparison, the ratio of the income limits for the bottom 20 per cent to the middle percentile stayed fairly constant at about 0.42 (Census 2004a). As a result of unequal growth in incomes, inequality among American households is currently at its highest level since the US Census Bureau began conducting its annual survey of household income. In the aggregate, this meant that more income became concentrated at the top of the income scale and less income at the bottom. The share of total income accruing to the 20 per cent of households at the top of the income scale rose from 43.8 per cent in 1967 to 49.8 per cent in 2003.

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122 Rising Inequality in the USA

In comparison, the share of income going to the 20 per cent of households at the bottom of the income scale fell from 4.0 per cent to 3.4 per cent over the same period. Interestingly, the aggregate income share of the bottom 20 per cent of households actually rose until 1980, when it reached 4.3 per cent, whereas the aggregate share of income accruing to the top 20 per cent fell slightly until 1980, when it reached 43.7 per cent (Census 2004a). This sharp rise in income inequality over the past three decades occurred even as families put more family members into the workforce. Back in 1973, most mothers did not work outside the home, while by 2000 most mothers did hold a paying job. The increase in hours worked by wives was greater among families in the bottom fifth of the income distribution. Between 1979 and 2000, wives in families with children increased their hours by 43.9 per cent, compared to a 27.4 per cent increase in hours among wives in families in the top fifth. Within married-couple families with children, inequality would have increased even more without the contribution of wives' income. Between 1979 and 2000, among families in the bottom fifth, income would have fallen by 13.9 per cent without the earnings of wives, rather than rising by 7.5 percent; among families in the top fifth, income would have increased by 51.5 per cent, rather than 63.0 per cent (Mishel etal. 2005). If wage and income inequality were counterbalanced by the potential for economic mobility, then greater inequality would not require that some stay at the bottom (or at the top). This would be especially true if inequality was the result of immigration as new immigrants enter at the bottom and then move up. However, this is not the case. In the 1970s, 50.7 per cent of families who began the decade in the bottom quintile and 49.1 per cent of families who began the decade in the second bottom quintile moved into a higher quintile over the decade. However, in the 1990s, only 46.8 per cent of families who began the decade in the bottom quintile and 37.9 per cent of families who began the decade in the second bottom quintile moved into a higher quintile (Bradbury and Katz 2002). Wysong et al. (2003) found that class matters now more than ever. Sons from the bottom three-quarters of the socio-economic scale were less likely to move up in the 1990s than in the 1960s. By 1998, only 10 per cent of sons of fathers in the bottom quarter (defined by income, education, and occupation) had moved into the top quarter, whereas by comparison, by 1973, 23 per cent of lower-class sons had moved up to the top. Thus, there is a smaller chance that a low-income family will move up the income ladder over time.

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Heather Boushey and Christian E. Weller 123

The labour force participation of wives has been critical to the story of mobility. Recent research has found that families where wives had high and rising employment rates, work hours, and pay were more likely to move up the income ladder or maintain their position, rather than fall down the ladder (Bradbury and Katz 2004). But, even the large increase in labour supply of women (and mothers, in particular) has not been sufficient to counterbalance declining mobility overall. Even though wages account for most of family income, other factors are important, too. Capital income as a share of personal income doubled from 7.1 per cent in early 1947 to 14.1 per cent in the second quarter of 2004 (BEA 2004). However, the assets underlying these income streams are fairly unequally distributed. For instance, Wolff (2002a) reported that the bottom 40 per cent of households had negative financial net worth in 1998, and that they had little total net worth. Further, Wolff (2004) reported that wealth inequality rose from 1998 to 2001 for total net worth. Macroeconomic background With income growth lagging, households increased their consumption by saving less and borrowing more.3 The personal savings rate declined from an average high of 9.7 per cent in the early 1970s to 4.7 per cent in the 1990s and to 2.1 per cent in the latest business cycle (Table 6.2). Table 6.2

Savings and consumer debt, business cycle averages

Business cycle dates

1949:IV-1953:II 1953:111-1957:111 1957:IV-1960:II 1960:III-1969:IV 1970:I-1973:IV 1974:1-1980:1 1980:11-1990:111 1990:IV-2001:I 2001:11-2004:1

Personal savings rate

Total consumer debt as share of disposable income

Mortgages as share of disposable income

Consumer credit as share of disposable income

7A 7.9 7.9 8.4 9.7 9.5 8.9 4.7 2.1

38.2 47.3 55.0 65.4 63.7 65.2 73.4 91.7 109.0

23.1 29.1 35.0 41.0 38.2 40.1 47.0 61.3 74.3

11.6 13.9 15.0 17.7 18.1 17.6 17.9 20.0 23.9

Notes: All figures are in per cent. Mortgages comprise both traditional mortgages and home equity loans. Consumer credit refers to revolving consumer credit, such as credit-card debt, and non-revolving credit-card debt, such as car loans. Source: Bivens and Weller (2005).

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124 Rising Inequality in the USA

Simultaneously, consumer debt, especially mortgage debt, rose from 63.7 per cent of disposable income in the early 1970s to over 100 per cent in the most recent business cycle. At the same time, the economic distress of households increased. From 2001 through mid-2004, households dedicated at least 13 per cent of their disposable income to service their debts - the largest share in twenty years (BOG 2004b). Charge-off rates have also been high with, for instance, credit card charge-off rates above 5 per cent of all loans since 2001 (BOG 2004a). In addition, personal bankruptcies have risen so that the share of households that declared bankruptcy reached an estimated record 1.5 per cent in 2003. While households borrowed more to make ends meet, firms used their additional profits for uses other than productive investments. Specifically, firms increased their share repurchases and dividend pay-outs. While in the 1970s, corporations used 10.7 per cent of their resources for these purposes, this share grew to more than 30 per cent since the 1980s as capital expenditures simultaneously declined (Table 6.3).

Table 6.3 Selected use of non-financial corporate resources, business cycle averages Financial uses as share of total internal resources

Productive uses as share of total internal

Business cycle dates

Total

Dividend payouts

Net equity issues

resources capital expenditures

1953:111-1957:111 1957:IV-1960:II 1960:III-1969:IV 1970:I-1973:IV 1974:1-1980:1 1980:11-1990:111 1990:IV-2001:I 2001:11-2004:1

17.9 17.9 20.1 10.7 14.8 31.4 32.0 30.8

23.3 22.3 21.8 20.0 17.2 18.5 25.2 25.4

-5.4 -4.5 -1.7 -9.3 -2.5 12.9 6.8 5.4

79.1 74.6 83.1 101.2 106.4 95.1 88.3 76.7

Notes: All figures are in per cent. Total internal resources are defined as after-tax profits plus inventory valuation adjustments and capital consumption allowance. Net equity issues, originally a source of funds, are multiplied by minus one to make them comparable with other uses of funds. Figures do not add to 100% since other sources, especially borrowing of funds, are excluded. Source: Bivens and Weller (2005).

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Heather Boushey and Christian E. Weller 125

Business cycle dates

Share of income of bottom 20%

Share of income of top 20%

Ratio of income limits of 95th to 50th percentile

1948-52 1953-57 1958-59 1960-69 1970-79 1980-90 1991-2000 2001-03

n.a. n.a. n.a. 4.10 4.13 4.35 3.66 3.47

n.a. n.a. n.a. 43.20 43.58 43.48 48.67 49.87

n.a. n.a. n.a. 2.61 2.69 2.82 3.36 3.56

Productivity growth 3.55 1.96 2.92 2.67 1.15 1.44 2.00 3.68

Real GDP growth

Real consumption growth

Growth contribution consumption & residential fixed investment

Consumption as share of GDP

Consumption as share of disposable income

4.75 2.90 2.93 4.33 2.93 2.90 3.23 1.88

4.77 2.92 2.96 4.33 2.92 2.89 3.22 1.86

-37.49 6.91 6.02 64.41 205.69 25.65 83.01 144.96

63.73 62.25 63.05 61.83 62.15 62.63 67.26 70.17

91.42 90.34 90.12 89.49 87.87 88.22 91.82 94.52

Notes: All figures are in per cent. Starting date for inequality data is 1967. Sources: BEA (2004), Census (2004a) and BLS (2004a).

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Table 6.4 Selected macroeconomic measures, business cycle averages, 1948-2003

Despite laggard investment, productivity accelerated. Compared to other early recovery periods, this was the first time during which productivity growth actually outpaced aggregate demand growth in the first two years of a recovery. Measured as business cycle averages, productivity growth in 2002 and 2003 was higher than in previous business cycles, although the economy sustained productivity growth that was almost as high for a period of four years in the late 1940s (Table 6.4). Reflecting the weakness in demand and the divergence between supply and demand, consumption growth slowed down since 2001 (Table 6.4). For 2001 until 2003, average real consumption growth was 1.9 per cent, compared to 3.2 per cent in the 1990s-the slowest consumption increase of any postwar business cycle. However, consumption never slowed during the most recent recession and consumer spending on new homes and home renovations accelerated more than it had in prior recoveries. Thus, consumer spending contributed more to growth than the actual growth rate, reflecting the continued trade deficits and the slowdown in investment (Table 6.4) (Weller etal. 2004). Explaining the rise in inequality A number of factors contributed to the rise in inequality between capital and labour. The two most convincing explanations are increasing trade intensity and changes in the institutional make-up of US corporations that gave more power to institutional investors and managers and reduced the influence of labour unions (Bivens and Weller 2005; Lazonick and O'Sullivan 2000). Increased trade, especially in manufactured goods, is a non-negligible factor in explaining the rise in inequality. About a third of the loss of manufacturing jobs that occurred from the end of 2000 to the end of 2003 - the largest driving force of the 'job-loss' recovery - can be attributed to rising trade deficits in manufactured goods (Bivens 2004; Atkinson 2003). This result is consistent with standard trade theory. The predicted structure of trade for a nation like the USA - labour-intensive imports and capital-intensive exports - implies that trade should lead to a decline in the demand for labour and rise in the demand for capital, moving wages (down) and profit rates (up) accordingly. During the 1970s and 1980s, the main distributional impact of trade seemed to be on the distribution of wages; as trade raised the return to skilled labour and lowered the return to unskilled labour (Cline 1997). The relative lack of a capital/labour income dimension of trade was consistent with what economists dubbed 'Leontiefs Paradox': the finding

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Heather Boushey and Christian E. Weller 127

that US exports were not notably capital-intensive, nor were US imports labour-intensive. What really seemed to distinguish US trade in the 1970s and 1980s was that it was particularly biased against blue-collar workers (Borjas and Ramey 1995). That is, for most of the period that we are interested in, trade can explain an increase in the within labour inequality, but not a rise in the inequality between labour and capital income. Another factor that explains the divergent trends between capital and labour is a rising imbalance in the corporate governance realm. Specifically, a growing concentration among institutional shareholders and rising power of managers in deciding corporate resource allocations was juxtaposed by a declining unionization rate. A greater reliance on managed assets in household savings led to a rising concentration of shares in the hands of mutual funds, brokers, public and private pension funds and insurance companies. In 1952, institutional investors owned less than 10 per cent of outstanding equities, and in 2004 it surpassed 50 per cent for the first time (BOG 2004c). Also, institutional investors had growing incentives to use this opportunity to allocate resources towards capital. Starting in the 1970s, institutional changes, such as the Employee Retirement Income Security Act (ERISA) of 1974 and the introduction of 401 (k) retirement saving plans, gave fund managers and households a common interest in maximizing asset returns (Bivens and Weller 2005). This altered the way corporations were run, creating a new class of professional managers that enjoyed greater freedom in allocating corporate resources towards a strategy of rent extraction, including downsizing, outsourcing and restructuring, as well as a reorientation towards financial service activities, away from actual production (Lazonick and O'Sullivan 2000; O'Sullivan 2000). Consequently, labour compensation declined, along with union representation, as jobs especially in manufacturing were lost. Thus, the allocation of corporate resources towards faster profit growth proceeded with less opposition than in the past. Profits in turn were increasingly used for dividend pay-outs and share repurchases, which directly benefited executives, whose compensation was dependent on the performance of a company's share value. Corporate governance changes explain the rise in income inequality in important ways. For one, they explain a growing emphasis of profit generation, thus shrinking the allocation of corporate resources towards labour. They also explain the growing inequality within labour as a result of more rent-extracting activities and executive compensation contingent on share price performance. Finally, the latter aspect also

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128 Rising Inequality in the USA

explains the growing share of personal income that is derived from assets, which in turn contributes to the rise in income inequality due to the unequal distribution of household wealth. Because inequality has risen along so many dimensions, the reasons for its expansion are not easy to pinpoint on a single source or in a single regression. The concentration of financial market power, combined with declining bargaining power - the decline in unionization, deregulation and privatization, assaults on social programmes, a lack of increase in the minimum wage, and an inequitable distribution of healthcare - all contribute the power imbalance of workers with respect to employers and the state. The level of unemployment is critical in explaining changes in inequality - higher unemployment leads to inequality growth and inequality tends to shrink during periods of tight labour markets. This is because unemployment affects the fortunes of those at the bottom of the labour market more than those at the top. Individuals with limited education or who earn in the bottom of the wage distribution are more likely to lose a job when unemployment rises. The mechanisms through which unemployment affects wages are not always direct, but, at their core, they are related to the relative power of labour and capital within the US economy. If workers are fearful of losing their job, because of high levels of unemployment, they will be less likely to bargain hard for higher wages and less able to search for a new position at a higher wage (or benefit) level. Structural changes in the US economy are also implicated in inequality's growth. The decline in unionization, the lessening of labour market regulation, changes in the industrial and occupation mix of jobs, and globalization have all contributed to growing inequality. A declining real minimum wage and de-unionization can explain about one-third of the growth in wage inequality, while globalization - immigration, trade and capital mobility - can explain another one-third of inequality's rise (DiNardo etal. 1996; Gottschalk 1997; Lee 1999; Card etal. 2003). Growing inequality is also the result of a lack of a broad-based social insurance system. Once an American becomes poor, it is exceedingly difficult to rise back up into the middle class. The OECD has found that in the USA there are not only more poor families, but they are less likely than the poor in other countries to 'exit' from poverty. For example, while 41.1 per cent of poor Germans exit poverty each year, only 29.5 per cent of poor Americans do so. Because income transfers are so small, the only way out of poverty is earnings or marriage; this has left US poor people more likely to exit poverty through earnings than in

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Heather Boushey and Christian E. Weller 129

other OECD nations. Yet, because of limited growth in wages among low-wage workers over the past few decades (up until the late 1990s), this led to lower poverty exit rates in the USA. Thus, the US social welfare state does not help to reduce inequality through helping families back into the middle class; further, the USA has more wage and income inequality than any other OECD country (Mishel et al. 2003). In general, the US labour market has become an increasingly insecure place for workers. As they emerged from the stagflation of the 1970s, US firms made the case to government and to workers that they needed more control over workers and that could not afford to compete internationally while paying decent wages and benefits. Much of the blame for stagflation was placed on labour's 'unreasonable' demands. The plant closings and outsourcing that happened over the next decade the decimation of manufacturing and the unions - scared policy-makers as well as labour unions. For example, one trend in the USA has been for cities and states to compete with one another to reduce taxes to lure and keep employers in their locality, often without requiring anything of the firms in exchange. At the same time, the responsibility for ensuring a living wage has fallen more to the government than to low-wage employers, as low wages are supplemented by the Earned Income Tax Credit, even as the inflation-adjusted minimum wage declined markedly. Further, no longer can a worker assume that they will stay in a job for their career. Internal labour markets are increasingly a thing of the past. Inequality and the macro-economy If the rise in the profit share translates into an increase in the profit rate, it may result in more investment and potentially more growth since greater profits provide firms with more incentives to invest, particularly if tax policy supports the increase in the profit rate (Bivens and Weller 2004; Palomba 2002). However, a greater profit rate may also attract more entrants into an industry and reduce the rate of profit below what was originally expected (Peretto 1995). In addition, profit rate gains may have been generated by reducing wage growth, which may suppress demand growth and thus profit growth over time (Palley 1996). Furthermore, through rent extraction, many core activities of a firm are abandoned. This may impede organizational learning and thus innovation and growth (Lazonick and O'Sullivan 2000; O'Sullivan 2000). These concerns, though, do not necessarily contradict the original notion that a higher profit rate will lead to more investments. They do suggest,

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130 Rising Inequality in the USA

however, that over time countervailing forces will gain ground and weaken the link. This may explain why there is little empirical evidence for profit led growth (Stockhammer and Onaran 2004, and in this volume). A positive link between inequality and innovation has been suspected, particularly because inequality may imply a greater wage premium on skills. The opposing view, though, contends that rising inequality leads to growing political instabilities, and thus to disincentives for accumulation, followed by reduced innovation (Alesina and Perotti 1996; Larrain and Vergara 1997; Rodriguez 2000). There may be a threshold below which inequality fosters growth, but above which political instability considerations outweigh skill development effects (Benhabib 2003; Chen 2003). Patterns of wage growth do not suggest a connection between inequality and skill development (Mishel et al. 2001, 2005; Appelbaum and Weller 2001). From the late 1970s to the mid-1990s, wages declined, especially for young high-school graduates. By the late 1990s they had not recovered to the levels of the late 1970s. Also, entry-level wages among male college graduates were stagnant from 1973 to 1989, and fell 9.9 per cent from 1989 to 1995. However, between 1995 and 1999 among young college graduates real wages rose 14.9 per cent for men and 9.4 per cent for women. Further, wage inequality rose fastest in the 1980s, when productivity growth was not faster than during the 1970s, when wage inequality did not rise, and when productivity growth accelerated in the 1990s there was no matching inequality increase (Mishel et al. 2001, 2005). Furthermore, most of what explains the rise in wage inequality is a pulling away of the top 10 per cent of wage earners in the 1990s, while the differential between low and middle wage earners was stagnant (ibid.). Finally, the occupations that account for the largest education wage differentials were managers and sales workers, not technical professions (Mishel etal. 2001). Additional findings are largely inconclusive as to the effect of inequality on innovation. Some researchers have found a positive, albeit small effect of inequality on growth (Scully 2002), while others found a negative relationship between the two (Alesina and Perotti 1996; Panizza 2002; Rodriguez 2000; Rupasingha etal. 2002). The findings of a link between inequality and growth, though, appear to be sensitive to the empirical model's specification (Crafts 1992; Panizza 2002). Also, the contention that income inequality in the USA has resulted in greater productivity growth due to better skill development does not seem to enjoy empirical support (Appelbaum and Weller 2001; Osberg 2003; Mishel eta/. 2001, 2005).

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Heather Boushey and Christian E. Weller 131

Even though there does not seem to exist a link between inequality and aggregate supply, there may be a connection between inequality and demand. If the labour share of national income declines, aggregate demand could fall as consumption growth slows. This effect could be exacerbated if inequality within labour rises, too. A greater concentration of total income among higher income earners may reduce aggregate demand growth as higher income earners have a lower marginal propensity to consume and thus are more prone to save than lower income households (Keynes 1936). On the face of it, the figures do not necessarily support the notion that rising inequality can lead to declining consumption. For instance, the share of consumption relative to disposable income, one of the measures that should decline with inequality, actually increases as inequality rises (Table 6.4). Also, research based on micro data appears to be somewhat ambivalent. Specifically, savings incentives should be relatively most effective for high-income earners and least effective for low-income earners. An analysis using micro data to study the effectiveness of savings incentives, such as 401 (k)s and individual retirement account, tend to find that savings incentives seem to be more effective in raising savings for low-income earners and not for high-income ones (Engen and Gale 2000). A number of studies, though, based on macro data suggest that there is a negative connection between inequality and aggregate demand (Arestis and Howell 1995; Brown 2004; Pressman 1997). It is possible that the gap between income and consumption has been filled by consumer debt. Inequality, consumer debt and financial distress As inequality rose, consumption should have declined without compensating increases in consumer debt (Brown 2004). Some researchers have argued that in fact the rise in inequality has given way to an endogenous development of credit markets, increasing the credit supply in response to rising inequality (Kruger and Perri 2002). The credit supply rose for a number of reasons and its expansion was most notable among low-income households. First, the standardization of mortgages and the introduction of mortgage-backed securities took shape in the 1960s with the creation of Ginnie Mae (Government National Mortgage Association, GNMA) under the Housing and Urban Development Act of 1968, the creation of Freddie Mac (Federal Home Loan Mortgage Corporation), the engagement of Fannie Mae (Federal National Mortgage Association, FNMA)in the pass-through market under

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132 Rising Inequality in the USA

the Emergency Home Finance Act of 1970, and tax advantages for mortgages under the 1986 Tax Reform Act (Vandell 2000). These innovations helped to reduce the risks for mortgage lenders and lowered the costs of mortgages (Van Order 2001). Pearce and Miller (2001) estimated that the costs savings to consumers amounted to somewhere between $8.4 billion to $23.5 billion. Second, financial innovation increased credit supply. The Tax Reform Act of 1986 phased out the deductibility of most non-mortgage interest and introduced new marginal tax rates that reduced the tax advantage of all types of debt. This led to a shift of consumer debt towards mortgages and home equity lines (Dunsky and Follain 2000, Stango 1999). Stango (1999) estimates that by 1991 aggregate mortgage debt was over 1 percent higher, credit-card debt approximately 14 per cent lower, and auto loan debt approximately 9 per cent lower than they would have been without these changes. Third, increased financial competition raised the credit supply. Specifically, competition among credit-card providers gave financial institutions incentives to offer credit cards to clients that were previously underserved (Manning 2000). The relative increases of credit-card debt appear to be larger among lower-income households than among higher-income households (Manning 2000; Yoo 1996). In addition, non-bank credit also expanded in response to rising inequality. These types of loans, including payday loans, pawnbroking, rent-to-own and appliance title loans, and tax-refund anticipation loans grew and were concentrated among low-income customers (Barr 2001; CFA 1998, 1999; Stegman and Faris 2003). Greater credit supply should offset the adverse effects of rising inequality on consumption. Higher debt-service costs, though, could outweigh the added impulse to consumption from more debt. In particular, household sources have to equal their uses: ACt + ATrt + AIt + AAt = AYt + ADt

(6.1)

The change in consumption, C, is thus equal to the change in disposable income, Y, plus the change in debt, D, minus the change in net transfers, Tr, minus the change in assets, A, minus the change in interest payments, I. Assuming that borrowing is the only thing that keeps consumption going, consumption can increase as long as new debt is larger than the increases in interest payments. Increases in interest payments are: AIt = ArtDt.l

(6.2)

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Heather Boushey and Christian E. Weller 133

134 Rising Inequality in the USA

Business cycle dates 1954:3-1957:3 1957:3-1960:2 1960:2-1969:4 1969:4-1973:4 1973:4-1980:1 1980:1-1990:3 1990:3-2001:1 2001:1-2004:2

Change in disposable income relative to consumer spending

Change in financial assets to consumer spending

Change in interest payments to consumer spending

Change in transfer payments to consumer spending

Change in debt to consumer spending

0.74 -1.78 3.91 2.76 -1.74 -0.94 -5.91 -2.18

-7.93 2.79 -0.55 4.11 -0.40 -0.18 -6.91 2.97

0.31 0.16 0.49 -0.05 0.22 0.47 0.00 -0.77

0.00 -0.13 0.13 0.11 -0.11 0.41 0.39 0.13

-1.28 1.68 -2.14 3.11 1.56 -2.44 0.22 5.14

Notes: All figures are in per cent. Totals do not add to zero due to statistical discrepancies. Disposable income refers to personal income minus taxes plus net investments in consumer durables and consumption of fixed capital minus all new spending on consumer durables, government insurance and pension reserves, and net capital transfers. Consumer spending refers to personal consumption expenditures plus capital expenditures on real estate. Sources: BOG (2004c) and BEA (2004).

such that the growth of household debt has to be greater than the percentage point increase in the interest rate. The figures from past business cycles show that debt has played a larger role in financing consumption in this business cycle than in any previous ones, and that debt changes were indeed greater than changes in interest payments (Table 6.5).4 Specifically, personal income became a negative contributor to changes in consumption, meaning that consumption growth was larger than personal income growth. Also, since the 1980s, debt growth has outpaced consumption growth helping to finance the gap left by slower income growth. Yet, despite faster debt growth, interest payments were unchanged and even declined relative to consumption spending since the 1980s. For debt and consumption to rise simultaneously, income has to go up, interest rates have to go down, or both. Debt and consumption grew at the same time, while income growth has been lagging at least behind consumption growth (Table 6.5). At the same time, though, interest rates have been falling in nominal and real terms. Thus, declining interest rates have allowed households to sustain their consumption.

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Table 6.5 Sources and uses of household finances

Inequality and consumer debt We can estimate the effect of inequality on the credit supply since under credit rationing, realized credit is equal to the credit supply (Stiglitz and Weiss 1981). Credit supply is measured as credit relative to disposable income. Its explanatory variables are standard measures of collateral - expected income gains-and interest that we supplement with measures of inequality. Specifically, we use real disposable income lagged once and the real mortgage rate. In addition, we use the labour share of national income as a measure for inequality between capital and labour. To account for within-labour inequality we use two measures, one for wage inequality and a proxy for wealth inequality and thus capital income inequality. Our wage inequality measure is Atkinson's inequality measure with a calibration factor of 0.5. As proxy of wealth inequality, we use the ratio of the stockmarket index to the housingprice index (Wolff 2002b):

+ ft(. 2 4 ^ § | p ) / 4 + PM-i + fat + *t

(6.3)

where LI is labour income, NI is national income, Atkinson05 is Atkinson's inequality measure calibrated with a parameter of 0.5, SP500 refers to the S&P 500 index and HPI to the housing price index, y is real disposable income, r is the real mortgage rate, and s is a randomly distributed error term. Data for labour income, national income and disposable income come from BEA (2004); data for the Atkinson's inequality measure is from CEPR (2004); data for the S&P 500 is from Yahoo! Finance (2004); data for the Housing Price Index is from OFHEO (2004); and interest rate data are from BOG (2004d). Income inequality is likely to affect debt over the course of some time, so that we use the average of the four quarters ending in the current quarter for all of our inequality measures.5 In each case the natural logarithm is used. Table 6.6 presents our results for the determinants of total debt. The first regression presents our baseline results with the expected positive signs for the explanatory variables. In regression (2), we add our measure for inequality between capital and labour. We would expect this measure to have a negative sign indicating that a greater distribution of national economic resources towards labour is less likely to give rise to endogenous credit expansions and thus less likely to lead to an

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Heather Boushey and Christian E. Weller 135

136 Rising Inequality in the USA ]Regression results for determinants of household debt, 1980-2003

Explanatory variables

(1) Baseline

yt-i

0.47*** (0.10) -0.05** (0.02)

rt LI/NIt

(2) Between inequality

(3) Within inequality

0.56*** (0.10) -0.04 (0.03) 0.72 (0.51)

0.62*** (0.10) -0.04 (0.03) 0.81 (0.52)

LPI/NIt Atkinson05t

-0.14 (0.14)

(4) Alternative between inequality

(5) Alternative within inequality

(6) Combined labour inequality

0.64*** (0.09) -0.04 (0.03)

0.61*** (0.11) -0.04 (0.03) 0.78 (0.52)

0.59*** (0.11) -0.04 (0.03) 0.78 (0.52)

1.01** (0.51) -0.11 (0.13)

AtkinsonlOt SP500/HPIt

0.01 (0.03)

0.01 (0.03)

-0.13 (0.16) 0.01 (0.03)

LIneqt Constant N Adj. JR-squared DurbinWatson

—4 14*** -4.56*** (0.85) (0.90) 93 93 0.25 0.23 1.86

1.86

-5.42*** (1.00) 93 0.45

-5.60*** (0.89) 93 0.65

-5.23*** (0.98) 93 0.44

-0.01 (0.02) -4.80*** (0.91) 93 0.33

1.88

1.86

1.87

1.88

Notes: In each case, a Prais-Winsten regression is used. LPI refers to labour income plus proprietors' income and AtkinsonlO refers to the Atkinson inequality measure with 1.0 parameter instead of 0.5. LIneq refers to the combined labour inequality measure derived by using the first factor. All inequality measures refer to the four-quarter average ending in the current quarter. Figures in parentheses are standard deviations. ** denotes significance at the 5% level, and *** denotes significance at the 1% level.

increase in the credit supply, ceteris paribus. This measure is statistically insignificant. In regression (3), we add our two measures for income inequality. Again, neither one is statistically significant. Regression (4) introduces an alternative measure for inequality between capital and labour. Now, we consider proprietors' income as part of total labour compensation; this generates a statistically significant, yet positive correlation between inequality and the amount of debt. One explanation for this unexpected sign may be that more labour income may also constitute more collateral for households to borrow against. In regressions (5) and (6) we test the robustness of our results with respect to within

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Table 6.6

labour inequality. In regression (5), we replace the Atkinson measure with the 0/£ calibration factor with the Atkinson measure with a 1.0 calibration factor. The results essentially remain the same. One problem with our labour income inequality measures may arise from the fact that both are highly correlated. To circumvent this problem, we combine both measures using factor analysis. We first standardize both variable and then calculate the principal factors. We use only the first factor to generate a new variable 'labour inequality', which is a linear combination of the two separate variables and explains 89 per cent of the variance of both variables. Using this new variable instead of two separate measures for labour inequality generates regression (6). The results are again largely robust. So far, we do not find a link between inequality and household debt. One explanation may be that total household debt is too broad a category to be affected by inequality. Borrowing by high and low-income households in response to rising inequality may have had offsetting effects. Specifically, higher-income earners are more likely than lowerincome households to own a home and thus be able to borrow against their real estate (Wolff 2002b, 2004). Income inequality rose because incomes of higher-income earners pulled away from the middle. Thus, households that were more likely to own their residence also had more collateral to borrow against, but less need to borrow additional money. In comparison, lower-income households saw below-average income gains as inequality rose, but also had fewer opportunities to borrow against their own homes. As they had a greater need to borrow, but less collateral, the literature suggests that a cycle of endogenous credit expansion took place, which may have manifested itself in a disproportionate increase in credit-card debt among low-income households. Thus, we estimate our results separately for mortgages (Table 6.7) and credit-card debt (Table 6.8).6 Table 6.7 presents our results for mortgage debt. We find a consistent positive and statistically significant relationship between the labour share of national income and mortgage debt, suggesting that less labour income allowed fewer households to buy a home and borrow against the value of their real estate than otherwise would have been the case. A 1 per cent decline in the four-quarter average of labour's share of national income translated into a 1 per cent decrease in the ratio of mortgage debt to disposable income. The results also show that the rising inequality in the distribution of wage earnings had an adverse effect on mortgage debt. A rise in earnings inequality translated into less mortgage debt as well. Thus, our results suggest that the increasing unequal

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Heather Boushey and Christian E. Weller 137

138 Rising Inequality in the USA Table 6.7 1Regression results for determinants of mortgage; debt, 1980--2003

(1) Baseline

Yt-i

0.51*** (0.11) -0.05* (0.03)

h LI/NIt

(3) Within inequality

0.59*** (0.16) -0.03 (0.03) 0.95* (0.51)

0.66*** (0.12) -0.03 (0.03) 1.13** (0.51)

LPI/NIt Atkinson05t

-0.27* (0.14)

(4) Alternative between inequality 0.63 (0.11) -0.03 (0.03)

-0.03 (0.03)

0.65*** (0.12) -0.03 (0.03) 1.09** (0.51)

-0.03 (0.03)

-0.27* (0.16) -0.03 (0.03)

LIneqt Constant N Adj. i?-squared DurbinWatson

0.66*** (0.12) -0.03 (0.03) 1.13** (0.51)

1.30** (0.53) -0.24* (0.14)

AtkinsonlO t SP500IHPIt

(5) * (6) Alternative Combined labour within inequality inequality

-4.82*** (0.98) 93 0.35

-5.12*** (0.97) 93 0.41

-6.31*** (1.09) 93 0.45

-6.10*** (1.05) 93 0.50

-6.12*** (1.08) 93 0.46

-0.03** (0.02) -5.68*** (0.98) 93 0.25

1.37

1.39

1.50

1.51

1.48

1.98

Notes: In each case, a Prais-Winsten regression is used. LPI refers to labour income plus proprietors' income and AtkinsonlO refers to the Atkinson inequality measure with 1.0 parameter instead of 0.5. LIneq refers to the combined labour inequality measure derived by using the first factor. All inequality measures refer to the four-quarter average ending in the current quarter. Figures in parentheses are standard deviations. * denotes significance at the 10% level, ** denotes significance at the 5% level, and *** denotes significance at the 1% level.

distribution between capital and labour away from labour and the rising inequality of labour income lowered the amount of mortgage below where it otherwise would have been. Our results on mortgage debt stand in contrast to our results on creditcard debt (Table 6.8). We find no connection between an increasingly unequal distribution between capital and labour and the amount of credit-card debt, but we find that greater inequality within labour results in more credit-card debt, regardless of which measure is used. For instance, a 1 per cent increase in wage inequality has typically resulted in a 0.5 per cent increase in credit-card debt relative to disposable

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Explanatory variables

(2) Between inequality

Heather Boushey and Christian E. Weller 139

Explanatory variables yt-i

prt

(1) Baseline 1.19*** (0.22) 0.001 (0.04)

LI/NIt

(2) Between inequality

(3) Within inequality

1.18*** (0.24) -0.01 (0.04) -0.81 (1.05)

0.99*** (0.23) -0.02 (0.04) -1.28 (1.04)

1.06*** (0.22) -0.01 (0.04)

0.51* (0.28)

-0.86 (1.08) 0.46* (0.28)

0.12* (0.06)

0.11* (0.06)

LPI/NIt Atkinson05t

(4) Alternative between inequality

Atkinson 101 SP500/HPIt LIneqt Constant N Adj. fl-squared DurbinWatson

-13.21*** -12.91*** -10.78*** -11.22 (2.11) (1.92) (1.96) (2.15) 93 93 93 93 0.85 0.78 0.85 0.85 1.48

1.93

1.93

1.92

(5) Alternative within inequality

(6) Combined labour inequality

0.98*** (0.23) -0.02 (0.04) -1.23 (1.04)

0.99*** (0.23) -0.02 (0.04) -1.28 (1.04)

0.61* (0.33) 0.11* (0.06) -10.83*** (2.11) 93 0.85

0.08** (0.03) -11.97*** (1.92) 93 0.84

1.93

1.93

Notes: In each case, a Prais-Winsten regression is used. Credit-card debt refers to the share of revolving credit out of total household debt. LPI refers to labour income plus proprietors' income and AtkinsonlO refers to the Atkinson inequality measure with 1.0 parameter instead of 0.5. LIneq refers to the combined labour inequality measure derived by using the first factor. All inequality measures refer to the four-quarter average ending in the current quarter. Figures in parentheses are standard deviations. * denotes significance at the 10% level, ** denotes significance at the 5% level, and *** denotes significance at the 1% level.

income. For the period from 1980 to 2003, our inequality measure had a standard deviation that was 6.5 per cent of its mean. Thus, a one standard deviation increase would explain a 3.2 per cent increase in debt relative to disposable income. This is a small fraction of the total increase in credit-card debt relative to disposable income as it rose almost fourfold over the period from 1980 to 2003. In comparison, a 1 per cent increase in our capital income proxy translated into an increase of 0.1 per cent in the ratio of credit-card debt to disposable income. The standard deviation of our capital income inequality proxy was 56 per cent of its average, which would have meant a 5.6 per cent increase in the ratio of credit-card debt to disposable income.

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Table 6.8 Regression results for determinants of credit-card debt, 1980-2003

One way to combine the results on mortgage debt and credit-card debt is to use the share of credit-card debt out of total debt as the dependent variable (Table 6.9). The results show that the trend towards rising inequality between labour and capital and within labour has resulted in a larger share of credit-card debt relative to total household debt over the period from 1980 to 2003. As the labour share of national income has trended downward, households increasingly shifted their borrowing towards credit-card debt, possibly because it was more accessible than mortgage debt. A 1 per cent decrease in the labour share of national income resulted in a 2 per cent increase in the relative

Table 6.9

Explanatory variables yu

prt

)Regression results for determinants of debt composition, 1980-2003

(1) Baseline 0.34*** (0.23) 0.04 (0.03)

LI/Mt

(2) Between inequality

(3) Within inequality

0.59*** (0.17) 0.01 (0.03) -1.53** (0.76)

0.44*** (0.16) 0.0005 (0.03) -2.08*** (0.72)

LPI/NIt Atkinson05t

0.66*** (0.20)

(4) Alternative between inequality

(5) Alternative within inequality

(6) Combined labour inequality

0.53*** (0.16) 0.01 (0.03)

0.44*** (0.16) 0.004 (0.03) -2.00*** (0.71)

0.44*** (0.16) 0.001 (0.03) -2.08*** (0.71)

-1.79** (0.75) 0.60*** (0.20)

AtkinsonlO t SP500/HPIt

0.11** (0.04)

0.10** (0.04)

0.76*** (0.22) 0.10** (0.04)

LIneqt Constant N Adj. i?-squared DurbinWatson

-687.39*** (317.39) 93 0.03

-8.60*** (1.46) 93 0.78

-5.86*** (1.49) 93 0.90

-6.52*** (1.48) 93 0.89

-6.06*** (1.46) 93 0.90

0.10*** (0.02) -7.43*** (1.32) 93 0.90

1.50

1.45

1.75

1.73

1.74

1.75

Notes: In each case, a Prais-Winsten regression is used. LPI refers to labour income plus proprietors' income and AtkinsonlO refers to the Atkinson inequality measure with 1.0 parameter instead of 0.5. All inequality measures refer to the four-quarter average ending in the current quarter. Figures in parentheses are standard deviations. * denotes significance at the 10% level, ** denotes significance at the 5% level, and *** denotes significance at the 1% level.

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140 Rising Inequality in the USA

borrowing from credit cards. Also, increasing inequality within labour led to a growing share of credit-card debt relative to total debt. A 1 per cent increase in wage inequality, averaged over four quarters, translated into an increase of 0.6 per cent in the relative size of credit-card debt and a 1 per cent increase in capital income inequality translated into a 0.1 per cent increase in the share of credit-card debt. The size of the effects is comparable to their impact on the volume of credit. Inequality and household economic distress The rise in consumer debt could also have given rise to household economic distress if it was more pronounced for lower-income households (Iyigun and Owen 1997). The increase in debt levels, caused by a growing disparity between labour and capital, should increase financial distress. So should the rise in labour inequality as more costly credit-card debt disproportionately increases among lower-income earners. Already, the largest increases in consumer default exist with respect to credit-card debt. The charge-off rate on credit-card loans increased almost threefold from 2.0 per cent in 1985 to 5.9 per cent at the end of 2003, while it only doubled on other consumer loans and declined on real-estate loans (residential and commercial combined) (BOG 2004a). The rise in economic distress measures is somewhat surprising given the fundamental characteristics of household finances. Importantly, the debt service burden rose from an average of 11.9 per cent in the early 1980s to 13.0 per cent since 1999, a 9 per cent increase. At the time, though, household debt relative to disposable income rose from 78.0 per cent to 105.8 per cent, or a 36 per cent increase. Moreover, calculations based on data from the Fed (BOG 2004c) show that household wealth relative to disposable income grew at the same time, too. Thus, as households borrowed more, their assets increased even faster, while the burden of repaying the debt rose much more slowly. Based on these figures, one would not necessarily expect a rise in economic distress, but that is exactly what has happened. Personal bankruptcies, as a share of households rose fourfold from 0.4 per cent in 1980 to 1.5 per cent in 2003. Further, default rates on consumer credit almost doubled from the early 1980s to the period since 1999, while consumer credit relative to disposable income increased only by 23.4 per cent. Thus, household economic distress clearly seems to have grown faster than one would expect by merely looking at household debt measures. Increasing inequality may explain this divergence. Rising inequality may have given rise to an endogenous credit expansion and thus a larger

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Heather Boushey and Christian E. Weller 141

credit supply, especially to those households that saw the smallest income increases, that is low and moderate-income households (Bird et al. 1998; Black and Morgan 1999). Additionally, lenders may have screened their customers carefully and offered worse terms to customers that were more likely to become delinquent on their payments than to others (Ausubel 1999; Stavins 2000). Combined with the lack of upward mobility, low and moderate-income households may have been caught in an increasing cycle of economic distress, caused by the combination of low income-growth, high debt-growth, and high debt-costs. Thus, both types of inequality may have contributed to a rise in economic distress due to the ensuing demand for credit and the extension of rising, and more costly credit, such as credit-card debt (Chatterjee et al. 2002, Gross and Souleles 1998; Stavins 2000). Our regression model to estimate the link between income inequality and economic distress builds on the existing literature and extends it by including our three income inequality measures. We use three measures of economic distress, personal bankruptcy, charge-off rates on all consumer credit and charge-off rates on credit-card debt. The inclusion of inequality measures in addition to debt service and debt composition essentially controls for the fact that credit may have expanded in forms not captured here, for example payday loans and pawnshops. Economic distress is typically a function of income growth, debt composition, out-of-pocket medical expenditures, debt service and unemployment, in addition to demographic characteristics (Ausubel 1997; Chaterjee et al. 2002; Gross and Souleles 1998; Stavins 2000). We supplement this model with our measure for between-labour and capital inequality and within-labour inequality:

(BR)

_

R

,

a T m

,

R

MEX

,

R

Yt ~ Yt-\ , aCCR

,

R

DS

+ &(. 2 J r ) / 4 + P\. tAtkinsonOSy*

where BR refers to the total number of quarterly bankruptcy cases, at an annualized rate, HH refers to the total number of households,7 MEX to total medical expenditures, CCR to credit-card debt, TC to total household credit, and DS to debt services. The source for medical expenditures is BEA (2004), the source for the unemployment rate is BLS (2004c),

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142 Rising Inequality in the USA

and the source for debt service is BOG (2004b). To make the results comparable for both our economic distress variables, we estimate the regression for the period from 1985 to 2003.8 Table 6.10 summarizes our regression results for all of our economic distress variables, personal bankruptcies and charge-off rates.9 All explanatory variables either have the expected sign or are statistically insignificant. Regression (1) presents our baseline results for personal bankruptcies. The share of households declaring bankruptcy in a given year is negatively related to income growth, positively to medical expenditures, to the composition of debt and to debt service. Also, inequality between labour and profits does not affect the bankruptcy rate as regression (2) shows. However, inequality within labour, especially arising from wealth inequality, results in a higher personal bankruptcy rate as our results in regression (3) suggest. Using our combined labour inequality measure in regression (4) does not change the results materially. A rise in labour inequality by 1 per cent results in a rise in the personal bankruptcy rate by 0.2 per cent. Thus, a one-standard deviation increase in labour inequality, which equals 217 per cent of the average labour inequality, would result in a 39 per cent increase in the personal bankruptcy rate. In comparison, though, the personal bankruptcy rate rose by 473 per cent from 1985 to 2003. Thus, rising inequality within labour has significantly contributed to the increase in personal bankruptcies, but it does not explain the majority of the increase. Again, it is important to keep in mind that this is an average effect that ignores the fact that slow income growth at the bottom of the income scale went handin-hand with a disproportionate increase of credit-card debt, non-bank loans and economic distress among lower-income households. Thus, the effect is likely more pronounced by income. The results differ somewhat for the regressions on charge-off rates on consumer credit and credit-card debt (Table 6.10). For instance, the unemployment rate, instead of personal income growth, is a significant indicator of default. Higher unemployment rates raise the rate of default which may be a reflection of the fact that unemployment rates are more volatile among low and middle-income households, where the expansion of credit-card debt has been more pronounced. However, healthcare expenditures did not play a significant role in determining default rates, which may reflect the fact that healthcare coverage and thus outof-pocket medical expenditures are unequally distributed. Further, the debt-service burden has a much more pronounced effect on default rates than on personal bankruptcies as the size of the effect almost doubles. A 1 per cent increase in the debt-service burden raises the default rate

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Heather Boushey and Christian E. Weller 143

Explanatory variables

(1) Baseline

(2) Between inequality

(3) Within inequality

(4) Combined labour inequality

URt (MEXJY)t (CCR/TC)t (DS/Y)t

-0.02* (0.01) -0.03 (0.02) 1.80*** (0.43) 0.64** (0.30) 0.96* (0.52)

LI/NIt

-0.02* (0.01) -0.03 (0.17) 1.81*** (0.44) 0.64** (0.31) 0.96* (0.53) -0.08 (2.69)

Atkinson05t SP500/HPIt

-0.02* (0.01) 0.24 (0.19) ^ yg*** (0.41) -0.02 (0.40) 0.95* (0.48) -2.47 (2.85) 0.60 (0.78) 0.40*** (0.15)

LIneqt 76 N fl-squared 0.96 Durbin-Watson 1.78

76 0.96 1.78

76 0.96 1.81

(6) Combined labour inequality

(7) Within inequality

(8) Combined labour inequality

Charge-offi "ate, consumer credit Charge-off rate, credit cards

Personal bankruptcy rate (y-yt-i)/yt-i

(5) Within inequality

-0.02* (0.01) 0.13 (0.19) 1.84*** (0.44) 0.17 (0.40) 0.87 (0.53) -2.47 (2.99)

0.18* (0.10) 76 0.96 1.80

-0.01 (0.01) 0.49** (0.24) 0.66 (0.58) -0.08 (0.60) 1.76** (0.75) -0.64 (3.42) 0.38 (0.87) 0.44 (0.15)

76 0.13 2.08

-0.01 (0.01) 0.35 (0.23) 0.80 (0.59) -0.25 (0.61) 1.92** (0.77) -1.70 (3.47)

0.21** (0.09) 76 0.08 1.96

-0.01 (0.01) 0.72*** (0.24) 0.13 (0.49) 0.77 (0.51) 1.69*** (0.57) 1.76 (3.51) -0.70 (0.99) 0.31* (0.18)

76 0.25 1.97

-0.01 (0.01) 0.67** (0.25) 0.80 (0.63) -0.09 (0.68) 1.73** (0.79) -2.16 (3.63)

0.21** (0.10) 76 0.11 1.96

Notes: In each case, a Prais-Winsten regression is used. All inequality measures refer to the four-quarter average ending in the current quarter. Figures in parentheses are standard deviations. * denotes significance at the 10% level, ** denotes significance at the 5% level, and *** denotes significance at the 1% level. 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Table 6.10 Regression results for economic distress measures

Heather Boushey and Christian E. Weller 145

Conclusion In this chapter we have looked at the macro-economic effects of rising inequality in the USA. The distribution of national income between capital and labour has become more unequal as has the distribution within labour. At the same time that inequality rose, consumer debt and household economic distress grew, too. The evidence on a positive link between rising inequality and innovation is not supported by the data. The data either suggest no connection or a potential negative link. In comparison, the link between growing inequality and aggregate demand is somewhat ambiguous since macro economic data show a negative connection that is not supported by the micro data. One way to clarify this ambiguity is the possibility that debt has increased and that it has increased more among low-income households. This seems to be the effect, especially when considering more costly forms of debt such as credit cards and non-bank credit. We find that credit-card debt is especially sensitive to changes in inequality and that rising inequality may thus have contributed to the stark increases in personal bankruptcies in the USA. However, while our results show that rising inequality has played a non-trivial role in the expansion of some forms of credit, and that it has contributed to the large increases in economic distress over the past two decades, it explains only a small part of the overall increases in debt levels and in economic distress. Yet, a look at aggregate data ignores the fact that changes in inequality, consumer credit and economic distress likely affected lower-income households more than others. Notes 1 All comparisons are for nine quarters or 28 months after the start of the recovery. 2 All differences were statistically significant at least at the 5% level. 3 Simultaneously, labour income became more unequally distributed, exacerbating the trends discussed here. 4 For ease of comparison, all figures are divided by consumer spending. 5 All series are non-stationary, integrated at the first degree, and cointegrated at the 1% level. 6 Credit-card debt refers to revolving consumer credit (BOG 2004e). 7 The total number of households is calculated by dividing the number of housing units by 1.1.

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by 1.7-1.9 per cent as regressions (5) through (8) show. The effect of the within-labour inequality on charge-off rates is similar to that on personal bankruptcy rates as they also rose fourfold from 1985 to 2003.

8 Our previous results on debt levels are unaffected by the choice of time period. 9 The results remain robust if the bankruptcy rate is calculated separately for Chapter 7 and Chapter 13 filings. They also are robust if the between-inequality measure includes proprietors' income and the AtkinsonlO measure instead of the Atkinson05 measure used for wage inequality. References Alesina, A. and Perotti, R. (1996) 'Income Distribution, Political Instability, and Investment', European Economic Review, 40(6): 1203-28. American Bankruptcy Institute (2004) Non-Business Bankruptcy Filings by Chapter, 1990-2004, per Quarter (Alexandria: ABI). Appelbaum, E. and Weller, C. (2001) 'Structural Change, Employment, and Inequality: Impacts on Productivity Growth', in A. Heise (ed.), USA - Modellfall der New Economy? (Marburg: Metropolis). Arestis, P. and Howell, P. (1995) 'Changes in Income Distribution and Aggregate Spending: Constraints on Full-Employment?', Review of Political Economy, 7(2): 150-63. Atkinson, R. (2003) The Bush Manufacturing Crisis, Policy Report (Washington DC: Progressive Policy Institute). Ausubel, L. (1997) 'Credit Card Defaults, Credit Card Profits, and Bankruptcy', American Bankruptcy Law Journal, 71 (Spring): 249-70. Barr, M. (2001) Five Opportunities for the Bush Administration and the 107th Congress (Washington, DC: The Brookings Institution Center on Urban and Metropolitan Policy). Benhabib, J. (2003) 'The Tradeoff Between Inequality and Growth', Annals of Economics and Finance, 4(2): 491-507. Bird, E. J., Hagstrom, P.A. and Wild, R. (1999) 'Credit Card Debts of the Poor: High and Rising', Journal of Policy Analysis and Management, 18(1): 125-33. Bivens, J. and Weller, C. (2004) Institutional Shareholder Concentration, Corporate Governance Changes, and Diverging Fortunes of Capital and Labour, paper presented at the conference 'Pension Fund Capitalism and the Crisis of Old-Age Security in the United States', September, held by the Center for Economic Policy Analysis at the New School University, New York, NY. Bivens, J. and Weller, C. (2005) 'Causes of the "Job Loss" Recovery', Challenge, 48(2): 23-48. Bivens, L. (2004) 'Shifting Blame for Manufacturing Job-loss: Effects of Rising Trade Deficits can't be Ignored', Economic Policy Institute Briefing Paper (Washington, DC: EPI). Black, S. and Morgan, D. (1999) 'Meet the New Borrowers', Current Issues in Economics and Finance, Federal Reserve Bank of New York, February (New York: FRBNY). Board of Governors and Federal Reserve (2004a) Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks (Washington, DC: BOG). Board of Governors and Federal Reserve (2004b) Household Debt Service and Financial Obligations Ratios (Washington, DC: BOG). Board of Governors and Federal Reserve (2004c) Release Z.l Flow of Funds Accounts of the United States (Washington, DC: BOG).

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146 Rising Inequality in the USA

Board of Governors and Federal Reserve (2004d) Release H. 15 Selected Interest Rates (Washington, DC: BOG). Board of Governors and Federal Reserve (2004e) Release G.19 Consumer Credit (Washington, DC: BOG). Borjas, G. and Ramey, V. (1995) 'Foreign Competition, Market Power, and Wage Inequality', Quarterly Journal of Economics (November), 110(4): 1075-110. Bradbury, K. and Katz, J. (2002) 'Are Lifetime Incomes Growing More Unequal? Looking at New Evidence on Family Income Mobility', Regional Review, 4: 3-5. Bradbury, K. and Katz, J. (2004) Wives' Work and Family Income Mobility, Federal Reserve Bank of Boston Public Policy Discussion Paper, No.(04-3) (Boston, MA: FRBB). Brown, C. (2004) 'Does Income Distribution Matter for Effective Demand? Evidence from the United States', Review of Political Economy, 16(3): 291-307. Bureau of Economic Analysis (2004) National Income and Product Accounts (Washington, DC: BEA). Bureau of Labor Statistics (2004a) Productivity (Washington, DC: BLS). Bureau of Labor Statistics (2004b) Consumer Price Index (Washington, DC: BLS). Bureau of Labor Statistics (2004c) Unemployment Rate (Washington, DC: BLS). Card, D., Lemieux, T. and Riddell, W.C. (2003) 'In Unionization and Wage Inequality: A Comparative Study of the U.S., the U.K., and Canada', NBER Working Paper No. 9473 (Cambridge MA: National Bureau of Economic Research). Census Bureau (2004a) Income, Poverty, and Health Insurance Coverage in the United States: 2003 (Washington, DC: Census). Census Bureau (2004b) Households and Housing Units Estimates (Washington, DC: Census). Center for Economic and Policy Research (CEPR) (2004) CPS ORG Uniform Data Files Version 0.9.3 (Washington, DC: CEPR). Chaterjee, S., Corbae, D., Nakajima, M. and Rios-Rull, J. (2002) 'A Quantitative Theory of Unsecured Consumer Credit Risk with Default, Federal Reserve Bank of Philadelphia Working Paper No. 02-6 (Philadelphia, PA: FRBP). Chen, B. (2003) 'An Inverted-U Relationship Between Inequality and Long-run Growth', Economics Letters, 78(2): 205-12. Cline, W. (1997) Trade and Income Distribution (Washington, DC: Institute for International Economics). Consumer Federation of America (1998) The Growth of Legal Loan Sharking: A Report on the Payday Loan Industry (Washington, DC: CFA). Consumer Federation of America (1999) Safe Harbor for Usury: Recent Developments in Payday Lending (Washington, DC: CFA). Crafts, N. (1992) Was the Thatcher Experiment Worth It? British Economic Growth in a European Context, CEPR Discussion Paper (710) (London, UK: Center for Economic and Policy Research). DiNardo, J., Fortin, N.M. and Lemieux, T. (1996) 'Labor Market Institutions and the Distribution of Wages, 1973-1992: A Semiparametric Approach', Econometrica, 64(5): 1001-44. Dunsky, R. and Follain, J. (2000) 'Tax-induced Portfolio Reshuffling: The Case of the Mortgage Interest Deduction', Real Estate Economics, 28(4): 683-718. Engen, E. and Gale, W (2000) The Effects of 401 (k) Plans on Household Wealth: Differences Across Earnings Groups, NBER Working Paper No. 8032 (Cambridge MA: National Bureau of Economic Research).

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Gottschalk, P. (1997) 'Inequality, Income Growth, and Mobility: The Basic Facts', Journal of Economic Perspectives, 11(2): 21-40. Gottschalk, P. and Danziger, S. (2003) Wage Inequality, Earnings Inequality, and Poverty in the US. Over the Last Quarter of the Twentieth Century (Boston, MA: Boston College). Gross, D. and Souleles, N.S. (1998) An Empirical Analysis of Personal Bankruptcy and Delinquency, Financial Institutions Center Working Paper no. 98-28-B (Philadelphia, PA: The Wharton School, University of Pennsylvania). Iyigun, M. and Owen, A. (1997) Income Inequality and Macroeconomic Fluctuations, FEDS Working Paper (1997-586) (Washington, DC: Board of Governors of the Federal Reserve System). Keynes, J. M. (1936) The General Theory of Employment, Interest and Money (Cambridge, UK: Cambridge University Press). Krueger, D. and Perri, F. (2002) Does Income Inequality Lead to Consumption Inequality? Evidence and Theory, NBER Working Paper no. 9,202 (Cambridge, MA: National Bureau of Economic Research). Larrain, F.B. and Vergara, R.M. (1997) Income Distribution, Investment, and Growth, Harvard Institute for International Development Working Paper (Cambridge, MA: Harvard University). Lazonick, W. and O'Sullivan, M. (2000) 'Maximizing Shareholder Value: A New Ideology for Corporate Governance', Economy and Society, 29(1): 13-35. Lee, David S. (1999) 'Wage Inequality in the United States during the 1980s: Rising Dispersion of Falling Minimum Wage?' Quarterly Journal of Economics, 114(3): 977-1023. Manning, R. (2000) Credit Card Nation: The Consequences of America's Addiction to Credit (New York, NY: Basic Books). Mishel, L., Bernstein, J. and Allegretto, S. (2005) State of Working America 2004-05 (Ithaca, NY: Cornell University Press). Mishel, L., Bernstein, J. and Schmitt, J. (2001) The State of Working America 2000-01 (Ithaca, NY: Cornell University Press). Mishel, Lawrence, Bernstein, J. and Boushey, H. (2003) The State of Working America 2002-03 (Ithaca, NY: Cornell University Press). O'Sullivan, M. (2000) Contests for Corporate Control (Oxford UK et al: Oxford University Press). Office of Federal Housing Enterprise Oversight (2004) Housing Price Index (Washington, DC: OFHEO). Osberg, L. (2003) 'Understanding Growth and Inequality Trends: The Role of Labour Supply in the US and Germany', Canadian Public Policy (January Supplement): 163-83. Palley, T. I. (1996) 'Inside Debt, Aggregate Demand, and the Cambridge Theory of Distribution', Cambridge Journal of Economics, 20(4): 465-474. Palomba, G. (2002) Firm Investment, Corporate Finance, and Taxation, IMF Working Paper no. 02/237 (Washington, DC: International Monetary Fund). Panizza, U. (2002) 'Income Inequality and Economic Growth: Evidence from American Data', Journal of Economic Growth, 7(1): 25-41. Pearce, J. and Miller, J. (2003) Freddie Mac and Fannie Mae: Their Funding Advantage and Benefits to Consumers. Federal Reserve Bank of Chicago Proceedings (March 2003) (Chicago: Federal Reserve Bank of Chicago).

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Peretto, P. (1995) Sunk Costs, Market Structure, and Growth, Duke University, Department of Economics Working Paper no. 95-34 (Durham, NC: Duke University). Piketty, T. and Saez, E. (2001) Income Inequality in the United States, 1913-1998, NBER Working Paper no. 8467 (Cambridge MA: National Bureau of Economic Research). Pressman, S. (1997) 'Consumption, Income Distribution and Taxation: Keynes' Fiscal Policy', Journal of Income Distribution, 7(1): 29-44. Rodriguez, C. (2000) 'An Empirical Test of the Institutionalist View on Income Inequality: Economic Growth Within the United States', American Journal of Economics and Sociology, 59(2): 303-13. Rupasingha, A., Goetz, S. and Freshwater, D. (2002) 'Social and Institutional Factors as Determinants of Economic Growth: Evidence from United States Counties', Papers in Regional Science, 81(2): 139-55. Scully, G.W. (2002) 'Economic Freedom, Government Policy and the Trade-off Between Equity and Economic Growth', Public Choice, 113(1-2): 77-96. Stango, V. (1999) 'The Tax Reform Act of 1986 and the Composition of Consumer Debt', National Tax Journal, 52: 717-39. Stavins, J. (2000) 'Credit Card Borrowing, Delinquency, and Personal Bankruptcy', New England Economic Review (July/August): 15-30. Stegman, M.A. and Faris, R. (2003) 'Payday Lending: A Business Model that Encourages Chronic Borrowing', Economic Development Quarterly, 17(1): 8-32. Stiglitz, J. and Weiss (1981) Credit Rationing in Markets with Imperfect Information, American Economic Review, 71(3): 393-410. Stockhammer, E. and Onaran, O. (2004) 'Accumulation, Distribution and Employment: A Structural VAR Approach to a Kaleckian Macro Model', Structural Change and Economic Dynamics 15(4): 421-47. Van Order, R. (2001) 'The Structure and Evolution of American Secondary Mortgage Markets, with Some Implications for Developing Markets', Housing Finance International 26(1): 16-31. Vandell, K. (2000) Securitization of the US Mortgage Market: Progress and Pitfalls, with Lessons for Japan, presentation at the Seventh Annual International Land Policy Review. Weller, C. (2004a) Reversing the Vpside-Down' Economy, CAP Policy Brief (Washington, DC: Center for American Progress). Weller, C. (2004b) Lagging Investment: The Cost of the Vpside-Down' Economy, CAP Policy Brief (Washington, DC: Center for American Progress). Weller, C, Bivens, J. and Sawicky, M. (2004) 'Macro Policy Lessons from the Recent Recession', Challenge, 47(3): 42-72. Wolff, E. (2002a) Is the Equalizing Effect of Retirement Wealth Wearing Off?, unpublished manuscript (New York, NY: New York University). Wolff, E. (2002b) Top Heavy: A Study of Increasing Inequality of Wealth in America, newly updated and expanded edition (New York, NY: The New Press). Wolff, E. (2003) 'What's Behind the Rise of Profitability in the U.S. in the 1980s and 1990s?', Cambridge Journal of Economics, 27(4): 479-99. Wolff, E. (2004) 'The Unraveling of the American Pension System, 1983-2001', unpublished manuscript, Department of Economics, New York, NY: New York University.

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Wysong, E., Wright, D. and Perrucci, R. (2003) 'Organizations, Resources, and Class Analysis: The Distributional Model and the U.S. Class Structure', working paper, Department of Sociology (Indiana University, IN: Kokomo). Yahoo! Finance (2004) S&P 500 index data, www.yahoo.com. Yoo, P. (1996) Charging up a Mountain of Debt: Households and Their Credit Cards. Federal Reserve Bank of St. Louis, Working Papers (96-015A) (St Louis, MO: FRBSTL).

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The Effects of Economic Liberalization on Income Distribution: A Panel-Data Analysis Gerardo Angeles-Castro

Introduction The economic liberalization process, undertaken on a global scale since the early 1980s, has induced support for a set of market-oriented policies that can be summarized as deregulation, privatization, liberalization of markets and macroeconomic discipline. This prescription creates the preconditions for the expansion of trade and the flow of investments across countries. The theoretical support for this development model is standard neoclassical theory (Jones 1988: 30-3; Corden 1993), which argues that trade, investment, and in general the market mechanisms boost growth and facilitate development. This view also holds that an important factor affecting growth and the effectiveness of the market system is the efficient organization of the domestic economy itself (Gilpin 1987: 265-6). The implications of this model for income distribution are that high and sustained rates of growth and the expansion of exports foster employment, reduce poverty and eventually provide additional resources that facilitate the distribution of income. Moreover, economic liberalization facilitates the operation of market forces and the adjustment to world prices, which allow resources to be allocated more efficiently. The theoretical formulations explaining this effect are the orthodox principle of comparative advantages (Jones 1988: 34-5) and the Stolper-Samuelson theorem (FitzGerald 1996: 32; Litwin 1998: 3). The latter is a neoclassical two-factor model, in which liberalization of foreign trade increases the use of the cheaper-abundant factor as exports and imports adjust according to the principle of 151 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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7

comparative advantages, while the costly-scare factor is used less. This mechanism increases the income of the factor which is relatively most used in the export sector and which is also most abundant. For example, this factor is conventionally assumed to be unskilled labour in developing countries, by the same token income distribution is assumed to improve. The economic policies involved in this early stage of the economic liberalization process are often referred to as the Washington Consensus1 or first generation reforms (Ortiz 2003: 14-17). These terms are applied especially in developing countries. This chapter is aimed at testing the effect of the variables that are assumed to improve income distribution over this early process of economic liberalization. These variables are mainly trade, investment, macroeconomic discipline and employment. Over the last few years, leading globalizers and multilateral institutions have induced support for a set of socio-political norms and have also recognized the need for a stronger governance dimension. They have added institution-building, civil society participation, social and human capital formation, safety nets, transparency and accountability, among others, to the original economic norms or first-generation policies enveloped in the Washington Consensus. This new global governance agenda is a response to the financial crises that have hit emerging markets since 1995, the increasing perception that liberalization brings with it inequality, and other subsequent forms of resistance to globalization (Higgott 2000: 131-40). This further stage in the economic liberalization process is usually called Post-Washington Consensus (PWC) and the set of socio-political norms embedded in this approach are often referred to as secondgeneration reforms. The PWC is an attempt to socialize and humanize the operation of market forces and to legitimize global economic liberalization, although there is also a genuine recognition of the importance of tackling issues of fairness and inequality (Edwards 1999). In this development paradigm, the re-empowerment of the state plays a central role for addressing the socioeconomic dislocation that may be generated by global liberalization. In this context, the understanding of governance is thus the effective and efficient management of the modern state. Moreover, from this perspective, domestic efficiency and sound and disciplined macroeconomic policies accentuate the benefits of globalization. These policies are associated with sustainable economic growth and are assumed to improve equity over the long run. In contrast, those countries which do not adopt sound policies and show evidence of

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152 Economic Liberalization and Income Distribution

pronounced macroeconomic disequilibria are likely to fall behind in relative terms (IMF 1997: 72; Camdessus 1998: xiv; Higgott and Phillips 2000: 363). In this context, the chapter also tests the effects of the PWC approach on income distribution. For this purpose we use variables such as government expenditure to proxy the size of the state, and we also explore the effect of first generation policies under different scenarios of macroeconomic stability and governance. Finally, we test the effect of human capital formation, represented by secondary school enrolment, on income distribution. Education is deemed as one of the key elements in the set of socio-political norms advocated by the PWC. We find that the variable on trade exerts a weak benefit on income distribution and the effect is statistically significant only on the samples which comprise countries associated with good governance or macroeconomic stability, while the effect is significant only on the latter sample when the variable on trade is represented by changes in trade volume. The flow of FDI increases inequality under any scenario although the effect is mitigated in those countries that exhibit domestic efficiency. Inflation worsens inequality in those countries with domestic inefficiency, and this variable adversely affects income distribution even in those countries which exhibit good governance, although in any case the effect is weak. Not surprisingly, inflation is not significant in those countries that have traditionally kept macroeconomic discipline. The export-led growth strategy is able to reduce inequality when the export sector is oriented toward manufactured production. On the other hand, the expansion of primary exports does not exert benefit on income distribution under any scenario. Employment benefits income distribution; however when we explore the effects of employment by sector we notice that the expansion of employment in industry reduces inequality, whereas employment in agriculture is not able to improve income distribution. Consequently, the analysis of exports and employment by sector suggests that emphasis on primary production does not form the basis for redistributional effects. Even those countries with some form of domestic inefficiency, which are associated with lower levels of development and also with comparative advantages supported on natural resources and unskilled labour, do not seem to improve income distribution with the expansion of primary exports. These results are in keeping with the theoretical foundations and expectations that have supported the global liberalization process to the extent that low inflation, fiscal discipline, larger employment and domestic efficiency can benefit income distribution. On the other hand, the results undermine other aspects of these theoretical foundations and

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expectations, as the benefits of trade on income distribution are weak and FDI worsens inequality, besides the fact that the export-led growth strategy and the expansion of employment based on the primary sector do not improve income distribution. Consequently, the results suggest that there is room for contesting theories and hypotheses explaining the relationship between trade, investment and income distribution and the relationship between primary production, industrialization and income distribution. As for the set of policies underlined in the second stage of the economic liberalization process, we find that domestic efficiency can help to reduce the adverse effect of FDI on income distribution, while it can also help to obtain some benefits from trade liberalization in income distribution. Moreover, a stronger state is important to decrease inequality, and the set of socio-political norms enclosed in the PWC approach, and represented in this study by a proxy of human capital formation, improves income distribution. Accordingly, these findings suggest that the PWC represents an improvement to mitigate the adverse effects that the global process of economic liberalization can exert on income distribution. Nevertheless, the empirical evidence in this study suggests that the role of the state is not enough to socialize the operation of trade and investment. In this context, even under conditions of macroeconomic stability and high governance, FDI does not benefit income distribution; on the contrary, it seems to hinder it. Moreover, the beneficial effect of trade on income distribution is weak in those countries with domestic efficiency. Hence, this fact suggests that further supranational mechanisms, beyond the scope of the state, are required to socialize the flow of trade and investment. The chapter is organized as follows. The next section analyses the characteristics of the data-sets on income distribution available in the literature and selects the appropriate option for this study. We then present the features of the explanatory variables included in the model, and explain the econometric method applied in the analysis. The fourth section gives results, and is followed by concluding remarks. The data Data on income inequality One of the features which characterize the available data-sets on income inequality is that the coverage is sparse and varies widely across countries and over time. In the absence of adequate longitudinal data, some

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154 Economic Liberalization and Income Distribution

studies attempting to assess the trend of inequality worldwide over time draw general conclusions from cross-sectional data so as to try to overcome this major drawback (Bourguignon 1994; Milanovic 1995; Jha 1996). However, this type of data does not deal with intertemporal relationships. In addition, other studies restrict attention to a subset of the data such as five-year intervals (Forbes 2000; De Gregorio and Lee 2002) or group the data in five-year or ten-year averages (Deininger and Squire 1998; Calderon and Chong 2001), but in these cases there is a risk of bias in the selection of the subset or in the construction of the average respectively. Finally, in order to improve coverage across space and through time, other studies use data-sets measuring a component of overall income inequality (Galbraith and Kum 2002); however, these data-sets are not representative samples covering all of the population. Accordingly, so as to provide an accurate assessment, the data-set on income inequality must contain a substantial coverage across countries and over time. It must also be consistent and harmonized, and based on a representative measure covering all of the population. The competing options available in the literature have the following characteristics: the World Bank data-set by Deininger and Squire (hereafter, D & S) in its 1996 version and the World Income Inequality database are important compilations of Gini coefficients reported in the literature; however, they suffer from a substantial degree of heterogeneity and sparse coverage. The Luxembourg Income Study assembles observations that are more harmonized than the previous two data-sets, since it obtains information from standardized macro-level data, but its coverage is constrained to 29 countries. The UTIP-INIDO data-set calculates industrial pay-inequality. It has a large coverage and shows evidence of consistency and accuracy, but it is not an index of overall inequality. The Estimated Household Income Inequality (EHII), constructed by Galbraith and Kum (2003), aims to fill the gaps and correct what they consider errors in the D & S data-set. This indicator takes advantage of the information in D & S and the information in the UTIP-UNIDO database. As a matter of fact, they replicate the coverage of the latter with estimated measures of household income inequality, taking into account the relationship between industrial pay inequality, household income inequality and an additional set of variables. Galbraith and Kum (2003: 9) underline two advantages from their data-set: First, the coverage basically matches that of the UTIP-UNIDO exercise, providing substantially annual estimates of household income

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Gerardo A ngeles-Cas tro 155

inequality for most countries, including developing countries that are badly under-represented in D & S. Second, the data set borrows accuracy from the UTIP-UNIDO ... with due adjustment for the different weight of manufacturing in different economies. At the same time, unexplained variations in the D & S income inequality measures are treated for what they probably are: as inexplicable. They are therefore disregarded in the calculations of the UTIP Gini coefficients. The EHII data-set provides consistency, representation of household income inequality, and large coverage. In addition, it is a new data-set available in the literature which can provide further insights for the study of income distribution. As a consequence, we select it from the competing data sets as a source of information for this study. Table A7.1 in the Appendix outlines the main features of the data-sets on inequality. Explanatory variables The analysis includes four different sets of explanatory variables. The first set comprises proxies representing markets, and it is aimed at testing the effects of the original Washington Consensus prescription on inequality. The second set contains macroeconomic stability proxies and it will explore the role of macroeconomic efficiency on income inequality. The third set includes governance proxies, and it is aimed at assessing the influence of the PWC themes on the distribution of income. Finally, the fourth set contains variables related to employment; these variables are included because employment is considered one of the main factors affecting inequality in the neoliberal model. The variables are analysed on a yearly basis and they are described as follows. The market proxies are trade volume, which is the sum of exports and imports of goods and services measured as a share of GDP. Alternatively, we also use changes in trade volume. So as to test the effect of exports by sector on income distribution we apply two variables representing the percentage of manufactured exports and the percentage of primary exports to merchandise exports. In order to represent the international flow of investment we use FDI inflow measured as a percentage of GDP. The source for the variables on trade is the World Development Indicators (hereafter, WDI) by the World Bank (2002); the source for the variable on FDI is a compilation of data from the WDI and UNCTAD (2003). Inflation is included as both fiscal discipline and macroeconomic stability proxy. It reflects the annual percentage of change in consumer prices and is taken from the WDI. This analysis also uses standard deviation of inflation for the period 1980-98, calculated from the same

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source to construct two sub-samples. The first sub-sample comprises countries with standard deviation lower than 8.5, whereas the second sub-sample groups the countries with standard deviation greater than 8.5. This indicator allows us to assess the effect of economic liberalization on inequality in two different scenarios of macroeconomic stability. The sub-sample classification is carried out through a two-step cluster analysis. The variables on governance comprise human capital formation, which is one of the main elements included in the concept of governance, and is represented by gross secondary school enrolment. This indicator is a compilation of data from UNESCO (2003) and WDI. The analysis also includes an aggregate governance indicator for the year 1996. It is the average of six indicators measuring the following dimensions of governance: voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, and control of corruption. Its score lies between -3.0 and 3.0 with a higher score corresponding to better governance. The data-set is obtained from the World Bank website. The indicator is used to construct low governance and high governance sub-samples that involve countries with scores lower than zero and greater than zero respectively. From these two sub-samples it is possible to analyse the trend of inequality within two different performances of governance. It has been claimed that the understanding of governance also involves the reempowerment of the state as a means to tackle issues of inequality. Bearing this in mind, we include government expenditure as a ratio of GDP as a variable to represent the size of the state and to explore its effect on income distribution. Because of constraints on data availability, this exercise is carried out only with the overall sample. The source is WDI. The employment proxies comprise an unemployment variable, which is measured by the share of the labour force that is without work in the total labour force. Furthermore, in order to assess the effect of employment by sector on income distribution, we consider variables on employment in two main sectors, Industry and Agriculture. They are the proportion of total employment recorded as working in the corresponding sector. As government expenditure, these variables are only analysed with the overall sample because of constraints on data availability. The source is WDI. The dimension of the panel The original equation includes trade, investment, inflation and education variables. After assembling these variables and their different

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Gerardo Angeles-Castro 157

sources of information, it is possible to construct an unbalanced panel consisting of 1,301 observations across 93 countries over the period 1980-98. The list of countries is presented in Table A7.2 in the Appendix. After including government expenditure and employment variables, the number of observations and countries drops. Hence, when these variables are included in the equation we conduct the regression only for the overall sample. The analysis of primary and manufactured exports is conducted in a separate equation including these variables only. In this case the number of observations and countries also drops, but allows us to conduct regressions across the sub-samples. In every panel the number of time periods available may vary from country to country, but the number of variables included in each year is the same. The model Initially we explore a general regression model for income inequality as follows: EHIIit = a{ + fr TRAGDPit + /32FDIGDPit + p3INFLit + /3 4 EDUSECit + uit

(7.1)

where EHII is the estimated household income inequality indicator, TRAGDP is the ratio of trade to GDP, FDIGDP is the inflow of FDI as a percentage of GDP, INFL shows the annual percentage change of consumer prices, and EDUSEC represents the gross secondary school enrolment as outlined earlier. Subscripts i and t indicate country and year respectively; the error term uit is assumed to satisfy white-noise assumptions; af lets the intercept vary for each country and captures countryspecific differences; and finally, (31 to /34 are parameters to be estimated. Standard methods The process of estimation starts with the standard ordinary-least-squares (OLS) method pooling or combining all the observations, and assuming that at = a. As column 1 in Table 7.1 illustrates, all the variables are individually statistically significant. However, the traditional OLS approach has two major drawbacks. It assumes that the intercept value of the countries is the same and it does not control for country-specific factors. So as to confirm whether these are implausible characteristics in the model, the Breusch and Pagan Lagrange Multiplier (LM) test (1980) is conducted. Based on the OLS residuals and under the null

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158 Economic Liberalization and Income Distribution

Gerardo Angeles-Castro 159 Table 7.1 Estimation methods

Constant Adjustment coefficient Observations Countries BP LM test Hausman test Sargan test AR (1) test AR (2) test

FEM (2)

-0.015* 0.474* 0.001* -0.098* 44.702*

-0.003 0.218* 0.000 0.054* 36.438*

1,302 93 [0.000]

1,302 93

sys-GMM (3)

0.841* -0.027* 0.594* 0.001* -0.102* 45.959* 0.159 1,209 93

[0.000] [0.000]

[0.000]

[0.247] [0.000] [0.074]

Notes: Dependent variable: EHII, P values in parenthesis, * significant at i., column (3) figures are long-run parameters.

hypothesis: o^ = 0, that is at = a, the LM test is distributed as a \2 with one degree of freedom (Greene 2000: 572-3). In this case, the result of the test is to reject the null hypothesis.2 Thus, it is possible to conclude that the classical regression model with a single constant term is inappropriate. We turn therefore to panel estimation methods that may take into account the specific nature of the countries. The fixed effect model (FEM) lets the intercept vary for each country by adding dummy variables that take into account country-specific effects. In the random effect model (REM), differences across countries are captured through a disturbance term <%, which follows coit = st + uitf where e, is an unobservable term that represents the individual specific error component, and uit is the combined time series and cross-section error component. The REM assumes that e, is not correlated to any explanatory variable in the equation. In order to choose between the FEM and the REM, we apply the Hausman test for specification (1978). The null hypothesis underlying this test is that the regressors and the unobservable individual specific random error are uncorrelated. If the test statistic, based on an asymptotic x2 distribution, rejects the null hypothesis, then the random effect

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EHIIt_j TRAGDP FDIGDP INFL EDUSEC

OLS (1)

estimators are biased and the fixed effect model is preferred. The result of the Hausman test from equation (7.1) suggests that the REM estimates are inconsistent and the FEM would be more appropriate.3 Since the LM test suggests that there are individual effects, and the Hausman test emphasizes that these effects are correlated with the other variables in the model, it is possible to conclude that of the alternatives previously considered, the FEM is the better choice. Column 2 in Table 7.1 shows the results from this model. Before adopting the FEM as the final estimation procedure, it is important to conduct an additional test in equation (7.1). It has been already contended that the error term uit is assumed to satisfy white-noise assumptions, that is zero mean, constant variance o2, and serially uncorrelated, which is denoted as M/t~I.I.D.(0, o2) (The error term is independently and identically distributed with zero mean and constant variance). By the same token an AR(1) (autoregressive process of order one) test should be available. In the presence of autocorrelation, both a2 and the standard errors are likely to be underestimated and biased, which leads to misleading conclusions about the statistical significance of the estimated regression coefficients.4 The test for first-order serial autocorrelation is not satisfied, as it rejects the null: no evidence of AR(1) or p = 0.5 The P value of the test is also presented in column 2, Table 7.1. To deal with this problem it is essential to explore the possibility that autocorrelation may arise due to model misspecification; to be precise, because of omitted lagged dependent variables. In this context, equation (7.1) is extended and transformed into a dynamic panel data model (DPDM) by adding a lagged dependent variable as follows: EHIIit = at + yEHIIit^p{TFtAGDPit + p2FDIGDPit + p3INFLit + p4EDUSECit + rit + uit

(7.2)

However, the inclusion of a lagged dependent variable introduces a source of persistence over time: correlation between the right hand regressor yit_x and the error term uit. Furthermore, DPDMs are characterized by individual effects r\{ caused by heterogeneity among the individuals.6 As a consequence, it is necessary to adopt different estimation and testing procedures for this model. The sys-GMM method In order to estimate the model, we use a system generalized method of moment estimation (sys-GMM) for DPDMs, initially proposed by Arellano and Bover (1995). Firstly, the estimation method eliminates

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160 Economic Liberalization and Income Distribution

Gerardo Angeles-Castro 161

country-effects (17,) by expressing equation (7.2) in first differences as follows:

(7.3) where X is the set of explanatory variables outlined earlier. On the basis of the following standard moment condition: E(EHIIif^sAuit)

=0

for t = 3,...,2V and s > 2

That is, lagged levels of EHIIit are uncorrelated with the error term in first difference, the method uses lagged endogenous variables as instruments to control for likely endogeneity of the lagged dependent variable, reflected in the correlation between this variable and the error term in the transformed equation. The resulting GMM estimator is known as the difference estimator. Blundell and Bond (1998) contended that the GMM estimator obtained after first differencing has been found to have large finite sample bias and poor precision. They attribute the bias and poor precision of this estimator to the problem of weak instruments, as they assert that lagged levels of the series provide weak instruments for the first difference (Blundel and Bond 1998: 115-16). So as to improve the properties of the standard first-differenced GMM estimator, they justified the use of an extended GMM estimator, on the basis of the following moment condition: ElAEHII^i^

+ uit)] = 0

That is, there is no correlation between lagged differences of EHIIit and the country-specific effect. The method therefore uses lagged differences of EHIIit (the endogenous variable) as instruments for equations in levels, in addition to lagged levels of yit as instruments for equations in first differences. The extended sys-GMM encompasses a regression equation in both differences and levels, each one with its specific set of instrumental variables. This type of estimation, called system estimator, not only improves precision but also reduces finite sample bias.7 The method assumes that the disturbances uit are not serially correlated. If this were the case, there should be evidence of first-order serial correlation in differenced residuals (that is, uit— uit-^ and no evidence of second-order serial correlation in the differenced residuals

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EHIIit - EHIIit_x = y(EHIIit^ - EHII^2) + pk(Xit - Xit_,) + (uit - uit_x)

(Doornik et al. 2002: 5-8). It is an important assumption because the consistency of the GMM estimators hinges upon the fact that E[AuitAuit_ 2] = 0. Accordingly, tests of autocorrelation up to order 2 in the first-differenced residuals should be available. The results of the sys-GMM regression are reported in column 3, Table 7.1. The tests of serial correlation in the first-differenced residuals are in both cases consistent with the maintained assumption of no serial correlation in uit. The AR(2) test fails to reject the null hypothesis that the first-differenced error term is not second-order serially correlated, whereas by construction, the AR(1) tests rejects the null that this process does not exhibit first-order serial correlation.8 In order to assess the validity of the instruments, a Sargan test of overidentifying restrictions, proposed by Arellano and Bond (1991), is also reported. Under the null hypothesis that the instruments are not correlated with the error process, the Sargan test is asymptotically distributed as a chi-square with as many degrees of freedom as overidentifying restrictions. In this case, the test is unable to reject the validity of the instruments. 9 Results Original equation The results are illustrated in Table 7.2. Column 1 shows the results initially obtained by regressing equation (7.3) with the whole sample. Subsequently, in order to assess the effect of economic liberalization on income distribution, under different scenarios of governance and macroeconomic stability, we conducted regressions with four different sub-samples. The first two sub-samples comprise countries with low and high governance and their results are illustrated in columns 2 and 3 respectively. The last two sub-samples contain countries with high and low standard deviation of inflation, and their results are shown in columns 4 and 5 respectively. All the equations are regressed using the sys-GMM procedure. Bearing in mind that a positive sign in the corresponding coefficient indicates a worsening in the distribution of income, the results yield the following conclusions. 1 Trade. The overall sample indicates that trade reduces income inequality. At first glance this finding is in keeping with the expectations supporting trade liberalization and is also consistent with other studies (Calderon and Chong 2001). However, if we look at the magnitude of the coefficients, we find that the impact is relatively low. A 37 units increase

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162 Economic Liberalization and Income Distribution

Gerardo Angeles-Castro 163

Whole sample

(D

Low High governance governance (2) (3)

High inflation SD (4)

Low inflation SD (5)

Short-run parameters EHII,-! TRAGDP FDIGDP INFL EDUSEC Constant

0.841* -0.004** 0.094** 0.000* -0.016* 7.306*

0.684* -0.003 0.140* 0.000* -0.020* 13.886*

0.942* -0.001* 0.021* 0.000* -0.002* 2.449*

0.775* -0.012** 0.203* 0.000* -0.021* 10.698*

0.899* 0.000* 0.032* 0.001 -0.007* 4.332*

Long-run parameters TRAGDP FDIGDP INFL EDUSEC Constant

-0.027* 0.594* 0.001* -0.102* 45.959*

-0.009 0.442* 0.001* -0.065* 43.876*

-0.017* 0.359* 0.003* -0.039* 42.129*

-0.055 0.900* 0.001* -0.094* 47.532*

-0.005* 0.317* 0.012 -0.072* 42.707*

Adjustment coefficient Observations Countries

0.159 1,209 93

0.316 546 47

0.058 663 46

0.225 517 44

0.101 692 49

Sargan test AR(1) test AR(2) test

[0.247] [0.000] [0.074]

[0.617] [0.007] [0.070]

[0.929] [0.001] [0.385]

[0.923] [0.007] [0.124]

[0.565] [0.002] [0.159]

Notes: Dependent variable: EHII, Sargan and serial correlation test are P values, * significant at 5%, ** significant at 10%, all equations use the sys-GMM estimation method.

in the rate of trade leads to a long-run decline of 1 point in the income distribution indicator ((0.004/(1-0.841))*37).10 Trade is deemed the cornerstone supporting distributional effects in the process of economic liberalization (Bulmer-Thomas 1996: 10). In this sense, we should expect a larger benefit from trade on income distribution but the weak evidence above is not supportive of this assumption. It should also be emphasized that trade is able to exert a long-term positive impact on income distribution under conditions of macroeconomic balance and high governance. On the other hand, the rate of trade as a percentage of GDP is not significant in countries with macroeconomic distortions and low governance. Thus, the outcome indicates that in the presence of macroeconomic disequilibria and failure of good governance, trade does not exert benefits on income distribution. To some extent this finding in particular is in accordance with the

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Table 7.2 Scenarios

neoliberal assertion that the overall efficiency within a country is an essential factor for the appropriate operation of trade policies. 2 Investment. The outcome of the overall regression suggests that FDI has an adverse effect on income distribution. An upturn of 1.7 points on the rate of investment as a percentage of GDP raises the inequality indicator by 1 point over the long run ((0.094/(1- 0.841))*1.7). This result undermines the assumptions and expectations outlined in the neoliberal postulates. In addition, Table 7.2 indicates that the effect of FDI is adverse under any scenario. However, if we compare the coefficients across columns 2 to 5, it is possible to observe that this effect is worse on countries with macroeconomic disequilibria and low governance. For example, a 1.7 point upturn on the rate of investment as a percentage of GDP raises the inequality indicator over the long run by 0.75 points ((0.14)/(1- 0.684)*1.7) and by 0.61 points ((0.021)/(1- 0.942)*1.7) in low and high-governance countries respectively, whereas the effects on countries with high-inflation and low-inflation standard deviation is 1.53 points ((0.203)/(l- 0.775)*1.7) and 0.54 points ((0.032)/(l-0.899)*1.7) respectively. Consequently, inefficiency within countries seems to be a factor that accentuates the adverse effect of FDI on income distribution. 3 Inflation. Macroeconomic imbalance is represented by the inflation variable. Results from the overall regression reveal that this variable is a determinant of income inequality. This finding is in accordance with the orthodoxy supporting liberalization and stabilization policies, although the magnitude of the effect is low. An increase in inflation of 930 points, which could be considered an episode of hyperinflation,11 is required to raise inequality by 1 point ((0.0002/(1- 0.841))*930). Hence, inflation has a negative effect on the distribution of income, but this effect does not seem to be large. Table 7.2 reveals that inflation has adverse effects on countries with low governance and macroeconomic distortions. It is worth noting that the repercussions of inflation also affect the distribution of income in countries with high governance. Not surprisingly, this is not significant in column 5; this fact indicates that the inflation rate is a variable that does not affect income distribution in countries that have traditionally kept a stable economy. 4 Education. Our results confirm that education reduces income inequality. Similar conclusions have also been obtained in previous studies (Chong and Calderon 2000; De Gregorio and Lee 2002). As for the overall sample, the education coefficient implies that an increase of 10 points in gross secondary-school enrolment is required to reduce the

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164 Economic Liberalization and Income Distribution

inequality indicator by 1 point over the long-run ((0.016/(1- 0.841))*10). Moreover, education exerts a positive impact under any scenario. Hence, human capital formation can mitigate the negative effect that may be caused by economic liberalization on income distribution and it is in keeping with the postulates of the PWC.12 5 The adjustment coefficient. The outcome of the regression illustrates that the adjustment coefficient is larger for those countries that exhibit macroeconomic mismanagement or a low level of governance. This fact suggests that these countries are more vulnerable to the effect of the variables involved in the economic liberalization process, because their distribution of income adjusts faster to the long-term level, or changes faster compared to those countries with more domestic efficiency. Applying changes in trade volume Some authors contend that trade volume is a variable that reflects countries' geographical characteristics such as their proximity to major markets, their size, or whether they are landlocked. As a consequence, this variable may tell us little about the effect of trade on growth or income distribution (Dollar and Kraay 2004: 26). With the above in mind, changes in trade volume is a variable that may eliminate geography or any other unobserved country characteristic. On the other hand, trade volume is a variable applied frequently in the empirical literature, including those studies exploring the relationship between economic liberalization and income distribution (Calderon and Chong 2001). In addition, this variable can be more effective in panel data studies, because they also consider variations over time and not only variations across countries. Finally, trade volume improves its explanatory power when it is applied in first difference estimations, such as GMM methods, because in this way unobserved country characteristics are eliminated. So as to test if our results can vary depending on the applied variable on trade liberalization, we regress equation (7.3), replacing trade volume with changes in trade volume. The outcome of this exercise, including both the overall sample and the four sub-samples, is illustrated in Table 7.3. It is worth nothing that the long-term coefficient of the variable changes in trade volume is not significant in the overall sample. This outcome suggests that there is no significant long-term relationship between inequality and changes in trade volume. This finding is consistent with the recent study by Dollar and Kraay (2004). Furthermore, changes in trade volume is not significant in the sub-samples except in column 5 where the variable enters negatively and at significant levels. Consequently, this result illustrates that countries with macroeconomic

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Gerardo Angeles-Castro 165

166 Economic Liberalization and Income Distribution

Whole sample

d)

Low High governance governance (2) (3)

High inflation SD (4)

Low inflation SD (5)

Short-run parameters EHIIt-! CTRAGDP FDIGDP INFL EDUSEC Constant

0.845* -0.001 0.060* 0.000* -0.016* 6.889*

0.677* -0.003 0.129* 0.000* -0.021* 14.081*

0.956* 0.000 0.006 0.000* -0.001 1.747*

0.754* -0.003 0.170* 0.000* -0.025* 11.060*

0.900* -0.003* 0.026* 0.003 -0.007* 4.215*

Long-run parameters CTRAGDP FDIGDP INFL EDUSEC Constant

-0.007 0.388* 0.001* -0.101* 44.467*

-0.010 0.398* 0.001* -0.066* 43.532*

-0.007 0.147 0.004* -0.019 40.015*

-0.013 0.688* 0.001* -0.101* 44.908*

-0.028* 0.258* 0.035 -0.071* 42.247*

0.155 1,207 93

0.323 546 47

0.044 661 46

0.246 516 44

0.100 691 49

[0.177] [0.000] [0.070]

[0.650] [0.007] [0.074]

[0.914] [0.001] [0.372]

[0.816] [0.007] [0.117]

[0.557] [0.002] [0.156]

Adjustment coefficient Observations Countries Sargan test AR(1) test AR(2) test

Notes: Dependent variable: EHII, Sargan and serial correlation test are P values, * significant at 5%, all equations use the sys-GMM estimation method.

stability can improve income distribution owing to the expansion of trade. A 36 per cent increase in trade volume leads to a long-term decline of 1 point in income inequality ((0.003/(1- 0.90))*36). As for the remaining three variables, they keep the same sign as the results in Table 7.2, across all the columns, while the magnitude of their coefficients does not differ substantially. Only in the case of high-governance countries in Table 7.3, column 3, there are two variations that deserve highlighting. Firstly, the secondaryschool enrolment variable is not significant. If we consider that highgovernance countries are associated with high levels of secondary-school enrolment and educational attainment, it is likely that an upturn in this variable does not impact considerably on income distribution. As a matter of fact, Table 7.2 shows that the coefficient of secondary-school enrolment is significant in any scenario, but in the high-governance subsample it is the smallest compared with the corresponding coefficients in

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Table 7.3 Scenarios using changes in trade volume (CTRAGDP)

the other sub-samples. In this case, we suggest that higher levels of education can provide better benefits to income distribution. Secondly the coefficient of the ratio of FDI to GDP is not significant either. Thus, when we consider changes in trade volume, FDI does not seem to exert an adverse effect on income distribution in this kind of economy. In summary, the effect of trade on income distribution seems to be weak and not robust, because changes in trade volume do not have a significant relationship with income distribution in the overall sample and, of the four sub-samples, only those countries associated with macroeconomic stability can obtain benefits from the expansion of trade, but the effect is weak as Table 7.3 illustrates. In addition, trade volume does not have a significant impact on countries that exhibit domestic inefficiency, and only has a small impact on the remaining scenarios in Table 7.2. Nevertheless, there is some statistical evidence, emerging from the two variables on trade, which illustrates that countries with domestic efficiency are more likely to improve income distribution on account of an upturn in trade. The conclusions for all other variables practically do not change, except for the ratio of FDI to GDP and secondary school education, in high governance countries, as outlined earlier. The effects of exports by sector In the economic liberalization process, trade openness plays a preponderant role, as it is assumed to give an unambiguous boost to the exportable sector and therefore to export-led growth. In this context, export growth may raise employment directly in the exportable sector and indirectly by permitting faster GDP growth. This process is expected to have positive implications for income distribution and longer-term growth. We have already contended that the basis for tracing the incomedistribution effects of trade is the Stolper-Samuelson theorem. According to this neoclassical model, foreign trade increases the income of the factor which is relatively most used in the export sector and which on the principle of comparative advantage is most abundant, this factor being conventionally assumed to be unskilled labour in developing economies; so income distribution improves (FitzGerald 1996: 32). In this context, we may expect that primary exports, based on natural resources and unskilled labour, provide larger benefits to income distribution than manufactured exports in those countries which exhibit low governance and high-inflation standard deviation, since these countries are associated with lower levels of development.13

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Gerardo A ngeles-C astro 167

168 Economic Liberalization and Income Distribution

Whole sample

(D

Low High governance governance (2) (3)

High inflation SD (4)

Low inflation SD (5)

Short-run parameters EHIIf_! MANEXP PRIEXP Constant

0.885* -0.013* 0.001 5.039*

0.736* -0.011* 0.009 11.107*

0.925* -0.006* 0.003 3.116*

0.860* -0.012** 0.021 6.039*

0.879* -0.011** -0.010 5.151*

Long-run parameters MANEXP PRIEXP Constant

-0.112* 0.005 43.850*

-0.041** 0.033 42.114*

-0.077* 0.039 41.693*

-0.084** 0.151 43.154*

-0.091* -0.081 42.717*

Adjustment coefficient Observations Countries

0.115 1,177 88

0.264 478 43

0.075 699 45

0.140 459 39

0.121 718 49

Sargan test AR(1) test AR(2) test

[0.546] [0.000] [0.080]

[0.757] [0.017] [0.214]

[0.769] [0.001] [0.193]

[0.883] [0.024] [0.373]

[0.556] [0.001] [0.075]

Notes: Dependent variable: EHII, Sargan and serial correlation test are P values, * significant at 5%, ** significant at 10%, all equations use the sys-GMM estimation method.

In order to test the effect of manufactured exports and primary exports on income distribution we conduct a regression including two variables representing the percentage of manufactured exports and primary exports to merchandise exports. Table 7.4 illustrates that the proxy of manufactured exports is negative and statistically significant in the overall sample and in the four sub-samples. An upturn of 8.9 points in the rate of manufactured exports to merchandise exports is linked with a long-run decline of 1 point in income inequality in the overall sample (0.013/(1-0.885)*8.9). On the other hand, the proxy of primary exports is not significant in any case, even in the low governance and high inflation variance sub-samples. To some extent, this outcome undermines theoretical pillars supporting the economic liberalization process. The role of employment and government size It has already been noticed that employment is deemed to be one of the main factors that can drive a better distribution of income over the economic liberalization process. So as to test this assumption, we extend

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Table 7.4 Exports by sector to total exports

the original equation by adding a proxy for the level of employment. We include the unemployment rate variable. Results are shown in Table 7.5, column 2. In addition, so as to test the role of employment by sector, we include variables of employment by industry and agriculture to total employment. Results are provided in Table 7.5, columns 3 and 4 respectively. Finally, we undertake an additional exercise to explore the

Table 7.5 Level of employment (UNEMP), employment by sector (EMPSEC) and government size (GOVEXPEN)

Whole sample

(D Short-run parameters EHnVi TRAGDP FDIGDP INFL EDUSEC UNEMP EMPIND EMPAGR GOVEXPEN Constant Long-run parameters TRAGDP FDIGDP INFL EDUSEC UNEMP EMPIND EMPAGR GOVEXPEN Constant

0.841* -0.004** 0.094** 0.000* -0.016*

Unemployment rate (2) 0.904* 0.000 0.023* 0.001* -0.009* 0.020*

Employment by sector to total employment Industry (3)

Agriculture (4)

Government size (5)

0.982* -0.001* 0.006 0.002* 0.001

0.981* -0.001* 0.009 0.002* 0.000

0.932* -0.001* 0.024* 0.000* -0.004*

-0.007* 0.000 7.306*

4.219*

-0.027* 0.594* 0.001* -0.102*

-0.002 0.236* 0.010* -0.096* 0.212*

0.947* -0.031** 0.356 0.100* 0.030

0.804**

-0.004* 3.174*

-0.032** 0.476** 0.089* 0.014

-0.021* 0.347* 0.005* -0.064*

-0.417* 0.000 45.959*

44.019*

53.995*

43.109*

-0.064* 46.347*

Adjustment coefficient Observations Countries

0.159 1,209 93

0.096 722 59

0.018 690 58

0.019 679 57

0.068 974 73

Sargan test: AR(1) test AR(2) test:

[0.247] [0.000] [0.074]

[0.437] [0.000] [0.438]

[0.636] [0.000] [0.864]

[0.523] [0.000] [0.940]

[0.189] [0.000] [0.472]

Notes: Dependent variable: EHII, Sargan and serial correlation test are P values, * significant at 5%, ** significant at 10%, all equations use the sys-GMM estimation method.

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Gerardo Angeles-Castro 169

role of the state and its empowerment in the distribution of income. For this purpose, we use the government expenditure to GDP variable. Results are provided in Table 7.5, column 5. In all the equations, the exercise is conducted only for the whole sample because of constraints on data availability. That is, after including the unemployment, employment by sector and government expenditure variables, the number of observations drops. Firstly, we observe that unemployment enters positively and significantly in the equation, indicating that higher levels of employment are associated with less inequality. A 4.75 points reduction of unemployment drops the inequality indicator by 1 point over the long run ((0.020)/(l- 0.904)*4.75). What is striking is that the trade volume does not remain significant. However, this result is not owing to the inclusion of unemployment in the equation but rather on account of the reduction of observations in the sample. As a matter of fact, when we conduct the regression (not reported) with the same sample comprising 781 observations and dropping the unemployment variable it is worth noting that the trade volume is neither significant. When we explore the effect of employment by sector on income distribution it is interesting to note that the employment in industry to total employment variable is significant and negative. An increase of 2.4 points in this ratio is required to reduce inequality by one point over the long-term ((0.007/1- 0.982)*2.4). It should also be added that the variables FDI to GDP and secondary-school enrolment are no longer significant in this equation. However, as in the case of the unemployment variable this outcome is not due to the inclusion of an additional variable in the equation, in this case employment in industry. This outcome is rather caused by the reduction of the sample. On the contrary, when the regression is conducted (not reported) with the same sample (690 observations) but dropping the employment in industry variable both FDI to GDP and secondary-school enrolment are not significant either. On the other hand, what is striking is that the employment in agriculture variable is not significant. In this sense, results in Tables 7.4 and 7.5 are supportive and complement each other. In Table 7.4 we show statistical evidence suggesting that the growth of manufactured exports decreases inequality, while in Table 7.5 we illustrate that employment in industry is associated with improvements in income distribution. In contrast, from the two previous tables there is no statistical evidence suggesting that primary exports and employment in agriculture can reduce inequality, even in those countries associated with lower levels of development and abundant

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170 Economic Liberalization and Income Distribution

unskilled labour such as countries with low governance and high inflation standard deviation. Consequently, results in Table 7.4 and Table 7.5 columns 3 and 4 undermine the theoretical foundations supporting the economic liberalization process. As for the proxy for government size, it enters negatively and significantly, while the other variables remain significant. An upturn of 15 points on government expenditure drops the inequality indicator by 1 point over the long run ((0.0044/(1- 0.932))*15). Hence, the reempowerment of the state is a factor that can improve income distribution. This finding is in keeping with the prescription advocated by the PWC. Concluding remarks From the statistical evidence presented above, we find that a strong state, associated with higher levels of government expenditure, is important to reduce inequality. We also find that countries with macroeconomic stability and high governance can mitigate the adverse effect of FDI on income distribution, while there is some evidence that they can obtain weak benefits from trade, in terms of income distribution. In contrast, countries that exhibit domestic inefficiency do not benefit from trade and the effect of FDI on their distribution of income is worse. Inflation, which can be a proxy of fiscal discipline, worsens inequality, but this effect is weak and seems to exert a real impact on income distribution only in episodes of hyperinflation. Not surprisingly, this variable is not statistically significant in the sample comprising countries with a stable economy. Furthermore, education socializes the operation of market forces, since it reduces inequality. In short, domestic efficiency, the empowerment of the state, and the set of second generation policies, represented in this study by a proxy of human capital formation, can mitigate the adverse effect of economic liberalization on income distribution, and to some extent can reduce inequality. Consequently, the PWC and second generation reforms represent an improvement in the global process of economic liberalization. In this study we show that higher employment reduces inequality. However, exploring the effects of employment and exports by sector it is found that emphasis on the primary sector is not a strategy that improves income distribution, even in those countries that to some extent can be associated with comparative advantages based on natural resources and unskilled labour. On the other hand the expansion of exports and employment through emphasis on the industrial sector can have better consequences for income distribution.

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Gerardo Angeles-Castro 171

Therefore, the effects of exports and employment by sector on income distribution illustrated in this study are in keeping with what might be called the 'new Keynesian approach'. According to FitzGerald this approach stresses that those attempts to exploit comparative advantages based on natural resources and unskilled labour do not form an appropriate basis for sustained export growth, since successful export growth depends on technological innovation and the improvement of skills in the labour force; furthermore, from this perspective such an alternative strategy has better consequences for income distribution than the neoliberal model. In this concern FitzGerald points out that from the new Keynesian view industrialization can raise productivity and hence labour incomes throughout the economy. Moreover, manufactured products require greater investment in human capital formation which also leads toward higher labour incomes. In addition, manufactured exports involve higher rates of both public and private investment. This set of events strengthens domestic markets and forms the basis for sustained economic growth. He also explains that from this critical viewpoint reliance on natural resources and unskilled labour does not solve the problems of depressed real wages and slow rate of growth, which leads to weak domestic markets, recessive fiscal retrenchment and structural unemployment, resulting in a worsening of income dispersion and absolute poverty. In contrast, with an appropriate industrialization wage cuts are unnecessary, domestic markets are stronger, faster growth increases employment and welfare expenditure and eventually inequality declines (FitzGerald 1996: 34-5).14 The effect of FDI on income distribution tends to be adverse and it does not provide any distributional effect. This finding undermines the neoclassical postulate which holds that the international flow of investments increases efficiency in resource allocation between and within countries. This assertion faces opposite arguments in the literature that may be generally supportive of the results that emerge from this study in terms of FDI. Some of these arguments are summarized as follows. The race to attract new inward investment and/or to retain multinational corporations (MNCs) results in subsidy packages, downward pressure on corporation and income taxes, and in general in tax incentives and tax reductions. Such tendencies have three major adverse consequences. Fiscal policies designed specifically to serve transnationals' interests lead to an evaporating tax base that constrains the scope for redistributive and social expenditure by governments (Bailey et al.

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172 Economic Liberalization and Income Distribution

1998: 296). In addition, the perceived capacity of MNCs to shift production might reduce countries' ability to tax capital, reduces their tax base and increasingly moves the burden of taxation on the less mobile factors such as labour (Held et al. 1999: 277). Finally, preferential tax treatment and other incentives to induce inward FDI may place domestic industry at a disadvantage and may also introduce a distortion affecting domestic investment. Such distortion between the return to foreign and domestic capital could have a strongly negative effect on growth and employment (Easterly 1993). Thus, the corporate and capital tax competition between nations that has emerged on account of capital liberalization and privatization is likely to result in declining social expenditure because of a reduction in the tax base, or a rising tax burden on the less mobile factors. As a matter of fact, Held et al. (1999) notice that corporate tax rates among countries have tended to fall since the early 1980s. This set of characteristics, in which FDI operates, can be a justification of our results. The increasing bargaining power of MNCs is another possible cause of inequality. Privatization of state-owned firms and liberalization of FDI encourage a surge of mergers and acquisitions across borders that tend to create dominant positions and oligopolistic markets. This likely pattern decreases the market power of small and medium-sized enterprises (SMEs) and leads to a deterioration of the domestic industry and to capital concentration. 15 In addition, the ability of MNCs to organize production transnationally and to shift production to reap the benefits of low wages increases corporate power relative to the power of labour, putting downward pressure on wages and working conditions. In this respect the globalization of production may contribute to widening wage differentials between skilled and unskilled workers within and between countries.16 Hence, the fact that the balance of power between multinational capital and social actors (the state, SMEs and labour, among others), under conditions of liberalization, may shift in favour of the former, represents an explanation of the adverse effect of FDI on income distribution. The operation of MNCs impacts on the effectiveness of the traditional tools of macroeconomic management and government economic policy in several ways. Held et al. (1999: 276-7) most especially underline two ways. The effectiveness of national monetary policy may be compromised since MNCs can borrow abroad when domestic interest rates are high, and conversely take advantages of low domestic interest rates to borrow to fund project overseas. In addition, MNCs may also play an

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Gerardo Angeles-Castro 173

important role in exchange rate markets. In this sense, although speculators may initiate an attack on a currency, it is when both MNCs and institutional investors shift out of that currency, even as a precautionary measure, that pressure on the exchange rate can become irreversible. As a consequence, if the monetary and exchange rate policy are aimed at supporting an efficient allocation of resources and redistributive actions, the apparent erosion in the effectiveness of these policies adversely affect the distribution of income. Arguments such as tax competition between nations, the increasing bargaining power of MNCs, and the erosion of national macroeconomic policy instruments are neglected in the neoliberal thesis, and provide a different perspective to explain the adverse effect on income distribution that may arise owing to the flow of FDI. As for the variables on trade, we find that there is a weak benefit of the expansion of trade on income distribution. On the other hand, we have pointed out that international trade is traditionally considered the corner-stone supporting distributional effect in the process of economic liberalization (Bulmer-Thomas 1996:10). Therefore, we should expect a larger benefit from this variable on income distribution, but the weak evidence above is not supportive of this assumption. Consequently, the empirical evidence obtained from this study is in keeping with the assumptions and expectations supporting the set of firstgeneration reforms to the extent that employment and low inflation can benefit income distribution. In contrast, the results undermine these assumptions and expectations because the benefit of trade on income distribution is weak and FDI worsens inequality. In addition, an export-led growth strategy and the expansion of employment based on the primary sector do not improve income distribution. Although second-generation reforms represent an improvement in the economic liberalization process, the empirical evidence in this study suggests that the role of the state is not enough to socialize the operation of trade and investment. In this context, even under conditions of macroeconomic stability and high governance FDI does not benefit income distribution; in contrast, it seems to be adverse. Moreover, the beneficial effect of trade on income distribution is weak in those countries with domestic efficiency. For these reasons, we argue that further supranational mechanisms, beyond the scope of the state, are required to obtain distributional effects from trade liberalization and from the flow of FDI.

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174 Economic Liberalization and Income Distribution

175

Appendix Characteristics of data-sets on income inequality

Data-set

Global coverage

Assembled from

World Bank data set on Gini coefficients (Deininger and Squire 1996)

» Observations: 682 'high-quality' • Countries: 108 • Obs/country avg: 6.31 * Period: concentrated between 1960 and early 1990s

Gini coefficients reported in the literature

WIID (world income inequality data-base) (UNU/WIDER)

• Obs: 603 gross income, household/family, national sample) • Countries: 105 * Obs/country avg: 5.74 • Period: concentrated between 1960 and early 1990s

Gini coefficients from D&S (1996), LIS, Central Statistical Offices, UNICEF, and research studies

Luxembourg Income Study (LIS)

• • • •

Observations: 132 Countries: 29 Obs/country avg: 4.55 Period: 1969-2000

Micro-level data and primary data sets from household income surveys

UTIP-UNIDO Theil index (University of Texas inequality project)

• • • •

Observations: 3,200 Countries: 153 Obs/country avg: 20.91 Period: 1963-99

Industrial statistics database by UNIDO. The data set is the Theil index of manufacturing pay inequality

EHII (estimated household Income Inequality (UTIP)

• • • •

Observations: 3,126 Countries: 153 Obs/country avg: 20.43 Period: 1963-99

Constructed from the relationship between the UTIP-UNIDO Theil and the Gini coefficients in D&S (1996) plus a limited a m o u n t of additional information

Sources: For Deininger and Squire (1996): World Bank (2003). For WIID: United Nations University, World Institute for Development Economics Research (2003). For LIS: Luxemburg Income Study (2003). For UTIP-UNIDO: University of Texas Inequality Project (2003). For EHII: University of Texas Inequality Project (2003a).

Table A7.2

List of countries (93)

Countries Algeria Argentina Australia Austria Bangladesh

Greece Guatemala Guinea Haiti Honduras

Nigeria Norway Pakistan Panama Peru

Continued

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Table A7.1

176 Economic Liberalization and Income Distribution Table A7.2 Continued

Barbados Belgium Bolivia Botswana Brazil Bulgaria Burundi Cameroon Canada Central African Republic Chile Colombia Costa Rica Cote D'lvoire Cyprus Denmark Dominican Republic Ecuador Egypt El Salvador Ethiopia Fiji Finland France Gabon Ghana

Hong Kong Hungary Iceland India Indonesia Iran Ireland Israel Italy Jamaica Japan Jordan Kenya Korea Lesotho Malawi Malaysia Malta Mauritius Mexico Moroco Mozambique Nepal Netherlands New Zealand Nicaragua

Philippines Poland Portugal Russia Senegal Singapore Slovenia South Africa Spain Sri Lanka Suriname Swaziland Sweden Syrian Arab Republic Thailand Togo Trinidad and Tobago Tunisia Turkey Uganda Ukraine United Kingdom United States Uruguay Venezuela Zimbabwe

Note: The whole list of countries is used in the regressions described in Tables 7.1 to 7.3. In the rest of the regression the number of countries drops.

Notes 1 John Williamson (1990) is given credit for first labelling as Washington Consensus the package of policies that multilateral institutions endorsed in trade and loan negotiations during the 1980s. This package of policies insisted on unregulated markets and a reduced role of the governments in economic activity. 2 We obtain a Lagrange Multiplier test statistic of 4,466, which far exceeds the 5 per cent critical value of x2 with one degree of freedom, 3.84. Since the null hypothesis is rejected, it is concluded that there are individual effects. 3 The value of the Hausman test statistic is 130.65 with a negligible P value; hence, the test rejects the null hypothesis. In this case, the key assumption of the REM 'the unobservable individual specific error st is not correlated to any explanatory variable' is violated; thus, the FEM is preferred. 4 For an empirical application see Galbraith and Kum (2002: 12). 5 The AR test statistic of order one is equal to 29.99 and the P value is negligible. Hence, the AR(1) test suggests evidence of first-order autocorrelation. 6 For an elaboration in this point see Baltagi (2001: 129-30).

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Countries

7 A discussion of the method through an empirical application can be seen in Calderon and Chong (2001: 226-7). 8 The P value in the test statistic for second-order serial correlation based on residuals from the first-difference equation is equal to 0.074. In this case we can not reject the null hypothesis if we establish a 95% confidence interval. Even in these circumstances the sys-GMM model represents a substantial improvement in terms of AR compared with ordinary methods. The P value in the test statistic for first-order serial correlation is negligible; in this case the null is rejected at any conventional level of significance. 9 The Sargan test statistic is equal to 55.38 with a P value equal to 0.247. Thus, the test is unable to reject the hypothesis that the instruments are not correlated with the error process. 10 Dollar and Kraay (2004) stress that between the late 1970s and late 1990s the rate of trade to GDP in OECD countries rose 29 points, that is from 21 to 50 per cent. While trade volume in the top third of developing countries in terms of this rate expanded 17 points, that is from 16 per cent to 33 per cent. Accordingly, the effect of trade volume on income distribution in this study seems to be weak because the expansion of the rate of trade to GDP required to improve income distribution by one point far exceeds the average increase in trade volume over the last two decades. Thus, this statistical evidence suggests that the effect of trade on income distribution has not been as large as was originally expected. 11 The threshold customarily used to define hyperinflation is an increase of prices averaging 50% a month or 600% a year (Havrylyshyn et al. 1994). 12 As complementary information, we found that a lower rate of population growth leads towards less inequality, as the corresponding coefficient enters positively and significantly in the overall sample and the four sub-samples (regression not reported). In this context, Heerink (1994) shows that income inequality and population growth reinforce each other, because lower levels of fertility results in a more equal income distribution; he also underlines the negative relationship between improvements in nutrition, health and education on the one hand and the fertility levels on the other. Not surprisingly, our data base also reveals a negative relationship between education and the rate of population growth. These findings suggest that education can contribute directly to improve income distribution, but also contributes indirectly to this effect by reducing the rate of population growth. 13 Kaufmann et al. (1999) provide evidence of a strong positive relationship between governance and better development outcomes. In this sense, countries with low level of governance are associated with low level of development and therefore they can have substantial reliance on natural resources and unskilled labour. 14 The new Keynesian view evolved partially as a response and as a critique to the new classical approach. For a review see for example Gordon (1990). 15 For an elaboration of the expansion and challenges of cross-border mergers and acquisitions see UNCTAD World Investment Report (2000: 15-28). 16 For a discussion about the balance of power among labour and capital see Held et al. (1999: 278-80).

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Gerardo Angeles-Castro 177

References Arellano, M. and Bond, S. (1991) 'Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations', The Review of Economic Studies, 58(2): 277-97. Arellano, M. and Bover, O. (1995) 'Another Look at the Instrumental Variable Estimation of Error-Component Models', Journal of Econometrics, 68: 29-51. Bailey, D., Harte, G. and Sugden, R. (1998) 'Debate: Transnational Corporations. The Case for a Monitoring Policy Across Europe' New Political Economy, 3(2): 279-300. Baltagi, B.H. (2001) Econometric Analysis of Panel Data, 2nd edn (London: John Wiley & Sons). Blundell, R. and Bond, S. (1998) 'Initial Conditions and Moment restrictions in Dynamic Panel Data Models', loumal of Econometrics, 87: 115-43. Bourguignon, F. (1994) 'Growth, Distribution and Human Resources', in G. Rains (ed.), In Route to Modern Growth, Essays in Honour of Carlos Diaz-Alejandro (Washington, DC: Johns Hopkins University Press). Breusch, T. and Pagan, A. (1980) 'The LM Test and its Applications to Model Specification in Econometrics', The Review of Economic Studies, 47: 239-54. Buhner-Thomas, V. (1996) 'Introduction', in V. Buhner-Thomas (ed.), The New Economic Model in Latin America and its Impact on Income Distribution and Poverty (London: Palgrave Macmillan). Calderon, C. and Chong, A. (2001) 'External Sector and Income Inequality in Interdependent Economies Using a Dynamic Panel Data Approach', Economics Letters, 71:225-31. Camdessus, M. (1998) 'Income Distribution and Sustainable Growth: The Perspective from the IMF at Fifty', in V. Tanzi and K.-Y. Chu (eds), Income Distribution and High-Quality Growth (Boston, Mass.: MIT Press). Chong, A. and Calderon, C. (2000) 'Institutional Quality and Income Distribution', Economic Development and Cultural Change, 48(4): 761-86. Corden, W.M. (1993) Protection and Liberalization: a Review of the Analytical issues, IMF Occasional Paper no. 54 (Washington, DC: IMF). De Gregorio, J. and Lee, J.-W. (2002) 'Education and Income Inequality: New Evidence from Cross-Country Data', Review of Income and Wealth, 48(3): 395-416. Deininger, K. and Squire, L. (1996) 'A New Data Set Measuring Income Inequality', The World Bank Economic Review, 10(3): 565-91. Deininger, K. and Squire, L. (1998) 'New Ways of Looking at Old Issues: Inequality and Growth', loumal of Development Economics, 57: 259-87. Dollar, D. and Kraay, A. (2004) 'Trade, Growth, and Poverty', The Economic loumal, 114:22-49. Doornik, J.A., Arellano, M. and Bond, S. (2002) Panel Data Estimation Using DPD for OX, Centro de Estudios Financieros y Monetarios, http://www.cemfi.es/arellano/ Easterly, W. (1993) 'How Much do Distortions Affect Growth', loumal of Monetary Economics, 32: 187-212. Edwards, M. (1999) Future Positive: International Cooperation in the 21st Century (London: Earthscan). FitzGerald E.V.K. (1996) 'The New Trade Regime: Macroeconomic behaviour and Income Distribution in Latin America', in V. Bulmer-Thomas (ed.) The

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178 Economic Liberalization and Income Distribution

New Economic Model in Latin America and its Impact on Income Distribution and Poverty (London: Palgrave Macmillan). Forbes, K. (2000) 'A Reassessment of the Relationship Between Inequality and Growth', American Economic Review, 90: 869-87. Galbraith, J.K. and Kum, H. (2002) Inequality and Economic Growth: Data Comparison and Econometric Tests, University of Texas Inequality Project, UTIP Working paper no. 21, http://utip.gov.utexas.edu/web/workingpaper/UTIP21rv.pdf Galbraith, J.K. and Kum, H. (2003) Estimating the Inequality of Household Incomes: Filling Gaps and Correcting Errors in Deininger & Squire, University of Texas Inequality Project, UTIP Working Paper no. 22. Gilpin, R. (1987) The Political Economy of International Relations (Princeton: Princeton University Press). Gordon, R.J. (1990) 'What Is New-Keynesian Economics?', loumal of Economic Literature, 28(3): 1115-71. Greene, W.H. (2000) Econometric Analysis, 4th edn (Engle Wood Cliffs, NJ: Prentice-Hall). Hausman, J.A. (1978) 'Specification Test in Econometrics', Econometrica, 46:1251-71. Havrylyshyn, O., Miller, M. and Perraudin, W (1994) 'Deficits, Inflation and the Political Economy of Ukraine', Economic Policy, 19: 353-401. Heerink, N. (1994) Population Growth, Income Distribution, and Economic Development: Theory, Methodology, and Empirical Results (New York and Berlin: Springer). Held, D. et al. (1999) Global Transformations: Politics, Economics and Culture (Cambridge: Polity Press). Higgott, R. (2000) 'Contested Globalization: The Changing Context and Normative Challenges', Review of International Studies, 26: 131-53. Higgott, R. and Phillips, N. (2000) 'Challenging Triumphalism and Convergence: The Limits of Global Liberalization in Asia and Latin America', Review of International Studies, 26: 359-79. International Monetary Found (1997) World Economic Outlook: Globalization and the Opportunities for Developing Countries, (May), chapter 4. Jha, S. (1996) 'The Kuznets Curve: A Reassessment', World Development, 24(4): 773-80. Jones, R. and Barry, J. (1988) 'Liberal Political Economy', in R. Jones (ed.), The Worlds of Political Economy (London: Pinter). Kaufmann, D., Kraay, A. and Zoido-Lobaton, P. (1999) Governance Matters, World Bank Policy Research Working Paper no. 2,196, http://www.worldbank.org/ wbi/governance/pubs/govmatters.html Litwin, C. (1998) Trade and Income Distribution in Developing Countries, Working Papers in Economics, Goteborg University, 9: 1-42. Luxembourg Income Study (LIS) (2003) The LIS Database, http://www.lisproject.org/ Milanovic, B. (1995) Poverty, Inequality and Social Policy in Transition Economies, World Bank, Transition Economics Division, Research Papers 9. Ortiz, G. (2003) 'Latin America and the Washington Consensus: Overcoming Reform Fatigue', Finance and Development, 40(3): 14-17. UNESCO Institute for Statistics (2003) Statistical Tables, http://portal.unesco.org/uis/ ev.php? URLJD = 5275&URL_DO = DO_TOPIC&URL_SECTION = 201 United Nations Conference on Trade and Development (2000) World Investment Report: Cross-Border Mergers and Acquisitions and Development (New York: United Nations Publication).

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United Nations Conference on Trade and Development (2003) Foreign Direct Investment Database, http://www.unctad.org/Templates/Page.asp? intltemID = 1923⟨ = 1 United Nations University and World Institute for Development Economics Research (2003) World Income Inequality Data Base, http://www.wider.unu.edu/ wiid/wiid.htm University of Texas Inequality Project (2003) UTIP - UNIDO Database, http://utip. gov.utexas.edu/ University of Texas Inequality Project (2003a) An Estimated Household Income Inequality Data Set for the Global Economy, http://utip.gov.utexas.edu Williamson, J. (1990) 'What Washington Means by Policy Reform', in J. Williamson (ed.), Latin American Adjustment: How Much Has Happened? (Washington, DC: Institute for International Economics). World Bank (2002) World Development Indicators 2002, CD-ROM (Washington, DC: World Bank), described in http://www.worldbank.org/data/wdi2002/cdrom/ World Bank (2003) Deininger and Squire Data Set, http://www.worldbank.org/ research/growth/dddeisqu.htm

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180 Economic Liberalization and Income Distribution

Pensions and Distribution in an Ageing Society: A Non-Conventional View* Sergio Cesaratto

This chapter explores from a Classical point of view the economic impact of ageing with a particular concern for the future of Social Security organized along pay-as-you-go (PAYG) lines. Elsewhere I have shown the shortcomings of the two major pension reforms under discussion. Cesaratto (2002, 2005: chapter 2, 2006a) pointed out the pros and cons of the Notional Defined Contribution (NDC) reforms that, although in principle (and not without delay), provide the financial stability of PAYG, attain it in the most obvious way of cutting pension benefits, thus leaving aside the social sustainability of PAYG. Cesaratto (2002, 2005: chapters 3 and 4, 2006b) put forward the various shortcomings of the transition plans aimed at the creation of fully-funded (FF) schemes. Cesaratto (2005: chapter 6) showed that, according to the theory of effective demand, the welfare state, and PAYG in particular, are not necessarily detrimental to economic growth, in fact they may foster it. I also regarded the welfare state and PAYG as part of a Classical view of income distribution in which there is no natural distribution setting associated with factors' full employment as in the Neoclassical theory. According to this view, it is the political opposition to changes in income distribution favourable to labour, rather than the Neoclassical mechanical association between distribution and output, that may determine a negative influence of social spending on growth. In this chapter I shall use a Classical-Keynesian approach to explore the sustainability of an ageing society and of PAYG within it. The

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8

concepts of working age and retirement age are eminently cultural, and only loosely associated, respectively, with physical strength and decline. In particular, in recent decades retirement and old age have been partially detached from the idea of physical decline, but times are changing (the OECD has extended the working lifespan from ' 15-64' to '15 and over'). The concept of ageing may instead be considered as a demographic concept relative to the changing age structure of the population. Contingent on the retirement of the baby-boom generation and, more persistently, on the combination of lower fertility rates and higher longevity, developed and increasingly also intermediate economies are facing a process of ageing. Conventional wisdom tells us that a forthcoming labour scarcity plus the ageing process will place the economies under an intolerable strain, jeopardizing the sustainability of PAYG. We shall argue that two effects worry the ruling classes: (1) a progressive shrinking of the industrial reserve army, and (2) an increased tax burden to sustain the elder generations. We shall begin in the next section by presenting some demographic scenarios that put ageing in the context of the possible evolution of the human population, also allowing it to be considered in a different, more positive, perspective. This evolution can indeed be interpreted as the result of the world population approaching a stabilization phase. Migration flows appear not to be able to reverse the ageing process. We shall then assess the impact of the demographic developments on the level of the working-age population, which is the potential labour supply, and on the proportion of old-age population over the population in working-age. The economic impact of ageing, however, cannot be assessed by mere demographic ratios and we must move from population to political economy.1 The later sections of the chapter are thus mainly devoted to discussing the impact of demographic development on the labour market, and to exploring the financial versus the real sustainability of PAYG viewed through the lens of the alternative economic theories. Stylized demographic trends Some impressive global scenarios Both developed and less-developed countries are undergoing major demographic transformations. Current demographic developments consist of the continuation of a secular process that started in the most industrialized countries in the nineteenth century as represented by a progressive fall in fertility and a lengthening of the average lifespan.

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182 Pensions and Distribution in an Ageing Society

Declining infant mortality, among other causes, might have represented the inception of the progressive fall in fertility, which has been the dominant demographic factor at work so far (Bloom and Canning 2004: 4-10). The lengthening of the expected lifespan, which was quite rapid in the recent past, is becoming progressively more important on the assumption that, in most regions of the world, fertility stabilizes at the reproduction level. By definition this complex process determines a progressive ageing of the population. The baby-boom burst in fertility in the developed countries after the Second World War appears as an isolated episode within this long period trend, although its effects will be still felt in the next few decades. Secular demographic transformation is called 'demographic transition', a process 'in which mortality and then fertility decline from higher to lower levels' (UN 2002a: 5). In developed countries the two persistent factors, lower fertility and increasing longevity, have been at work for many decades. In these countries the transition of fertility to below the population replacement level of 2.1 children per woman took place a couple of decades ago (the fertility rate fell from 2.8 in 1950-55 to 1.5 in 2000-05, cf. UN 2002a: 5). On top of this, in the first quarter of the century the developed countries will experience the progressive retirement of the baby-boom generation, the so-called baby bust. According to the UN Population Division (2002b), a number of intermediate-fertility developing countries, roughly those at a relatively high stage of economic development, are also completing the fertility transition from high fertility rates towards below-replacement rates. In both cases the initial expectations that the threshold of the replacement level would not be exceeded proved to be wrong. Predicting the future levels and composition of the population is not so simple. The divergence in the scenarios of the future evolution of the world population produced by the combination of different conjectures is striking. The UN experts suggest that these scenarios are not 'projections' since they represent only 'a few of the many possible future paths of the world population. The value of the scenarios ... is that they illustrate, often dramatically, the implications of small differences in future fertility levels' (UN 2003: 8). Before we focus on the effects of the falling fertility rates on ageing and the working-age population in the more developed countries, let us first dwell on the effects on total world population trends. Small differences in the fertility rates of the world population, or of significant countries or areas - below or above the replacement rates - produce dramatic divergences in the scenarios. In those prepared by the

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Sergio Cesaratto 183

UN Population Division (UN 2003), the fertility rate is assumed to be below or above the replacement level (2.1) by just a quarter of a child (Table 8.1). In the below-replacement scenario (fertility 1.85 children per women) the world population is projected to be 7.4 billion in 2050 and 2.3 billion in 2300, while in the 'high' scenario (fertility 2.35) the Table 8.1 Evolution of the world population: alternative UN scenarios by regions (billions) World Year

Low

Medium

Zero-growth

High

Constant

2000 2050 2100 2150 2200 2225 2300

6.1 7.4 5.5 3.9 3.2 2.7 2.3

6.1 8.9 9.1 8.5 8.5 8.8 9

6.1 8.9 9.1 8.5 8.3 8.3 8.3

6.1 10.6 14 16.7 21.2 27.8 36.4

6.1 12.8 43.6 244.4 1,775 14,783 133,592

2000 2050 2100 2150 2200 2225 2300

1.2 1.1 0.8 0.6 0.6 0.5 0.4

1.2 1.2 1.1 1.2 1.2 1.2 1.3

2000 2050 2100 2150 2200 2225 2300

4.9 6.3 4.7 3.3 2.6 2.2 1.9

4.9 7.7 7.9 7.3 7.3 7.5 7.7

More-developed regions* 1.2 1.2 1.1 1.1 1.1 1.1 1.1

1.2 1.4 1.7 2.2 2.8 3.6 4.7

1.2 1.2 0.9 0.8 0.7 0.7 0.6

Less-developed regions 4.9 4.9 7.7 9.3 12.4 7.9 73 14.6 7.2 18.4 7.2 24.2 7.2 31.8

4.9 11.6 42.7 243.6 1,775 14,782 133,591

Notes: * Excl. Oceania. The scenarios are as follows: Low: total fertility rates (slightly) below replacement rate for most of the periods. Medium: total fertility rates below replacement rates over 2050-75 and then at replacement level. High: total fertility rates (slightly) above replacement rates. Zero-growth: when population reaches a standstill under the medium scenario, then births exactly balance deaths in order to maintain population constant in spite of the enduring reduction of mortality. Constant fertility: each country maintains the fertility it showed in 1995-2000. Source: UN Population Division (2003).

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184 Pensions and Distribution in an Ageing Society

figures are, respectively, 10.6 and 36.4 (the world population was 6.1 billion in 2000). In the 'medium' scenario, in which fertility remains below the replacement level up to 2175 and then returns to the replacement level, the population would reach 9.2 billion in 2075 and then decline to 8.3 billion in 2175. What is striking is that all these scenarios result in a significant ageing of the world population (that is, a small increase in the fertility rates has dramatic effects on the population levels but has a negligible effect on the ageing process). Developing countries are where some of the possible population developments show the most explosive outcomes and where, of course, the completion of the demographic transition is most hoped for. In these countries, even a fertility rate which has remained only slightly above replacement since 2100 leads, albeit in the long run, to levels of population that appear, at least so far, to strain sustainability, without avoiding substantial ageing (UN 2003: 13-14). Developed countries have completed their transition and are, in a sense, in the opposite situation in which the continuation of the present trends will determine a dramatic diminution of total native population. What must be noted, however, is that although in some developed countries a recovery of the fertility trends may be hoped for, in addition to migration, in order to reach a stabilization of the local population, this will not be enough to slow down the ageing process. After years of alarm about the explosion of the world population, ageing is now drawing much attention in the developed countries, where the below-replacement rates are felt as a problem. According to many expert opinions collected by the UN (for example UN 2003b: 9), this has diverted the attention of the developed world from the consequences on the world population of too-high worldwide fertility rates. It is impressing that the hypothetical continuation of the current fertility rates would lead to a population of 244 billion in 2150 and of 134 trillion (sic) in 2300! What is striking in this case is that only in this scenario - or in equivalent ones - might we obtain, in the long run, a reversal of the ageing process capable of calming the ageing alarmists. To rational minds, ageing would thus appear as the price that humanity has to pay to bring population growth under control - so that lower fertility, higher longevity and ageing appear as a positive result of human development. Working-age population and ageing in the more developed countries Although it is serious in all developed countries, the challenge from demographic developments is not the same in all regions and countries.

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Sergio Cesaratto 185

The broadest subdivision is between traditional settlement areas (typically the western offshoots: the USA, Canada and Oceania), in which the impact is softer, and non-settlement regions (typically Europe and Japan), in which the impact is more dramatic. Among developed European countries, however, there are also marked differences.2 The first consideration is that ageing is a process that has been taking place for many decades at the global level, including the less-developed countries, due to the demographic transition synthesized by the trend of the fertility rated and life-expectancy. In all regions the age-group composition of the population is changing in favour of the older sections and demographic dependency ratios are on the rise. These ratios should be considered with care, since they may tell us little about the economic sustainability of the inactive population. It may be noted here that the total demographic dependency ratio rises considerably less than the oldage ratio (the former actually falls in the less-developed world due to the expected dramatic fall in the fertility rate). The second consideration regards the differences between the developed regions. In short, if we were to enlist the regions according to the momentum of the ageing process, this is more serious in Japan and Southern Europe than in Western and Northern Europe, and is less dramatic in the traditional immigration or 'settlement' western offshoots. To sum up the argument so far, in spite of the quantitative uncertainty, especially in the medium-long range - in the short term the retirement of the baby boom generation is a certain fact - it can safely be acknowledged that an ageing process is underway, condensed by an increasing 'demographic' old-age dependency ratio. This process cannot be reversed unless the population is allowed to explode at world and local levels. The process is occurring, however, at a different pace in different world regions. Examining the most developed regions, the difference between them is represented by the fertility rate, closer to the replacement level in the 'new' countries and below it in the 'old' regions. Past and expected migration flows to the former, settlement, countries are also higher. The two aspects are likely also to be interconnected, since migrants tend, at least initially, to show a fertility rate higher than the native population. The next question is then the degree to which more robust migration flows both in settlement and non-settlement developed regions may slow down, or even reverse, the ageing process. Replacement migration The UN Population Division has tried to assess the 'replacement migration' necessary to retain in 2050 some demographic variables at the

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186 Pensions and Distribution in an Ageing Society

present level (UN 2000). The estimates (Table 8.2), based on the UN projections of 1998 (medium variant), indicate the number of immigrants necessary, respectively, to keep constant: (1) the size of the overall population (column 3) (2) the size of the working-age population (15-64) (column 4) and (3) the old-age dependency ratio constant (column 5). The number of migrants is increasing from (1) to (3). For instance, in the EU (15 countries) between 2000 and 2050 about 47 million migrants would be needed to maintain the size of the overall population at the present level; about 79 million to maintain the size of the working-age population; and 700 million migrants to preserve the oldage dependency ratio. The last target is practically out of reach even for non-European settlement countries. The first target is the most easily reached in most cases with robust but plausible migration flows (both total and per-year) since the required migration is actually in line with that experienced in the recent past (UN 2000: 93). It is more difficult to obtain the second result (the population in working age declines faster than the total population since the former suffers from the smaller size of the younger generations while the latter benefits from the increasing longevity). Also in this case, however, the UN argues that while 'some of these numbers may appear high, they remain within the range of migration experienced in the recent past in some industrialized countries' (UN 2000: 94). In some countries, the dramatic impression given by the migration flow required simply to keep the labour population constant (for example in Italy, 357 thousand immigrants per year according to the UN) is diminished if we consider that from the point of view of economics, the sustainability of ageing depends not on the amount of the labour-age population, but on the share of it that is in effect used in production, on its efficiency and on income distribution. We shall next focus upon the repercussions of ageing: (a) on the labour market and (b) on PAYG's costs in relation to output levels.

Ageing and the labour market Scenarios on the evolution of labour supply and dependency ratios In a recent study (Burnieaux et al. 2003), the OECD has estimated the evolution of labour supply over the periods 2000-25 and 2025-50 in the participant countries. It should not pass unnoticed that in this official document the potential labour supply is defined as the population aged 15 and over, modifying the hitherto standard definition of working-age

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Sergio Cesaratto 187

188 Impact of migration flows: alternative UN scenarios (thousands)

Medium variant scenario

Country or region

Medium variant Constant Constant with zero total age group migration population 15-64

Constant ratio 15-64/165

Hypothetical net number of migrants over 2000-50: scenarios by country or region France Germany Italy Japan Republic of Korea United Kingdom United States Europe European Union (15)

325 10,200 310 0 -350 1,000 38,000 18,779

0 0 0 0 0 0 0 0

1,473 17,187 12,569 17,141 1,509 2,634 6,384 95,869

5,459 24,330 18,596 32,332 6,426 6,247 17,967 161,346

89,584 181,508 113,381 523,543 5,128,147 59,722 592,572 1,356,932

13,489

0

47,456

79,375

673,999

Total population in 1995 and by hypothetical scenarios in 2050 2050

1995 France Germany Italy Japan Republic of Korea United Kingdom United States Europe European Union (15)

58,020 81,661 57,338 125,472 44,949 58,308 267,020 727,912

59,883 73,303 41,197 104,921 51,275 56,667 349,318 627,691

59,357 58,812 40,722 104,921 51,751 55,594 290,643 600,464

61,121 81,661 57,338 127,457 53,470 58,833 297,970 727,912

67,130 92,022 66,395 150,697 60,125 64,354 315,644 809,399

187,193 299,272 193,518 817,965 6,233,275 136,138 1,065,174 2,346,459

371,937

331,307

310,839

372,440

418,509

1,228,341

Potential support ratio in 1995 and by hypothetical scenarios in 2050 1995 France Germany Italy Japan

4.36 4.41 4.08 4.77

2050 2.26 2.05 1.52 1.71

2.26 1.75 1.52 1.71

2.33 2.26 2.03 2.07

2.49 2.44 2.25 2.19

4.36 4.41 4.08 4.77

Continued

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Table 8.2

Sergio Cesaratto 189 Table 8.2

Continued Potential support ratio in 1995 and by hypothetical «scenarios in 2050

Republic of Korea United Kingdom United States Europe European Union (15)

12.62 4.09 5.21 4.81

2.4 2.37 2.82 2.11

2.4 2.36 2.57 2.04

2.49 2.49 2.63 2.38

2.76 2.64 2.74 2.62

12.62 4.09 5.21 4.81

4.31

1.97

1.89

2.21

2.42

4.31

Source: UN Population Division (2000).

population as that aged 15-65, as if retirement had become a residual, not the last part of the standard life-course. More importantly, it must be observed that the OECD economists share the Neoclassical view according to which labour supply tends to be employed at its 'natural' level that may be identified for short with full employment. 3 According to a less-conventional view, labour demand depends on effective demand and not on the labour supply, so that labour supply cannot be defined as 'abundant' or 'scarce' without knowing the labour demand (let alone that, in this view, the secular trends of labour demand are one main determinant of the long-run evolution of the labour supply). So, we shall sometimes use the expression 'relative labour scarcity (or abundance)', bearing in mind that the scarcity and abundance must be defined with respect to given levels of labour demand and not in absolute terms. With this warning in mind, let us consider the OECD estimates of the future evolution of labour supply. In Table 8.3 we have reclassified the OECD data, grouping countries into Settlement, Newcomers, and Greying (gently or not) nations. 4 This procedure allows some broad patterns to be identified, with the proviso that each country has a very marked specificity in its demographic and economic history. In their baseline scenario the OECD experts consider the positive effects on labour market participation due: 1 to the cohort effect (frozen at 2000 levels) which, more significantly in the Southern European countries, will positively affect the

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2050

1995

190 Table 8.3 Evolution of labour supply 2000-50, OECD projections

Total population change

Total labour supply

Baseline scenario 2025-50

Total population change

Total labour supply

Labour supply With further reforms 2000-25*

With further reforms 2000-50*

Settlement countries Australia Canada New Zealand United States

29.8 23.8 25.1 24.9

18.3 12.4 11.9 14.5

9.8 3.6 5.9 19

0 -1.9 -3.8 17.3

25.2 17.1 17.9 19.7

26 15 13.7 40.5

Newcomers Mexico Turkey

49.8 43.4

60.4 11.8

17.8 17.7

11.6 2.4

63.8 17.1

83.4 21.6

16.6 10.1 -6.9 6.6 12.6 34.8

5.1 4.4 2.8 0.9 8.4 7.5

-3.1 2.5 0.8 -2.2 5.5 -0.8

17.7 15.7 -2.6 17.7 22.4 45.3

14.4 18.7 -1.7 14.9 28.1 44.7

4 8

1.1 1.6

-2.3 -5.4

9.5 18.1

7.2 13.2

Gently greying Europe Iceland 21.1 14.4 Norway Sweden 8.9 Netherlands 14.5 Luxembourg 18.6 Ireland 24.2 United Kingdom 12 Portugal 8.1 Greying world Denmark Finland Austria Belgium France Germany Switzerland Italy Spain Greece Czech Republic Hungary Poland Slovakia Korea Japan OECD unweighted average

7.8 5.6 4.7 8 10 2.5 6.4 -2.2 10.7 1.4

-3.7 -8.3 -9.8 3.5 -3.4 -3.7 1.6 -4.2 9.1 9.8

-0.7 -6.8 -5.8 2.1 -1 -7.8 -3.5 -14.2 -5 -5.7

-3.5 -8.4 -15.4 -4.1 -6.6 -13.4 -7.6 -24.7 -15.2 -11.1

-1.6 -3.4 -2.7 12.8 9.3 5.7 7.8 4.4 24.6 11.6

-5.1 -11.4 -16.9 8.5 2.8 -8.3 -0.3 -20.2 7.7 -0.6

-0.5 -1.9 5.7 10 11.2 -1

-12.9 -17 -9 -4.4 -7.2 -11.8

-14.7 -15.6 -11.9 -10.3 -13.1 -16.1

-32.5 -34.8 -28.6 -31.8 -24.2 -23.1

-7.4 -16 -4 -0.4 4.7 -2.5

-36.9 -44.7 -31.1 -31.3 -18 -24.5

13.2

4.8

-0.8

-8.8

12.9

7

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Baseline scenario 2000-25

Sergio Cesaratto 191

They also postulate lower unemployment rates and higher fertility rates. All these factors increase the participation rates, but are not able to contrast the demographic effect in the long run. Over the period 2000-25, in spite of the fact that total population is still rising (column 1), the change in its composition due to the ageing process is the main factor behind the fall of the labour supply in the Greying countries (column 2). The labour supply is still rising in the settlement countries, latecomers and in most gently-greying countries in which the more marked rise in total population helps to offset the ageing process. On average, labour supply in the OECD area is still on the rise. Over the period 2025-50 the fall in total labour supply is dramatic in most countries, with the notable exception of the USA (column 3). The OECD next assumes that additional reforms are enacted in order to provide further inducement to the female participation rate, through various incentives, and to later retirement, so as to obtain a fast convergence to a standard retirement age of 67 in 2025 accompanied by actuarial disincentives to earlier retirement. We report here the most prudent Tow' scenarios. The outcome (columns 5 and 6) in most countries is a positive growth in labour supply. However, considering a longer time span, 2000-50, the sign would remain negative for most countries in the Greying world, particularly in Japan and Italy. The participation rates of the standard working-age population (Table 8.4) would decline slightly in 2000-25 in most countries due to the ageing process and the associated retirement process, and rise slightly in the following period. A more substantial rise is expected if further reforms are legislated that favour female and older worker participation. In synthesis, there is a remarkable variety of regional situations. In the settlement and newcomer countries the evolution of the population and of the participation rates is such as to assure a growth in labour supply. In countries like Italy, characterized by current low employment rates, a given constant level of labour demand may be met in the short run by employing the large pool of domestic idle labour and by resorting to immigration, but a relative shortage of labour might appear, ceteris paribus, in the long run (Aprile et al. 2002). Japan may encounter a similar situation (Feldman 2004). Independently of the regional patterns, however, the composition of the labour force is presumably changing everywhere in favour of the female and older sections, augmenting, 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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participation rates of the younger generations of women with a stronger educational background; and 2 to already deliberated pension reforms aimed at increasing the retirement age.

192 Table 8.4 Evolution of participation rates in OECD countries: scenarios by the OECD

Levels in 2000a Settlement countries Australia Canada New Zealand United States average

2000-25

2025-50

2000-25

2025-50

73.8 76.3 75.2

-0.3 1.2 -2.3

-0.6 0.2 -0.9

2.9 3.8 1.4

2.3 4 0.4

77.2

-1.7

0.8

1.4

2.2

Newcomers Mexico Turkey

62.3 51.8

6.5 -10.2

0.2 -2.4

9.1 -6.3

9.1 -8.9

Gently greying Europe Iceland Norway Sweden Netherlands Luxembourg Ireland United Kingdom Portugal

86.6 80.7 78.9 74.6 64.2 67.4 76.6 71.1

2.3 1.7 -5 2.2 2 9.7 -1.2 1.4

-0.9 1.1 0 1.6 1.8 1.1 0.8 0.4

2.5 4.1 -4.3 9 10.3 16.3 1.7 7.8

1.5 5.2 -0.2 10.3 11.9 17.4 2.5 8.2

Greying world Denmark Finland Austria Belgium France Germany Switzerland Italy Spain Greece Czech Republic Hungary Poland Slovakia Korea Japan

80 74.3 70.6 65.2 68 72.2 80.5 60.3 66.7 63 71.6 60.2 65.8 69.9 64.3 72.5

-2.3 0.3 -4.6 1.7 -2.6 2.2 1.7 2.9 3.2 8.4 -1.4 -1.9 -0.7 -1.3 -3.2 1.4

0.3 1.4 0.4 0.4 0.3 0.3 -0.6 0.2 1.7 0.6 -5.3 -5.7 -6.2 -5.8 0.9 -0.3

-0.7 3 -0.4 8.7 6.5 9.6 5.4 8.1 11.8 11.1 3.8 0.3 4.2 2.4 3.9 10.7

-0.4 4.2 -0.1 9.1 6.8 9.9 4.6 8.3 13.5 11.7 -1.4 -4.8 -1.9 -3.3 4.5 10.5

OECD unweighted average

70.7

0.3

-0.5

4.9

4.5

Notes:a Percentages of population aged 15-64. b Conservative scenario. Source: Burnieaux etal. (2003).

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Further re forms,b changes over

Baseline scenario, changes over

ceteris paribus, the pressure on the male, prime age section of the labour supply. In addition in all countries the old-age dependency ratio, defined as the ratio between the inactive over-65s on the labour force (those aged over 15 that participate in the labour market), actually rises whatever the scenario. Worth noticing are the trends in the total dependency ratio, defined as the ratio between the inactive population and the labour force.5 In the OECD baseline scenario this ratio rises less than the oldage ratio given the compensating effect exerted by the diminished number of both dependent young and adults. In a number of cases it even becomes negative in the 'further reforms' scenario, with the effect being felt more strongly in the more greying countries. We shall return to this. The economics of the impact of the demographic changes on the labour market Classical economists showed a primary interest in the relations between population, wages and accumulation. The centrality in their theories of the notion of wage rate as the amount of commodities that workers and their families must receive in order to survive (Garegnani 1984) naturally suggests an interest in the circumstances that regulate the standard of living and the reproduction of the labour force. In addition, the determination of the wage rate on the basis of the bargaining power of labour propounds a connection between the speed of the accumulation process - which influences labour demand and wages - and population developments - which influences labour supply. Having said this, with the exception of Malthus, the Classical economists were far from holding the simplistic view of these interrelations that has often been attributed to them. In particular: (1) labour demand, and not just the wage level, was seen as inducing population changes; moreover (2) the level of wages could influence population in either direction; and finally, (3) unfavourable population developments and accumulation rates had no mechanical or immediately negative influence on the wage rate, which depended on enduring social habits and conventions (Stirati 1994: chapter 4 and 175-6). While Marx regarded the existence of an excess of labour population over the job opportunities as a necessary check on wages, he considered population movements too slow to account for the preservation of a labour reserve army over the cycle and during the process of accumulation - a role that was not, nonetheless, excluded in the long run. The most direct role in preserving the industrial reserve army was rather assumed by the modalities of the accumulation process itself, in particular: by (a) the weakening of

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Sergio Cesaratto 193

the accumulation process, for a given 'organic composition of capital' and, were its pace putting too much pressure on a given labour supply, by (b) the progressive substitution of variable capital (direct labour) with constant capital in the production process that diminished labour demand in the course of the accumulation process (Marx [1867] 1974, Vol. I: chapter XXV: sections 1-3, for example 580-1 and 597-9).6 In the Marginal theory, population, although behind the determination of the labour supply schedule, played a very indirect, de facto secondary role in the determination of the wage rate which results from the relative factors' scarcity and the technical conditions of production. The interest in the complex relations between the wage rate and labour population developments investigated by the Classical economist was lost, as much as the existence of a surplus of labour population, involuntary unemployed, as a check on wages, whose interpretation was also the fruit of the Classical conflict view of income distribution. The excess of population in working age over the employed population is seen by Marginal theory as consisting of voluntarily or temporarily unemployed. According to Neoclassical theory, a fall in the rate of growth of labour supply does negatively affect the patterns of employment and output. It is, however, expected that the per capita capital endowment rises. As a result of the mutation in the relative scarcity of factors, the wage rate is expected to rise and the profit rate to fall.7 In principle, therefore, a fall in the population in working age is accommodated by the Neoclassical view like any other mutation of factors' endowments. However, we are authorized to suspect that, in practice, a situation of greater labour scarcity is seen by these economists with disquiet, given its impact on the bargaining power of labour and distribution (see for example Cotis 2003).8 The impact of ageing on the costs of PAYG in relation to output, to which we shall return, is viewed with even more open apprehension. The Classical-Keynesian approach looks at the demographic developments in the context in which employment is determined by the patterns of effective demand. According to this approach, employment is labour-demand and not labour-supply led as in the Neoclassical approach. Historical experience suggests that, in the past, capitalism has never suffered from labour scarcity, mainly because it has resorted to migration flows. Peasants, women, children and immigrants - that is the 'pre-capitalist' world that overlaps the 'reserve army' in which Marx included the elderly - in different historical phases have constituted pools of labour supply from which capitalists have drawn workers in their millions, when necessary (Patnaik 2003). This is not to underestimate the novelty of the demographic developments that occur which,

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194 Pensions and Distribution in an Ageing Society

as we have seen, not even robust migration can arrest. What must necessarily be reiterated in analysing these events is that whatever the events on the labour supply side, labour demand does not mechanically depend on labour supply through the flexibility of the wage rate, as argued by Neoclassical economists, but on effective demand. In dealing with the relative fall in the working-age population - possibly bounded by migration, but only within the limits suggested by population density, political and cultural considerations - the non-conventional approach would point in the directions suggested by Marx and reconsidered by Kalecki (1943), that it is necessary for capitalism to be endowed, on average, with a labour reserve army in order to discipline the workforce. The first reaction of capitalism to a reduction in the labour supply - for a given labour demand - would be to recruit those who are still outside the labour market, women, old workers, but also the young and even invalids (as stated in a official document of the OECD 2004).9 A persistent situation of relative labour scarcity for a given level of labour demand may also determine a reaction on the side of the capitalist class applied to reconstituting the industrial reserve army through variations of output levels - achieved by deliberate economic policies or by a fall in investment decisions. It is mainly in this sense that, in a Classical-Kaleckian context, circumstances on the labour supply side can influence labour demand and output. So, although in principle a situation of relative labour scarcity may favourably affect the direct and social wage rates and raise the propensity to consume, thus sustaining effective demand, it may also induce a reaction on the side of the dominant classes aimed at restraining labour demand and preserving an industrial reserve army. Marx's theory of the labour reserve army would also suggest a wave of labour-substituting innovations. The real threat is that, especially in Europe, the ageing process associated to the alarm over a labour shortage and the consequent fear of the necessity of increasing the share of income going, directly or indirectly to labour, might lead to neo-Malthusian, economic stagnation policies in order to preserve an industrial reserve army. The present policies of weakening the labour-market institutions that reinforce the labour bargaining power may also be explained in this perspective. In this context, policies devoted to diminishing the expected level of pensions may change the life-cycle conceptions that were consolidated in the second half of last century, inducing the social acceptance of a higher retirement age up to the point of again making acceptable the idea of working in old age - which, given the higher longevity, would mean over 65 years or so - to avoid poverty.

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Sergio Cesaratto 195

196 Pensions and Distribution in an Ageing Society

Ageing and the cost of PAYG

The second question associated with ageing is the increasing weight of PAYG on output. The conventional wisdom is that this will determine an increase in the tax burden, which might act as a disincentive on labour and saving supply, or increase public deficits and debt which, by absorbing saving and determining a rise in the interest rates, would undermine capital accumulation. Let us consider some OECD estimates of future PAYG costs on GDP in order to estimate the order of magnitude involved (Dang et al. 2001). Behind the projections there is a supply-side model in which labour supply and productivity growth determine the rate of growth of GDP. This is unsatisfactory from a Keynesian point of view, according to which the GDP trend is based on the pattern of effective demand - which depends on policies (including pension policies) rather than on 'natural' market forces. Nonetheless, this conventional kind of exercise may provide an order of magnitude for the phenomenon under observation. The OECD bases its estimates on the following equation: PENS GDP

POP+55 pop20~64 Av. Benefit Recipients 20 64 POP ' Employment Av. Productivity POP+5S

PENS/GDP is PAYG's costs on gross output. POP^^/POP2064 is the ratio between the population over 55 over the population in working-age (standard definition). This ratio measures the ageing process that influences the relative old-age pension costs since many workers retire before 65. POP20'64/Employment is the inverse of the employment rate. This ratio measures the aforementioned expected rise in the share of working-age population in employment given, on the one side, the fall in the potential labour-supply and, on the other, the increasing female labourmarket participation and the measures to reduce early retirement. Observe that a fall of this ratio, say due to a fall of POP20'64 for a given employment level, indicates that a decreasing number of inactive adults is dependent on the active adults, and this may compensate the ageing burden. The term Av. Benefit/Av. Productivity is the ratio of the average pension benefit on per capita productivity, measuring the effects of pension reforms - such as the abolition of the real indexation of pensions to wages or, in Italy and Sweden, the effects of the NDC reforms that link the pension benefit to the average (not the final) wage and reduce them whenever the expected years of retirement increase. Finally, the terms Recipients/POP+55 is the eligibility rate, which also reflects the introduction of more restrictive rules of access to retirement and pensions. 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Scenarios on the cost of PAYG on GDP

The OECD estimates the rate of change over 2000-50 of PENS/GDP as the summation of the rate of change of the components on the right hand side of equation (8.1). Table 8.5 shows the results. Initial spending ratios, shown in the first column, depend not just on the stage reached in the ageing process, but also on the employment Table 8.5 Changes in old-age pension spending 2000-50, OECD estimates Total old-

,age pension spending; level in 2000

Total oldage pension spending; level in 2050

Contributions of Old-age depend- EmpolyEligiVariation ency ment Benefit bility 2000-50 ratio ratio ratio ratio

Settlement countries Australia Canada New Zealand United States

3 5.1 4.8 4.4

4.6 10.9 10.5 6.2

1.6 5.8 5.7 1.8

Average

4.3

8.1

3.7

Gently greying Europe Norway 4.9 Sweden 9.2 5.2 Netherlands United Kingdoim 4.3

12.9 10.8 10 3.6

8 1.6 4.8 -0.7

5.9

9.3

3.4

6.1 9.5 8.8 12.1 11.8 14.2 9.4 7.8 6 10.8 2.1 7.9

8.8 11.7 12.1 15.9 16.8 13.9 17.4 14.6 7.2 8.3 10.1 8.5

2.7 2.2 3.3 3.8 5 -0.3 8 6.8 1.2 -2.5 8 0.6

Average

8.9

12.1

3.2

OECD unweighted average Coeff. of variation*

8.1

11.6

3.5

Average Greying world Denmark Austria Belgium France Germany Italy Spain Czech Republic: Hungary Poland Korea Japan

0.43

2.5 5.1 4.7 2.4

-0.1 0 -0.1 -0.1

-0.5 -0.6 1 -0.2

-0.2 1.3 0 -0.3

3 3.9 3.8 1.7

0.1 -0.5 -0.5 0.1

3.9 -2.1 0.2 -2.5

1.2 0.4 1.4 0.1

2.7 7.6 4.7 7.6 6.4 10.1 8.6 8.2 2.9 7.3 4.8 5.1

-0.3 -1.9 -0.7 -0.5 -0.7 -3.2 -2.6 -0.8 -1 -1.3 -1 -1.2

-1.5 -1.1 -1.6 -3.4 -2.7 -5.5 0 -0.1 -0.3 -5.9 0.2 -3.9

1.7 -2.4 1 0.4 2.1 -1.5 2 -0.1 -0.4 -2.1 5 0.9

5.6

-1.0

-1.5

0.6

0.35

Notes: * standard deviation/average. f Source: Dang et al . (2001).

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Sergio Cesaratto 197

rate - which, in countries like Italy where it is particularly low, determines a heavier pension burden on the employed. It also depends on the national characteristic of the national pension system - which is much less generous in countries in which the benefit is not broadly linked to pre-retirement earnings but is mainly 'flat-rate' (the traditional example is the UK). The coefficient of variation (the standard deviation over the average) measures the scatter of the national data around the average. It falls from 0.43 in 2000 to 0.35 in 2050 (0.32 if the expenditure in the UK is considered as 6.5 per cent, which now sounds more reasonable),10 suggesting that in 2050 there will be a greater relative homogeneity among the OECD countries. Although the ratio of over 55 on the population in working age is increasing at a different pace, the pension reforms endeavoured by some countries (and further reforms will take place in the next future) affecting the level of pensions in relation to productivity (and wages) and restricting the eligibility rights, and the rise in the rate of employment of the working age population in countries where this was relatively low, contribute to this greater homogeneity. The case of Italy is very representative, since in spite of presenting the most extensive ageing process (with Japan), this country succeeds in stabilising (albeit in the long run) the expected spending ratio as a result of the NDC reform and of a rising employment ratio. The dramatic effect on the level of benefits with reference to per-capita output is quite evident from the table. The social problem that this perspective opens does not regard only Italy.11 The OECD is clearly more worried about the impact of the increasing old-age spending (which should include also health spending) on taxation and the public debt than on the social effects. Compensation factors: productivity growth and the (relative) constancy of the total dependency ratio The role of productivity growth in alleviating the rise of the ratio of pension spending to output needs also to be carefully examined. Productivity growth is not a panacea, as is often envisaged. In a nutshell, if productivity growth is used to offset ageing (the rise in the number of retirees over employment), than it cannot be used to increase pensions in line with increased productivity. It might therefore be necessary to redistribute income from wages and profits towards the retirees if we want to keep pensions in line with the growth of incomes in the active population. Nonetheless, productivity gains, which have been spectacular over the last two centuries, will lead to a substantial increase in the level of net real income of active workers in spite of a possible higher

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198 Pensions and Distribution in an Ageing Society

contribution rate (Palley 2002). The burden of PAYG can also be transferred to non-wage earners either by increasing real wages in proportion with contributions, or by using general taxation. As Wray (1999: 1 et passim) has pointed out, most economists fail to distinguish between the financial imbalances of PAYG, that may well increase into the future, given the current parameters that govern the schemes, and the 'real problems involved in producing a sufficient quantity of resources to care for future retirees', that cannot realistically be considered as an insurmountable burden. The viability of PAYG is, to a large extent, a question of distribution of the social product between generations and social classes, and this has no mechanical negative impact on economic growth and welfare. One big question concerns the difficulty of raising taxes, especially over financial capital in this era of financial liberalization and tax competition. In this regard, it must be noted that financial liberalization has been a deliberate political choice pursued, inter alia, in order to create problems for the financing of the Welfare State. It may also be asked if the cost of an ageing society is not compensated by the lower costs of youth and dependent adults. As aptly observed by Concialdi, ultimately 'it is the ratio of the population out of work to the population employed that gives the most reliable idea of the likely evolution of future social expenditures' (Concialdi 1999: section 4). Indeed, as also seen above, the total dependency ratio (the inactive population on the labour force) rises less than the ratio of the old-age dependency ratio (inactive elders to the labour force). Conventional economists have actually led us to regard the ageing process as a progressive contraction of the active population in favour of the inactive, forgetting that this is a process partially offset by the falling number of dependent adults. They are probably trapped into this way of thinking by the Neoclassical theory that our economies are, on average over the business cycles, in full employment. Concialdi defines as the 'overall economic dependency ratio' the proportion of people out of work (whether inactive or unemployed) to people actually employed (Concialdi 1999: section 4). The inactive section of the population has two components: the inactive young and the non-working adults. As far as the former group is concerned, the debate on the relative costs of their upbringing and education versus the support costs of the old has not led to conclusive results (see, for instance, Denton and Spencer 1999). The prevalent opinion seems that once the reduced spending for the shrinking young section of society is duly taken into account, this will not be a decisive counter force to the

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Sergio Cesaratto 199

increasing relative costs of ageing. With regard to the second group, as we have seen, the ageing process should accelerate the participation in the labour market of women and of mature workers, reducing the share of inactive adults (in practice many capitalist economies will approach a genuine full employment). Concialdi estimates the overall economic dependency ratio for the European Union over the next two or three decades on the basis of various hypothesis on the trends of total employment. The principal conclusion he draws is that there is, in principle, some chance that future population changes will not increase the economic burden on workers (Concialdi 1999: section 4). In a nutshell, this author assumes that in the next two decades or so in Europe employment will not fall significantly (and will possibly increase slightly). Since also total population is not expected to fall - merely to grow older - the overall economic dependency ratio will not rise greatly. So, if productivity rises, the dependent and the active population can both share in the productivity gains without changing the distribution of the social output between the two sections of the population: when we look at the whole population of the European Union, variations in the numbers of the dependent population will be relatively small over the next 25 years. There was an estimated dependent population of 222 million people in 1995. The figure for the year 2020 will be between 218 and 230 million. Consequently, the average cost of the dependent population could approximately follow the rate of real economic growth without increasing the burden on workers. (Concialdi 1999: section 5) If the overall economic dependency ratio rises, the dependent population can only share part of productivity growth, but its welfare will still rise as long as the latter grows at a higher rate than the former. Let us define etot = DepPop/Nw as the overall economic dependency ratio and d = (DepPopbd)/(Nw7r) as the weight of the dependent population on output; Nw is the number of workers, hd is the average transfer to the dependants and ir is output per worker (time subscript omitted). The last expression d = etot (bd/ir) can be written. If we want d to remain constant, then: bd=w-

etot

(8.2)

where the hat indicates the rates of growth. According to Concialdi (1999: figure 5), in spite of the rise in etoV an expected TT higher than etot will allow a substantial rise in bd in many European countries at least up to 2020 (for example around 40-50 per cent in France, Germany and

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200 Pensions and Distribution in an Ageing Society

Italy). Note that it is the approximation to full employment conditions that does the trick (idle labour resources tend to disappear and this compensates for the rise in the old population). In this regard our earlier conclusions must be recalled: it is the contraction in the labour reserve army that may represent the real obstacle to an effective coping with an ageing society, not the lack of labour resources. Concialdi's method is interesting, and it deserves to be developed in future research. This should also better assess the impact of the changing composition of the dependent population - less young and prime age inactives, more old - on private and social support costs, and on the financing sources (say, inactive spouses would transit from family support to old-age pensions), since this has serious income distribution implications. Final remarks This chapter has tentatively explored the possible economic impact of ageing on the labour market and the viability of PAYG. The conventional wisdom is that the fall in fertility may negatively influence the level and growth of employment, at least in the developed countries. Not all countries would be on the same footing in this regard: some possess reserves of labour that are currently (shamefully) kept idle; traditional settlement countries may welcome a larger number of immigrants than congested non-settlement regions. In addition, in most countries the emerging situation may produce a spontaneous increase in the demand for the labour services of older workers, many of whom are presently still being dismissed against their will. Finally, per capita productivity growth, including some reversal of working hours, may free labour resources from the current activities. The conventional view strongly reflects the standard theory whereby the level of employment is governed by the labour supply through the flexibility of wages. We reject this view. This does not imply, however, discharging the impact of the falling supply of labour population on to the labour market. Assuming as a working hypothesis the persistence of employment at the present levels (with output growth resting on productivity growth), the falling supply of domestic labour population is not necessarily a constraint on output growth, insofar it is in most countries compensated by higher participation rates (including later retirement), technical progress, immigration and, perhaps, some recovery in fertility. The challenge of a shrinking labour supply will, however, seriously bite in some countries like Japan and Italy. The novel dimension added in this

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Sergio Cesaratto 201

chapter is whether the additional sources of labour supply are such as to preserve an industrial reserve army and if capitalism can live without a significant labour reserve army that keeps the whip of competition on the workers. It is in this sense that, according to non-conventional economic analysis, a shrinking labour supply may affect employment and growth by inducing deflationary choices, particularly in Europe. The more so if ageing brings about a rising cost of the dependent population. Most projections forecast a rise in PAYG's cost over income. Whereas differences within developed countries will persist, the tendency - as presently predicted - is towards a greater homogeneity. We discussed the role of productivity growth in attenuating the expected rise in PAYG's burden on social output. In synthesis, this factor can help to keep the effects of a rising dependency ratio at bay, but cannot at the same time be used to raise pension benefits in line with per capita output growth. If we wish to avoid a relative impoverishment of the retirees, we may have to accept the idea that wages and/or profits have to share part of the productivity gains with the retirees. To look at the old-age dependency ratio alone might, however, be too limited a prospect. Some authors suggest looking at a total dependency ratio that includes also the dependent youth and the dependent adults, both shrinking components. The total dependency ratio would therefore suggest a less gloomy future. The composition of the dependent population would, however, change in favour of the old component, more dependent on public (tax-financed) public support compared to the other components (young and spouses) sustained by the family. The old component is generally considered also to be more costly. Although the total flow to the dependents changes less than expected, the increase and changing composition of the flow may open up questions of political acceptability. We may finally note that according to the Classical-Keynesian approach there is no mechanical relation between an increasing amount of resources going to the old, or more generally to the dependents, and economic growth. On the one hand social transfers have positive effects on aggregate demand and hence on growth. On the other hand they may negatively affect the political climate and the incentive to invest. The incentive to invest may be negatively affected also by tax competition in open economies. This is not, however, a mechanical result and may be avoided if a robust and persistent social consensus sustains those social transfers, so as to induce capitalists to accept a lower post-tax rate of profit. International social dumping might be avoided by a degree of tax coordination and, perhaps, by the reintroduction of forms of capital control. From an analytical point of view what must be strongly noted is the absence, in a heterodox framework, of an automatic negative

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202 Pensions and Distribution in an Ageing Society

Sergio Cesaratto 203

Notes 1 This is an echo of the procedure famously advanced by Marx in the Grundrisse: It seems to be correct to begin with the real and the concrete, with the real precondition, thus to begin, in economics, with for example the population, which is the foundation and the subject of the entire social act of production. However, on a closer examination this proves false. The population is an abstraction if I leave out, for example, the classes of which it is composed. These classes are in turn an empty phrase if I am not familiar with the elements on which they rest. For example, wage labour, capital, etc. ... Thus, if I were to begin with population, this would be a chaotic conception of the whole, and I would then, by means of further determination, move analytically towards ever more simple concepts, from the imagined concrete towards ever thinner abstractions until I had arrived at the population again, but this time not as a chaotic conception of a whole, but as a rich total of many determinations and relations. (Marx 1857-58 [1973]: 100) 2 The reader is referred to table 8.2 in Cesaratto (2005) that provides a broad idea of the most likely comparative evolution in different regions based on UN projections concerning the period 2000-50 (UN-Population Division 2002a). 3 Of course, for mainstream economists the potential and the effective labour supply do not coincide, given the existence of people that remain voluntarily outside the labour market. Only with the contraction of the number of people in labour age, do potential and effective labour supply tend to correspond. 4 The OECD experts assume that migration flows remain at their recent past levels, which have been very high for the USA but not necessarily so for European countries, so these estimates should be looked upon with the proviso of a conservative hypothesis on the migration flows for many countries. 5 The reader is referred to table 8.6 in Cesaratto (2005) also based on Burnieaux etal. (2003). 6 Marx could therefore conclude that the law of capitalist accumulation, metamorphosed by economists into a pretended law of Nature, in reality merely states that the very nature of accumulation excludes every diminution in the degree of exploitation of labour, and every rise in the price of labour, which could seriously imperil the continual reproduction, on an ever enlarging scale, of the capitalistic relation. (Marx [1867] 1974, Vol. I: 582) In other words, the existence of a labour reserve army does not depend, according to Marx, on fertility variations, too slow to be effective for this purpose, but on the patterns of accumulation. It should be noted that in Marx labour supply does not directly affect labour demand, as the existence of persistent unemployment shows (this is true also for the other Classical economists, cf. Stirati 1994: chapter 6), but may affect the rate of accumulation, and therefore indirectly labour demand, by influencing distribution.

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effect of increasing social transfers on accumulation: these effects may take place, but their origin resides in the refusal of a changing income distribution, not in some mechanical relation.

7 The rise in the wage rate may induce some voluntary unemployed, whose reserve wage is below the new level of the wage rate, to enter the labour market, thus raising the activity and employment rates. 8 An example of Neoclassical analysis is provided by Boersch-Supan (2003). 9 '[R]eforms need to identify disabilities correctly, distinguishing between minor and major disabilities in order that the term "disabled" is no longer equated with being unable to work' (Boersch-Supan 2003: 10-11). 10 The projections for the UK are over-optimistic. According to the Economist (Sept. 2004) the disarray of the British private-pillar 'casts doubts on the sustainability of Britain's cheap public pensions'. This opinion follows the results of a government commission on pensions that presented very pessimistic forecasts about expected pension incomes in Britain. 11 The OECD experts specify that the expected decline in average benefits relative to average productivity over the period 2000-50 will be - 1 6 % in Belgium, - 1 1 % in Denmark, - 2 1 % in France, -20% in Germany, - 3 0 % in Italy, - 3 8 % in Japan, - 5 1 % in Poland, - 2 2 % in Sweden, and - 4 7 % in the United Kingdom. References Aprile, R., De Persio, P. and Lucarelli, A. (2002) 'Una previsione di medio lungo periodo dei tassi di attivita secondo un approccio generazionale', Economia & Lavoro, 36: 61-87. Bloom, D.E. and Canning, D. (2004) Global Demographic Change: Dimension and Economic Significance, Federal Reserve Bank of Kansas City Symposium on Global Demographic Change: Economic Impacts and Policy Challenges, Jackson Hole, Wyoming, http://www.kansascityfed.org/PUBLICAT/SYMPOS/ 2004/pdf/BloomandCanning.Paper.0923.pdf. Boersch-Supan, A. (2003) 'Labour Market Effects of Population Aging', Labour, 17: 5-44. Burnieaux, J.M., Duval, R. and Jaumotte, E (2003) Coping with Ageing: A Dynamic Approach to Quantify the Impact of Alternative Policy Options on Future Labour supply in OECD Countries, OECD Economic Department Working Paper no. 371 (Paris: OECD). Cesaratto, S. (2002) 'The Economics of Pensions: A Non-Conventional Approach', Review of Political Economy, 14: 149-77. Cesaratto, S. (2005) Pension Reform and Economic Theory: A Non-Orthodox Analysis (Cheltenham, UK and Northampton, MA, USA: Edward Elgar). Cesaratto, S. (2006a) 'Notes on the Pros and Cons of the Notional Defined Contribution Reforms', Journal of Income Distribution forthcoming. Cesaratto, S. (2006b) 'The Transition to Fully Funded Pension Schemes: A NonOrthodox Criticism', Cambridge Journal of Economics forthcoming. Concialdi, P. (1999) 'Demography, Employment and the Future of Social Protection Financing, in Ministry of Social Affairs and Health', paper presented at the conference 'Financing Social Protection in Europe', Helsinki (www.vn.fi). Cotis, J.-P (2003) 'Reform of the European Labour Markets: A View from the OECD', mimeo. Dang, T.T., Antolin, P. and Oxley, H. (2001) Fiscal Implications ofAgeing: Projections of Age-Related Spending, OECD, Economic Department Working Paper no. 31 (Paris: OECD).

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204 Pensions and Distribution in an Ageing Society

Denton, FT. and Spencer, B.G. (1999) Social and Economic Dimensions of Aging Population, Social and Economic Dimensions of an Aging Population, Research Papers (1). Feldman, R.A. (2004) 'Japan Economics - Immigrants: Torrent or Trickle?', Morgan Stanley, Global Economic Forum (8 January 2004), http://www. morganstanley.com/GEFdata/digests/20040108-thu.html Garegnani, P. (1984) 'Value and Distribution in the Classical Economists and Marx', Oxford Economic Papers, 56: 291-325. Kalecki, M. (1943) 'Political Aspect of Full employment', in M. Kalecki (1971) Selected Essays on the Dynamics of the Capitalist Economy (Cambridge: Cambridge University Press): 138-45. Marx, K. (1857-58) Grundrisse, Foundations of the Critique of Political Economy (Rough Draft) reprinted 1973 (Harmondsworth: Penguin Books). Marx, K. (1867) Capital. A Critical Analysis of the Capitalist Production (I—III), reprinted 1974 (London: Lawrence & Wishart). Palley, T.I. (2002) 'Social Security: Prefunding is Not the Answer!', Challenge, 45: 97-118. Patnaik, P. (2004) 'What Should be the Scope of "Development Economics"?', http://www.networkideas.org/themes/macroeconomic/oct2003/mp06_ Development_Economics.htm. Stirati, A. (1994) The Theory of Wages in Classical Economics (Aldershot, UK and Brookfield, USA: Edward Elgar). UN Population Division (2000) Replacement Migration: Is It a Solution to Declining and Ageing Population? (New York: UN). UN Population Division (2002a) World Population Ageing: 1950-2050 (New York: UN). UN Population Division (2002b) Completing the Fertility Transition (New York: UN). UN Population Division (2003) World Population in 2300 (New York: UN). Wray, L.R. (1999) The Emperor Has No Clothes: President Clinton's Proposed Social Security Reform, Jerome Levy Economic Institute o Bard College, Public Policy Note (2). http://www.levy.org/pubs/pn/pn99_2.pdf.

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Sergio Cesaratto 205

Do Profits Affect Investment and Employment? An Empirical Test Based on the Bhaduri-Marglin Model* Ozlem Onaran and Engelbert Stockhammer

Introduction This chapter aims at clarifying the macroeconomic effect of changes in functional income distribution empirically for a range of developed and developing countries. In doing so, our goal is to discuss the crucial policy issues related with neoliberal policies in the developing, as well as developed countries in the post-1980 era; by focusing o n the effects of distributional policies we seek to contribute to the explanation of the reasons for the stagnant accumulation and employment growth rates. Both the structural adjustment agenda in the developing countries, and the debate about the European u n e m p l o y m e n t have been cases where mainstream economics has pushed for policy changes favouring a procapital redistribution of income, and a deregulation of the labour * This chapter puts together the empirical conclusions of two previous papers by the authors, and improves on the theoretical and political implications of the findings. Several findings, indicated in the text are reprinted from Structural Change and Economic Dynamics, vol. 15, Stockhammer, E. and Onaran, O. 'Accumulation, distribution and employment: a structural VAR approach to a Kaleckian macro model', 421-47, copyright© 2004, with permission from Elsevier, and from Emerging Markets Finance and Trade vol. 41, Onaran, O. and Stockhammer, E., 'Two Different Export-Oriented Growth Strategies: Accumulation and Distribution in Turkey and South Korea,' no. 1, 65-89, copyright© 2005, with permission from M.E. Sharpe, Inc. At several stages, we have benefited from comments by Eckhard Hein, Amit Bhaduri, Philip Arestis, and the fruitful discussions in the Eighth Workshop on 'Wages, Distribution and Growth' of the Research Network 'Alternative Conceptions of Macroeconomic Policies under the Conditions of Unemployment, Globalization and High Public Debt', Berlin, 29-30, October 2004. 206 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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9

market. For neoclassical economics unemployment is, in the last instance, a labour market phenomenon. It is due to 'too high' real wages, which in turn are a result of so-called labour market 'distortions', like labour market regulations and trade unions. In contrast, PostKeynesians argue that unemployment is the result of demand deficiencies on the goods markets, and that the latter result particularly from a slowdown in investments. The resolution of this controversy requires the test of the dynamic interaction between distribution, accumulation, growth and employment. For this purpose, in this study a Kaleckian-Post-Keynesian macroeconomic model, which is an extended version of the Bhaduri and Marglin (1990) model, serves as the starting point. The merit of a Kaleckian model for our purposes is that it highlights the dual function of wages as a component of aggregate demand as well as a cost item, as opposed to mainstream economics which perceives wages merely as a cost item. Depending on the relative magnitude of these two effects, Kaleckian models distinguish between profit-led and wage-led regimes, where the latter is defined as a low rate of accumulation being caused by a high profit share. Allowing for capacity utilization to vary in these models gives rise to the possibility of a wage-led regime, that is a higher rate of accumulation as a result of an increase in the wage share, if the demand effect on investment is stronger than the profit effect. Which regime prevails in a certain economy is an empirical question. Are actual economies wage-led or profit-led? Current orthodoxy implicitly assumes that they are profit-led, and thus supports the neoliberal policy agenda. The purpose of the chapter is to carry this discussion into the empirical terrain, and to test whether accumulation and employment are profit-led in two groups of countries. We do so by means of a structural vector autoregression (SVAR) model. The model is estimated for USA, UK and France to represent the major developed countries, and for Turkey and Korea to represent developing countries. The latter are chosen since they represent two different export-oriented growth experiences. The results of the adjustment experiences of both countries are in striking contrast to orthodox theory, however, they also present counter-examples to each other in terms of their ways of integrating into the world economy. Thereby, they provide examples for comparing different economic policies among the developing countries as well. The rest of the chapter is organized as follows. The next section introduces the theoretical Kaleckian-Post-Keynesian model. This is followed by a brief discussion of the estimation method and presents the hypotheses to be tested by the empirical analysis. We then summarize the

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Ozlem Onaran and Engelbert Stockhammer 207

208 Do Profits Affect Investment and Employment?

The model For analysing the dynamic effects of distribution on growth, accumulation and employment in these two groups of countries, we utilize a postKeynesian open economy model, which is an extension to the model of Bhaduri and Marglin (1990). We augment the goods market block of this model by a demand-driven labour market, a reserve army effect in the Marxian sense, and technological change. Table 9.1 is a summary of this linear open economy model. The model developed by Marglin and Bhaduri (1990) is a more general formulation of earlier neo-Kaleckian models by Rowthorn (1981), Dutt (1984), Taylor (1985) and Blecker (1989), and allows for profit-led as well as for wage-led growth regimes.1 This generality borrows itself to the decomposition of the profit rate (r) into the profit share (TT), capacity utilization (z) and (technical) capital productivity (k):

r= =

i fll = 7rz/c

(91)

Then, for the sake of simplicity, assuming that technical capital productivity is constant, the rate of accumulation (g{), which is the ratio of new investment to the stock of capital (£), can be formulated as a function of the past values of the profit share (IT), and capacity utilization (z), which constitute the current expected rate of profit. Equation (9.2) in Table 9.1 presents an extended linear version of this accumulation function, where the effect of productivity growth on investment is also incorporated. The goods market part consists of behavioural functions for accumulation, savings and net exports. This part is then complemented by a distribution function, a labour productivity function and an unemployment function. Equation (9.3) in Table 9.1 is a simple Cambridge savings function, where the ratio of domestic savings to capital stock is a function of capacity utilization and income distribution, that is the profit share. Assuming that workers have a lower marginal propensity to save than capitalists, b 2 is positive and measures the differences in savings propensity between profit incomes and wage incomes. Equation (9.4) in Table 9.1 incorporates international trade focusing on the effect of distribution and growth on net exports, leaving the other crucial variable of an open economy outside the model. Profit 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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estimation results for developed and developing countries respectively, followed by our conclusions, as well as open questions and challenges for future research, with a discussion of policy implications of the results.

Ozlem Onaran and Engelbert Stockhammer 209 Table 9.1 Summary of the model i

^

gt = Y

= a

+ UlZt l + ai7Tt 1 +

°

~

a x

&^

(9.3) Cambridge Savings equation (9.4) Net exports (9.5) Income distribution (9.6) Employment (9.7) Productivity growth

gXt = T0 + T& + T2Zt

£

accumulation (growth of capital stock) domestic savings / capital stock capacity utilization (capital productivity) profit share net exports (normalized by capital stock) unemployment rate productivity growth

™Sdomestic

Z 77

nx u g* All coefficients are positive numbers

=

^

-

^domestic

+

^ ^

nxt = -h1zt + h2irt 7rt = d0 + dxzt + d2ut + d?gxt ut = n- exgt -e2Azt - e37rt + e 4 u t _i + esgxt

Notes: See Stockhammer and Onaran (2004) for a detailed discussion of the theoretical background.

share is inversely related to unit labour costs. Accordingly net exports (again normalized by capital stock) are a positive function of the profit share and a negative function of capacity utilization (since imports are a positive function of the domestic demand). The fifth equation in Table 9.1 models the distribution of income as a positive function of capacity utilization via pro-cyclical mark-up, a positive function of the unemployment rate (u), reflecting labour's bargaining position via the Marxian reserve-army effect, and finally the growth of labour productivity. The latter will positively affect the profit share if wages are imperfectly indexed to productivity growth. Equation (9.6) in Table 9.1 models the labour market. Unemployment is a negative function of output, thus the change of capacity utilization and the growth of capital stock. Next, if the cost of labour is important for labour demand, as the neoclassical theory would suggest, the profit share (being inversely related with the real wage, after controlling for productivity) is expected to have a negative effect on unemployment. Unemployment will also depend on past unemployment via a hysteresis effect. Finally, if technological change is not accompanied by a growth in demand, the growth of labour productivity could lead to an increase in unemployment. The constant, e0f captures labour supply shocks. Finally, equation (9.7) in Table 9.1 models the growth of labour productivity (x) as determined by accumulation and capacity utilization. Exogenous technical progress is captured by the constant term, r0. 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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(9.2) Accumulation

210 Do Profits Affect Investment and Employment? The goods market equilibrium is determined by investment being equal to total domestic and foreign savings, that is: /g o\

Capacity utilization implied by the goods market equilibrium can be written as:

b1 + h1

[gt + (h2 - b2)7Tt]

(9.9)

The effect of an increase in the profit share on capacity utilization is indeterminate, and will depend in the medium run on the relative responsiveness of consumption and investment to profits. Contemporaneously as well, this effect, thus the sign of %, will be indeterminate. If exports react strongly to the profit share, whereas domestic consumption decreases only mildly, (i.e. domestic savings increase mildly), then Jf > 0. Such a growth regime is called exhilarationist. Whereas if savings differentials are large compared to the net export effect of the profit share, then % < 0, and the regime is called 'stagnationist' (Bhaduri and Marglin 1990). However, when the lagged effects through investment also kick-in in the longer term, the overall effect of profit share will depend on the relative magnitude of its positive direct effect on investment, the positive international demand effect, and the negative effect on domestic consumption. Finally substituting (9.7) and (9.9) into (9.2), we get accumulation as a function of distribution: _, (ax + a5r2 \r gt = a0 + a5r0 + \ h + h + <*sTiJgt-i + \a2 + ax{\ + asr2) h z h y ^

(9.10)

Again here the effect of the profit share on accumulation, idgl/dir^), can be decomposed to the direct positive effect of the profit share on accumulation (the partial dgl/di:^^ a2), the positive international demand effect ((a_-//dzt_!) x (dz^Jdnx^) x (dnx^j/dn^) = (a 3 (l + a5T2)fr2)/ (fri+^i)) anc * the negative domestic consumption effect ((dgl/dzt-i) x {dzt_1ldi:t_l) = (-«i(l+a5T2)^2)/(^i+^i)). Depending on the relative magnitudes of these effects, an increase in the profit share leads either to an increase in accumulation, in which the regime of accumulation is profitled, or to a decrease, i.e. to a wage-led regime of accumulation.

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pi _ ^Stotal _ ^Sdomestic _ ^.y

Ozlem Onaran and Engelbert Stockhammer 211

The main methodological motivation behind this study is to model the dynamic relationship between distribution, accumulation, capacity utilization and employment considering b o t h lagged and contemporaneous interactions within a systems approach that goes beyond the limited framework of comparative statics. The existing empirical contributions in the literature about the effect of distribution o n accumulation, growth and employment do not address the issue of simultaneity

Table 9.2 Hypotheses HI

Demand-led labour market

H2 The effect of distribution on growth

- ^ < 0; - ^ < 0 dz *

Goods market determines labour market

-^ = ? d7r

Is accumulation wage-led or profit-led?

dir .

H3 Reserve-army effect du

>0

dir

Unemployment lowers wages Productivity increases do not lead to equivalent wage increases

H4 Imperfect wage indexation

dgx

H5 Technological unemployment

j du ^- > 0 %x

Productivity increases cause unemployment

H6 Neoclassical labour market

dir

du <0

Wage decrease increases employment

H7

dgX

<0

Increase in wages leads to substitution of labour with capital, which in turn increases productivity

>0

An increase in net exports leads to an increase in accumulation

>0

Lower unit labour costs, i.e. a higher profit share, increase international competitiveness

<0

Exports increase the labour demand

Substitution

dir

H8

Export-led accumulation

dnx

H9 Profit-led exports

^

H10 Export-led employment

dnx

dU

>0

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Empirical m e t h o d o l o g y a n d hypotheses

(for developed countries see Bowles and Boyer 1995; Gordon 1995a, 1995b; Hein and Kramer 1997; Bhaskar and Glyn 1995; Stockhammer 2004a, 2004b; Hein and Ochsen 2003; for developing countries see Yenturk 1998; Onaran and Yenturk 2001; Seguino 1999; Sarkar 1992). To overcome this shortcoming we employ a structural vector autoregression (SVAR) analysis which incorporates the contemporaneous interaction as well as the lagged relationship. SVAR helps to capture the complex simultaneous interaction between distribution, accumulation, growth and employment, and the system aspect that is crucial to the theoretical model. The VAR model allows past values of all variables to influence present values of any variable. Thus, results that are not in accordance with the structural model outlined above are possible due to lagged effects. The structural model provides the motivation and shapes the interaction of the contemporaneous effects only. Thus it will be useful to summarize the hypotheses to be explored empirically. The first five hypotheses summarized in Table 9.2 follow directly from the model presented above. Hypotheses six and seven are standard theses of the neoclassical theory about the labour market. Hypotheses eight-ten are related to the typical policy recommendations of the neoliberal structural adjustment programmes, particularly in developing countries. All the effects discussed above (except H2) are partial effects. The VAR framework used does not distinguish between partial and total effects, but gives the effects at different points in time. Only the estimated contemporaneous effects are clearly partial effects. We will interpret the effects in the first two or three periods as partial effects in the short run, but also discuss the longer term effects, wherever significant. Summary of the results for developed countries The advantages of VAR models, unfortunately, come with a disadvantage: Given the lagged structure that incorporates the dynamic effects to the estimation, it requires a long-enough time series. For a given length of time-series data, the implication is a limit on the number of variables that can be included into the system. This limit leads to differences in the specifications for developing and developed countries. In the case of the developed countries, the focus is on the interaction between the labour market and the goods market. However, the foreign trade is not modelled explicitly. Nevertheless, the estimated coefficients and impulse responses of the profit share on capacity utilization (and of course other variables) will include indirect effects via export demand.

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212 Do Profits Affect Investment and Employment?

Moreover, shocks to capacity utilization do include shocks coming from fiscal policy, monetary policy and the foreign sector; in fact they include all shocks to effective demand other than investment. The SVAR system estimated consists of accumulation (of the business sector), capacity utilization (output gap), the profit share (of the business sector), the growth rate of labour productivity and the unemployment rate.2 The model is estimated for the periods 1970:1-1997:2, 1966:1-1997:2, and 1972:1-1997:1 for the UK, the USA and France respectively, based on semi-annual data. The different periods are due to data availability. The VAR is estimated with four lags. The results of the response by various variables as a result to shocks to the relevant variable in the hypothesis to be tested (impulse response analysis) are summarized in Table 9.3. A more detailed technical discussion can be found in Stockhammer and Onaran (2004). The Keynesian-Kaleckian model performed fairly well, and in line with the theoretical model; strong support is found for the demand-led labour market hypothesis. The goods market variables play a strong role in determining unemployment, and shocks to accumulation as well as capacity utilization have statistically significant negative effects on the rate of unemployment. How long these effects last differs across countries. Distribution seems to play little role in determining goods market outcomes. None of the effects in the impulse responses were statistically significant. The result may be due to offsetting effects of profitability and demand, which would be consistent with the theoretical framework. However, this also might be suggesting a theoretical challenge about the role of profit share in investment models. We will discuss more on this issue in the next section. We found no evidence for the reserve-army effect. A shock to unemployment has little or no effect on the profit share. Only in the UK was there a positive effect, but not statistically significant. This finding is not consistent with the literature, and may be due to the generous lags of the dependent variable. A shock to productivity growth has a statistically significant positive effect on the profit share in the USA and France. So wages are not perfectly indexed. An innovation to labour productivity growth also has a significant and upward impact on unemployment in all countries, and, in fact, rather persistently so. Thus technological development does not automatically generate demand, and can lead to technological unemployment. Weak or no evidence was found for both of the neoclassical labour market hypotheses. In France and the UK, a shock to the profit share

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Ozlem Onaran and Engelbert Stockhammer 213

214 Do Profits Affect Investment and Employment?

UK HI Demand-led market Yes. H < 0 and H < 0 g and z, Both sig. or close to sig. H2 Distribution-led No effect, regimes Insig.

USA

France

Yes. Both g and z sig.

Yes. Both g and z sig.

Insig. Insig. (g profit-led) (g profit-led) (z exhilarationist) (z stagnationist)

H3 Reserve-army effect g > 0 H4 Imperfect wage indexation | g > 0

Yes. insig. No.

No. No effect Yes. sig. for three periods contemporary effect sig.

No.

H5 Technological unemployment — >0

Yes. Long contemporary effect sig.

Yes. Sig to 6 lags contemporary effect sig.

Yes. Sig to 4 lags

H6 Neoclassical labour market % < 0

No. No effect

Yes. But sig. only after 7 periods

No. Insig.

H7 Substitution — <0

No. Insig. / no effect

No. Insig.

No. Insig.

Yes. Contemporary effect sig.

Note: Sig = statistically significant. Source: Stockhammer and Onaran (2004).

had basically no significant effect on unemployment. Only in the USA, and only after seven periods, a shock to the profit share led to a decline in the unemployment rate. Again, the profit share had no significant negative effect on productivity. Thus the substitution hypothesis was also rejected. Summary of the results for developing countries In the case of the developing countries, that is Korea and Turkey, the effect of international trade on growth and employment on the one hand, and the source of international competitiveness on the other hand are important points of focus for policy analysis. Therefore, we not

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Table 9.3 Summary of impulse responses for the UK, the USA and France

only explicitly model international demand, but also decompose the effect of exports and imports, in order to be able to test widely accepted mainstream policy assumptions regarding export orientation. It is particularly important to highlight the opposite effects of different exportoriented growth strategies on distribution and employment: decreasing wage share, low growth, low investment, low employment in Turkey and increasing wage share, high growth, high investment, high employment in South Korea. The inclusion of the international trade block came at the cost of excluding the explicit modelling of productivity change. The effects of changes in productivity can only be interpreted as exogenous shocks. Moreover, due to data limitations, several proxies had to be used instead of the variables in the theoretical model. Second, since the agricultural sector follows a completely different pattern, particularly in terms of labour demand, where unpaid family work and self-employment is important, and can lead to significant rates of disguised unemployment, we estimate the model as a whole for the non-agricultural economy. However, then it is very hard to measure the non-agricultural unemployment or employment rate due to problems in anticipating the sector specific labour supply. As a result we simply use the employment level in logarithms to model the labour market block. Accordingly, the SVAR system estimated consists of investment/GDP instead of accumulation, growth instead of capacity utilization, the profit share, and the logarithm of employment (all variables for the non-agricultural sector). The model is estimated for the periods 1972-2000 for Korea, and 1965-97 for Turkey, based on available annual data. The VAR is estimated with two lags. The results of the response by various variables as a result of shocks to the relevant variable in the hypothesis to be tested (impulse response analysis) are summarized in Table 9.4. A more detailed technical discussion can be found in Onaran and Stockhammer (2005). The results also show that demand is the main driving force behind employment, and accumulation is an important component to enhance the job-creation capacity of the economy. Moreover, the employment regime is not profit-led, and quite on the contrary to the arguments of neoclassical economics, it decreases with a decrease in the wage share. In South Korea the wage-led employment pattern is more evident, whereas in Turkey the cumulative negative effect dies away after five periods. This can be explained by the effect of the profit share on demand. In Turkey an innovation to the profit share creates a negative response of the investment rate in the next period, and the shock continues for

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Ozlem Onaran and Engelbert Stockhammer 215

216 Do Profits Affect Investment and Employment?

South Korea

Turkey

Demand-led labour market g < 0 and — <0 H2 Distribution-led regimes

Yes. g and z both sig.

Yes. g and z both sig.

g wage-led z significantly stagnationist

H3

Yes. Sig. even in long run No. Contrarily, positive effect Yes. Sig. strong persistent

insig. (g slightly wage-led in the second period) (z in the first two periods significantly stagnationist) Yes. Sig for six periods No. Contrarily, positive effect for 4 periods No. Slightly significant only after 6 periods Yes. Sig. Persistent and strong positive effect No. Sig. persistent and strong negative effect

HI

Reserve-army effect % > 0 H6 Neoclassical labour market % < 0 H8

Export-led accumulation

H9

Profit-led exports

H10 Export-led employment

No. Positive but insig. Yes. Sig. persistent and strong positive effect

Note: sig. = statistically significant.

another period, and then dies out without leading to any significant improvement in investment. In South Korea an increase in the profit share creates a strong and persistent negative effect o n accumulation. Regarding the effects on capacity utilization, an increase in the profit share is immediately transformed into a decline in growth, indicating a stagnationist regime in b o t h countries in the short run. The recovery of the growth rate is due to the improvements in exports. However, in Turkey it takes rather long - three periods - for the positive effect of increased exports to lead to a recovery, and in South Korea the recovery does not take place at all. Reflecting the crucial differences in the design of export-oriented growth strategy in the two countries, in South Korea the response of the investment rate to international competition is very strong and persistent, whereas in Turkey the response hardly shows u p with a lag of three years and is never too strong. Also in Turkey exports increase w h e n unit

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Table 9.4 Summary of impulse responses for South Korea and Turkey

labour costs decline (that is, a positive response of exports to profit share), and thus when domestic demand contracts. However in South Korea, a shock to the profit share has no significant effect on exports. Turkey's export growth based on low wages and increased use of existing capacity rather than new investments proves to be unable to stimulate investments, whereas in South Korea export competitiveness is the primary stimulus behind investment decisions of firms. In Turkey, investments are stimulated by domestic demand, whereas in South Korea exports are even more important than domestic demand. In South Korea, exports are a systematic target of industrial policy, and competitiveness is based on improvements in productivity. The consequence of this striking difference in the export-oriented growth strategies shows up also in the labour demand. The response of employment to an increase in exports is persistently negative in Turkey, whereas it is strongly and persistently positive in South Korea. This result points at a very important policy implication indicating that the increase in competitiveness, which is maintained by low wages, does not transform into higher employment. Another important implication of the results for Turkey is that they provide counter-evidence to the expectations about an increase in labour intensity of production following an increase in export orientation. Finally, although distribution does not immediately adjust to changes in labour-market conditions in the model, the lagged effects are significant and in the expected direction according to the reserve army theory. Conclusions and challenges for future research The results indicate that the Kaleckian model overall performs well; estimations are mostly according to the predictions of the model, although within large confidence intervals. The Keynesian and Kaleckian hypotheses about the labour market are confirmed: Accumulation and capacity utilization/growth have a strong impact on employment. Goods market variables have a strong impact on unemployment and the economy is driven by investment expenditures; accumulation also impacts strongly upon capacity utilization. The neoclassical hypotheses of the labour market are not validated. There is little evidence of employment reacting to wages (profit share), and no evidence for substitution. The ineffectiveness of labour costs on employment does not differ much between developed vs. developing countries; the only difference is that in the latter there is even a negative response of employment to a decline in the wage share. The findings also suggest that

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Ozlem Onaran and Engelbert Stockhammer 217

productivity growth does play an important role. It is not distributionally neutral and causes unemployment. However, the results also point at some challenges for the model. No statistically significant effect of the 'profit share' was found on investment and growth in developed countries, as well as in one of the developing country cases, Turkey (apart from the slightly significant but very small effect in the second period). There is basically no result in terms of the Kaleckian distinction of wage-led vs. profit-led regimes for a wide range of different countries, and it also is not easy to generalize that developing countries tend to be more wage-led just based on the Korean case. Are the international demand and profitability effects, on the one hand, and the domestic demand effect, on the other hand, exactly offsetting each other in all the other countries that we studied? Although that is theoretically possible, it is not likely in the VAR setting, particularly because there would be some inter-period differences in the way the lagged effects operate through different channels, and it is unlikely that there is no period where there is a significant effect. It is also interesting that this is the case for many different countries. The next question is whether the 'profit share' is an appropriate measure for income distribution. At the conceptual level it is useful, because it serves the dual task in the model as a proxy for wages in the distribution and savings functions, and a proxy for profits in the investment function. However, there may be measurement problems. First there is the issue of taxes. The savings differential through which the profit share is expected to affect consumption, works through net income, i.e. post-tax income, whereas the profit share measures pre-tax income distribution. The same is true for the profit share effect on labour demand. If there are significant changes in the tax wedge between posttax wages and gross compensation, the profit share might be a bad proxy. However, since tax structures change slowly, it would be surprising, if this problem dominated the VAR estimations. Second, profit is value added minus labour compensation. Thus it includes the income of selfemployed, whereas wage payments to management are counted as wages. Although these are important concerns, clearly the profit share is statistically negatively (and significantly) correlated with real wage. Thus the profit share variable is certainly not dominated by noise due to measurement errors. Finally, the results bring up the question whether the model is looking at the right variables. Are other factors affecting investment, such as expectations, financial structure, state policies and institutions, more important? Although the wage-led accumulation regime scenario and

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218 Do Profits Affect Investment and Employment?

the effect of demand on accumulation explain part of this story, there certainly are more to that in explaining the striking difference in investment rates between these countries. Within the institutional and class structures of these economies, there are many factors that determine accumulation other than demand and distribution. The limit of the VAR framework is that with generous lag structures the number of variables that can be incorporated is restricted due to a lack of degrees of freedom. However, the limits are also related to the difficulties in quantifying institutional structures. For example, within a business environment created by active state policies there was a virtuous cycle of an increasing wage share, high investment, high productivity and high growth in South Korea, as opposed to the Turkish case with the vicious circle of a decreasing wage share, low growth, low investment and low productivity. Unfortunately, it is difficult to model and test the complicated role of the state's economic and specifically industrial policy by adding simple and measurable variables. State expenditures would be too coarse a measure, because the policy aspect lies in the details of these budgetary expenditures that even go beyond the composition between current vs. investment expenditures, such as subsidy and incentive structures. Similarly the multi-foreign exchange system for different industries and even firms in Korea cannot simply be captured by the rate of depreciation of the official exchange rate. Such complexities make it hard to carry the institutional information into the time series framework. The incorporation of the financial would also improve the model. Unfortunately, not only the limitations of SVAR, but also limitations regarding the data to measure these effects related to financial variables and expectations, leave these crucial aspects unexplored. Real interest rates were completely insignificant in the estimations; obviously they were unable to capture the full complexity of the structural change in the financial system and the role of the institutions for the cases we studied. We also experimented with the specifications including inflation and the change in inflation to reflect the macroeconomic environment. Again, no major changes in the impulse responses occurred, though, unsurprisingly, confidence intervals increased. The complicated link between the wage share and investments could to some extent be uncovered with a model that decomposes the wage share into real wages and productivity. Such an analysis could provide an insight in how wage bargaining, investments and technological change interfere.

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Ozlem Onaran and Engelbert Stockhammer 219

220 Do Profits Affect Investment and Employment?

Important policy implications follow from the results. If we turn around the result about the ineffectiveness of distribution on accumulation and employment, we can conclude that actual economies are 'not profit-led'. Thus, a pro-capital incomes policy is neither a necessary nor a sufficient condition to achieve higher accumulation and growth. On the contrary, the decline in domestic demand can have detrimental effects on the long term growth potential of the economy. Secondly, demand is the driving force behind employment. The increase in competitiveness, which is maintained via wage suppression, does not necessarily transform into higher employment. The limits in creating employment via low wages and a growth regime based on the use of existing capacity rather than new investments point out the significance of active policies to stimulate accumulation. This alternative line of economic policy necessitates a different perspective on international competitiveness, which is based on enhancing productivity. Moreover, if distribution is neutral with respect to investment, then there is room for egalitarian redistribution policies, without harming the growth potential of the economy. In terms of the development agenda, the responses of accumulation, growth and employment to distribution are suggestive in explaining some crucial aspects of the mechanism behind the inability of orthodox, market-based, export-oriented growth strategies relying on decreasing wage shares to stimulate accumulation and employment. The centrality of demand and the inability of low wages as a policy tool to stimulate investment point at important policy lessons for the design of an alternative export-oriented growth strategy. Clearly, institutional settings and state policies matter more than distribution in achieving a high, investment and productivity-led export performance. Obviously, the neoliberal reader could think that state policies were at the heart of the structural problems of the Korean economy, that resulted in overinvestment in sectors with falling profit rates. However, these state policies led to unforeseen growth rates, and the need of the Asian model was to revise its state industrial policies, and not to abolish them. Speculating more on the design of the relevant industrial policy tools is beyond the scope of this chapter, however, there are more policy issues that should be addressed. Are such policies available simultaneously to all developing countries trying to compete for a limited global market? Obviously that brings in the questions about the design of a new international system targeting

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Policy implications

at coordinated and expansionary macroeconomic policies, which would benefit not only the developing but also developed countries. Although the existing balance of power relations between the multinationals dominating the world markets and the working masses of the world, an alternative international macroeconomic policy seems quite unachievable even in the context of EU, which is claiming to be not only an economic but also a political union. The neo liberal policies representing the interests of the firms, preventing any coordinated policy, which could target demand management is hiding behind the discourse of market efficiency and anti-inflation targets. Although the global chorus of neoliberalism ranging from academics to central bank experts is repeating the need for tight fiscal and monetary policy, we still conclude by repeating the need for a coordinated international expansionary macroeconomic policy. Notes 1 See Blecker (1999) for a discussion of the extension of the model to the open economy and Blecker (2002) for a review of other possible extensions to neoKaleckian models. 2 A series of tests was performed to ensure the robustness of the results. First, it was checked whether the results were sensitive to variable specification. The profit share of the total economy was used instead of the profit share of the business sector. The employment share (employment divided by working-age population) was used instead of the unemployment rate. Instead of the output gap, detrended capital productivity and GDP growth were used. In neither case were there major changes in the results. References Bhaduri, A. and Marglin, S. (1990) 'Unemployment and the Real Wage: The Economic Basis for Contesting Political Ideologies', Cambridge Journal of Economics, 14: 375-93. Bhaskar, V. and Glyn, A. (1995) 'Investment and Profitability: The Evidence from the Advanced Countries', in G. Epstein and H. Gintis (eds), Macroeconomic Policy After the Conservative Era. Studies in Investment, Saving and Finance (Cambridge: Cambridge University Press): 175-96. Blecker, R. (1989) 'International Competition, Income Distribution and Economic Growth', Cambridge Journal of Economics, 13: 395-412. Blecker, R. (1999) 'Kaleckian Macromodels for Open Economies', in J. Deprez and J.T. Harvey (eds), Foundations of International Economics: Post Keynesian Perspectives (London, New York: Routledge): 116-49. Blecker, R. (2002) 'Distribution, Demand and Growth in neo-Kaleckian MacroModels', in M. Setterfield (ed.), The Economics of Demand-led Growth (Cheltenham, UK: Edward Elgar): 129-52. Bowles, S. and Boyer, R. (1995) 'Wages, Aggregate Demand, and Employment in an Open Economy: An Empirical Investigation', in G. Epstein and H. Gintis

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222 Do Profits Affect Investment and Employment?

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(eds), Macroeconomic Policy After the Conservative Era. Studies in Investment, Saving and Finance (Cambridge: Cambridge University Press): 143-71. Dutt, A. (1984) 'Stagnation, Income Distribution and Monopoly Power', Cambridge Journal of Economics, 8: 25-40. Gordon, D. (1995a) 'Growth Distribution, and the Rules of the Game: Social Structuralist Macro Foundations for a Democratic Economic Policy', in G. Epstein and H. Gintis (eds), Macroeconomic Policy After the Conservative Era. Studies in Investment, Saving and Finance (Cambridge: Cambridge University Press): 335-83. Gordon, D. (1995b) 'Putting the Horse (back) Before the Cart: Disentangling the Macro Relationship between Investment and Saving', in G. Epstein and H. Gintis (eds), Macroeconomic Policy After the Conservative Era. Studies in Investment, Saving and Finance (Cambridge: Cambridge University Press) 57-108. Hein, E. and Kramer, H. (1997) 'Income Shares and Capital Formation: Patterns of Recent Developments', Journal of Income Distribution, 7(1): 5-28. Hein, E. and Ochsen, C. (2003) 'Regimes of Interest Rates, Income Shares, Savings and Investment: A Kaleckian Model and Empirical Estimations for Some Advanced OECD-Economies', Metroeconomica, 54(4): 404-33. Marglin, S. and Bhaduri, A. (1990) 'Profit Squeeze and Keynesian Theory', in S. Marglin and J. Schor (eds), The Golden Age of Capitalism. Reinterpreting the Postwar Experience (Oxford: Clarendon Press): 153-86. Onaran, 6. and Stockhammer, E. (2005) 'Two Different Export-oriented Growth Strategies: Accumulation and Distribution in Turkey and South Korea', Emerging Markets Finance and Trade, 41(1): 65-89. Onaran, O. and Yenturk, N. (2001) 'Do Low Wages Stimulate Investments? An Analysis of the Relationship between Distribution and Investments in Turkish Manufacturing Industry', International Review of Applied Economics, 15(4): 359-74. Rowthorn, R. (1981) 'Demand, Real Wages and Economic Growth', Thames Papers in Political Economy. Autumn: 1-39, reprinted in Studi Economici, 1982 (18): 3-54. Sarkar, P. (1992) 'Industrial Growth and Income Inequality: An Examination of "Stagnationism" with Special Reference to India', Journal of Quantitative Economics, 8(1): 125-38. Seguino, S. (1999) 'The Investment Function Revisited: Disciplining Capital in South Korea', Journal of Post Keynesian Economics, 22(2): 313-38. Stockhammer, E. (2004a) The Rise of Unemployment in Europe. A Keynesian Approach (Northampton: Edward Elgar). Stockhammer, E. (2004b) 'Explaining European Unemployment: Testing the NAIRU Theory and a Keynesian Approach', International Review of Applied Economics, 18(1): 3-24. Stockhammer, E. and Onaran, O. (2004) 'Accumulation, Distribution and Employment: A Structural VAR Approach to a Kaleckian Macro Model', Structural Change and Economic Dynamics, 15: 421-47. Taylor, L. (1996) 'Stimulating Global Employment Growth', in J. Eatwell (ed.) Global Unemployment. Loss ofJobs in the 90s (Armonk, NY: M. E. Sharpe), 147-72. Yenturk, N. (1998) 'Ajustement et accumulation: la Turquie', Canadian Journal of Development Studies, xix (1): 55-77.

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Class Conflict and the Cambridge Theory of Income Distribution* Thomas I. Palley

Why the interest in income distribution? Understanding the determination of income distribution is a central concern of economics. Ricardo regarded it as the central issue of economics, writing that '(determining) the laws which regulate this distribution is the principal problem in political economy' (Ricardo 1821: 5). Income distribution is clearly an important social and political concern, having ramifications for fairness and the social and political stability of society. How we explain income distribution also has major implications for how we understand the economy, thereby impacting attitudes and approaches to policy. The dominant approach to income distribution is marginal productivity theory, which emphasizes demand and supply for factors of production. The determination of income distribution is therefore part of the working of the price system. Distribution is determined by competitive market forces that ensure factors are paid their contribution to production, and the process of determining factor prices in turn links the determination of factor employment. The theoretical implication is that there is no ethical basis for intervention as competitive markets bar exploitation and ensure factors are paid what they are worth. Indeed, intervention stands to distort the market process, creating unemployment and reducing welfare. The marginal product approach to income distribution sanitizes the economy of conflict and the need for intervention. Other theories of * This chapter originally appeared as 'Class Conflict and the Cambridge Theory of Distribution,' in B. Gibson (ed.), The Economics of Joan Robinson: A Centennial Celebration, Cheltenham: Edward Elgar, 2005. My thanks to Edward Elgar for permission to reprint the material. 223 10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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10

income distribution have dramatically different implications, yet they are neglected and even suppressed within modern economics. Why that is so is an interesting question in itself. The current chapter expands the Cambridge theory of income distribution, which is a Keynesian theory in which income distribution is determined macroeconomically by the forces of aggregate demand (AD) rather than the price system. The chapter expands the Cambridge approach to incorporate labour market conflict. The Cambridge theory was developed by Kaldor (1956), and its key insight concerns the role of aggregate demand (AD) in determining income distribution. The core idea is that AD needs to adjust to the level of full employment output, and this is accomplished by adjustment in the pattern of income distribution. Pasinetti (1962) subsequently introduced class into the analysis, distinguishing between capitalists' and workers' income shares and the AD impact of their differential propensities to save. However, though adding class to the determination of income distribution, Pasinetti's model is strangely devoid of class conflict in the traditional Marxian sense - that is, class conflict centred on the labour market and bargaining strength. In Pasinetti's framework class enters through behavioural propensities, with the propensity to save differing across classes. This chapter joins this behavioural propensity channel with traditional labour market class conflict. The balance of the chapter is as follows. The next section describes the sociological structure of the economy and its relation to income distribution. I then recapitulate the Cambridge Post-Keynesian (CPK) theory of income distribution, and describe the Kaleckian extension of the CPK approach that includes less than full employment outcomes. The fifth section incorporates labour-market class conflict into the extended Kaleckian CPK model, followed by a comparative statics and stability analysis. The issue of ownership and its relation to income distribution is introduced, and a final section concludes the chapter. Structure of the model The key analytic contribution of the chapter is to distinguish the income distribution effects of labour market conflict from those of product market competition. Kaleckians have always recognized the significance of both labour market conflict and product market competition, but these two forces have been lumped together under the 'degree of monopoly'. The logic by which the chapter disentangles labour market and product competition effects is illustrated in Figure 10.1, which

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224 Class Conflict and the Cambridge Theory of Income Distribution

Thomas I. Palley 225

National Income

i f

v

Wages

Profits

i

1

r

Workers' wages

r

V

v

V

Manager-capitalists' wages

Distributed

1

\r

Retained

v V

Dividends paid to workers

v Dividends paid to manager-capitalist

Figure 10.1 The national income tree shows the national income tree. National income consists of wages and profits. Wages are in turn paid to workers and managers. The latter are also identified as capitalists. Profits are partly retained by firms, and partly distributed as dividends to shareholders. Dividends are in turn shared between workers, who have part-ownership, and managercapitalists who own the rest of the firm.1 The chapter treats the division of income between wages and profits as being primarily influenced by the extent of product market competition, while the division of the wage bill is determined by labour market bargaining power. The model makes several important theoretical innovations. First, it introduces managerial pay, an area that has taken on great significance with the Chief Executive Officer (CEO) pay and share-option explosion of the last 20 years. Second, the concern with distribution of the wage bill introduces a second margin for income distribution effects, supplementing the traditional Cambridge focus on the profit share. Third, the presence of a wage distribution channel means that the economy can simultaneously exhibit 'wage-led' and 'profit-led' tendencies.2 An economy is defined as wage-led if improved income distribution (a lower

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ir

profit share) raises AD: it is profit-led if improved income distribution lowers AD. In standard Kaleckian models of growth and income distribution the economy is either wage-led or profit-led. In the current paper, an economy can simultaneously have both properties. This can be seen as follows. Shifts in the wage distribution from managers to workers, holding the profit share constant, can increase AD so that the economy is wage-led. At the same time, increases in the profit share, holding the wage distribution constant, can increase investment so that the economy simultaneously displays profit-led characteristics. This combination may best describe the US economy.3 At the policy level, the model identifies several margins on the income tree where policy can intervene. A major policy recommendation is that progressive policy focus on the distribution of the wage bill rather than the profit share. Redistributing the wage bill is always expansionary, whereas redistributing the profit share can be contractionary if the economy is profit-led. Second, the model offers insight into the effects of changes in the business sectors' profit retention ratio. The CPK model revisited The CPK approach to growth and distribution was pioneered by Kaldor (1956). The standard short-run Kaleckian macroeconomic model (derived from Kalecki 1942) is characterized by three features: (1) income distribution is exogenously given, (2) income distribution influences AD, and (3) the level of output then adjusts to equal the level of AD.4 Putting the pieces together, the pattern of income distribution therefore influences the short-run level of equilibrium income. Kaldor (1956) reversed this reasoning. Instead of assuming income distribution to be exogenous, Kaldor took output as exogenously given and equal to its full employment level. Given that AD must still equal output, Kaldor argued that in the long run income distribution would adjust. Rather than having output adjust to income distribution, as in the short-run Kaleckian model, income distribution adjusts to ensure a level of AD consistent with full employment income. Assuming a positive propensity to save out of profit income and no saving out of wage income, this gives rise to the famous Cambridge equations for the profit share and profit rate given by: P/Y = I/sPY

(10.1a)

P/K = I/sPK

(10.1b)

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226 Class Conflict and the Cambridge Theory of Income Distribution

Thomas I. Palley 227

Investment share

Figure 10.2 The Kaldor (1956) model

where P = profits, Y = output, I = investment spending, K = capital stock, and sP = propensity to save out of profits. These equations constitute investment-saving balance (IS) equations in which income distribution has adjusted to ensure AD equals full-employment output. The Kaldor model is illustrated in Figure 10.2 which shows the profit share as a function of the investment share. The important feature of Kaldor's analysis is that it examines the special case where the investment share is consistent with full employment output. This investment share is denoted I/Y* in Figure 10.2. Pasinetti (1962) extended Kaldor's model by introducing two social classes - capitalists and workers. Like Kaldor, he too focused on the case of full-employment steady-state growth. The key analytic contribution was to give a class structure to income distribution and savings behaviour. The assumptions of the model are that capitalists receive just profit income, workers receive b o t h profit and wage income, and capitalists have a higher propensity to save t h a n do workers. 5 Given these conditions, Pasinetti shows that the functional distribution of income and the profit rate depended exclusively on capitalists' propensity to save and the level of full-employment investment spending. 6 The equilibrium conditions t h e n get restated as: P/Y = I/sKY

(10.2a)

P/K = I/sKK

(10.2b)

where sK = capitalists' propensity. Pasinetti's result has been the subject of significant attention. The introduction of government saving leaves the result unchanged (Dalziel

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P/Y=l/s„Y

1991); so too does the introduction of life-cycle saving (Baranzini 1982). However, the introduction of financial factors changes the result, and workers' propensity to save matters for steady-state income distribution. Palley (1996a, 2002a) shows that in a world with bank-created inside debt (that is an endogenous money world) workers' saving propensity matters for income distribution. This is because they pay interest on bank loans, which are costless to produce. This interest increases capitalists' incomes, necessitating a reduction in the profit share to maintain a full-employment investment-saving balance. Interestingly, the result does not hold in a loanable funds world in which capitalists make loans in the form of real resources that are transferred to workers. Palley (1997) also shows that in a model with money and an inflation tax, workers' saving also matters because they are taxed disproportionately on their money holdings.

The Kaleckian extension of the CPK model The Kaldor-Pasinetti approach analyses the determination of income distribution under the assumption of full employment. This is a strangely un-Keynesian assumption, since Keynes (1936) took pains to explain in The General Theory that he thought full employment was a special case of classical economics. Several authors (Rowthorn 1982; Dutt 1984, 1990; Lavoie 1995) have contributed to development of a more general Kaleckian model of growth and income distribution that extends the CPK model. The important contribution of these authors is to introduce less than full employment conditions. These extended models involve adding an investment function equation, and a mark-up or real-wage equation. The mark-up and real-wage equations perform identical functions namely determining the profit share. This last feature reveals how Kaleckian models have difficulty distinguishing the income distribution impacts of labour market conflict from those of product market competition. Labour market conflict and product market competition are conflated and work through the mark-up, which impacts the price level, the real wage, and the profit share. The logic of these models is easily illustrated. Let price be a mark-up over average wage costs and given by:

p = [l + m]w/a

(10.3)

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228 Class Conflict and the Cambridge Theory of Income Distribution

Thomas I. Palley 229

P/Y =m/[l + m]

(10.4)

Multiplying by the output-capital ratio yields: P/K = mk/[l + m]

(10.5)

where k = output-capital ratio, which ratio is a positive function of the rate of capacity utilization. In addition, if the mark-up is assumed to be a positive function of capacity utilization and the exogenously given degree of product market competition, the mark-up schedule can be written as: P/K = m(u, c)k(u)/[l + m(u, c)]

mu>0, rac<0, ku>0

(10.6)

where c = degree of product market competition. To this mark-up schedule is added a Kaleckian investment equation given by: I/K = a0 + axu + a2P/K + a3P/Y

av alt a3, a4>0

(10.7)

where u = capacity utilization rate. Investment spending is therefore assumed to be a positive function of capacity utilization (a x > 0), the profit rate (a2 > 0), and the profit share (a 3 >0). There has been much discussion of what constitutes appropriate specification of the investment function (see Lavoie 1995). There are many drivers influencing investment spending. These include capacity expansion, cost reduction, and technology adoption. The Kaleckian equation incorporates variables that legitimately influence all of these drivers. Capacity utilization is directly relevant to the need for capacity expansion; the profit rate affects firms' willingness to adopt new technologies; and the profit share can be thought of proxying for cash-flow effects that have been found to be empirically important in microeconomic firm-level based studies (Fazzari, Hubbard and Petersen 1988). Substituting equation (10.4) into equation (10.7) then yields: I/K = a0 + a\u + a2P/K + a3m(u, c)/[l + m(u, c)]

(10.8)

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where p = price, m = mark-up, w = nominal wage and a = constant average product of labour. In this case, the profit share can be shown to be:

230 Class Conflict and the Cambridge Theory of Income Distribution Now substituting (10.8) into (10.2b) yields: (10.9)

where sK = capitalists' propensity to save. Equation (10.9) is a reformulated IS curve in which investment is endogenous and depends on capacity utilization, the profit rate and the profit share. The full PostKeynesian-Kaleckian growth model consists of equations (10.6) and (10.9). Equation (10.6) is a microeconomic profit-rate equation that is derived from the pricing behaviour and cost structure of firms. Equation (10.9) is the IS schedule. Together equations (10.6) and (10.9) jointly determine capacity utilization, u, and the profit rate, P/K. The model is illustrated in Figure 10.3 which depicts the model in [u, P/K\ space. Equation (10.6), the profit-rate equation, is denoted by MM. Equation (10.9), the investment-saving balance equation, is denoted by IS. The slope of the IS equation in [u, P/K\ space is in principal ambiguous and Figure 10.3 is drawn under the assumption that it is positively sloped. A positive slope requires sK > a2, which is the more likely case given that the link between investment and capacity utilization is empirically weak.7 The mark-up equation, depicted by the MM schedule, is drawn as flatter than the IS schedule reflecting the fact that empirical evidence suggests the mark-up is fairly stable over the business cycle.8 The intersection of the IS and MM schedules corresponds to a [u, P/K\ combination for which the goods market clears (that is, investment-saving balance holds), and for which the profit share and profit rate are consistent with the microeconomic pricing decisions of

IS MM |

P*IK

u

~

Figure 10.3

Capacity utilization

The Kaldor-Pasinetti-Kalecki model

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P/K = {a0 + axu + a3m(u, c)/[l + m(u, c)]}/[sk - a2]

firms. These schedules jointly determine P/K and u. This in turn allows determination of I/K, K/Y and m. Determination of m determines P/Y, which then allows determination of I/Y. Figure 10.3 can then be manipulated to generate some standard Kaleckian comparative static results.9 An increase in capitalists' propensity to save shifts the IS schedule left, lowering the equilibrium profit rate and rate of capacity utilization. An exogenous decrease in the level of competition increases the mark-up and shifts the MM schedule up, lowering the equilibrium profit rate and rate of capacity utilization. In principal, the financial factors alluded to earlier, concerning worker borrowing of inside bank money and the inflation tax, can also be included. These factors affect the IS schedule by impacting overall saving, and they allow financial factors to impact the determination of the equilibrium profit rate and rate of capacity utilization. An increase in worker bank borrowing shifts the steady state IS schedule down, and lowers the equilibrium profit rate and rate of capacity utilization. The reasoning is that workers pay interest on their debts that is distributed to capitalists who own the banks. This raises aggregate saving because of capitalists' higher propensity to save, necessitating a reduction in the profit rate which lowers investment and capacity utilization. Bringing class back to Cambridge Though having a class structure embedded in aggregate demand (the Pasinetti contribution), class conflict in the Kaleckian model is opaque. This is because it is made to operate through the mark-up, which in turn depends on the rate of capacity utilization. However, traditionally, class conflict over income distribution has been thought of as operating through the labour market. One way of introducing labour market conflict is through an Okun's law relationship, whereby there is a monotonic negative relationship between capacity utilization and unemployment. In this case, the rate of capacity utilization can be thought of as proxying for the unemployment rate, so that labour market class conflict operates indirectly through the rate of capacity utilization. This is the approach adopted by Dutt (1992) in a model in which workers' target real wage is impacted by the rate of unemployment. However, this approach effectively conflates capacity utilization and unemployment rate impacts. In effect, worker-firm conflict over wages in the labour market is treated as identical to firm-firm competition over the mark-up in product markets. This is a problem that has always

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Thomas I. Palley 231

been present in the Kaleckian model. Product market competition and labour conflict are distinct economic forces that have differential impacts and work through different channels. The distinction between the profit-wage functional distribution of income and the distribution of wage income, identified in Figure 10.1, provides an avenue for distinguishing between these two effects. The model that is developed below argues that inter-firm competition affects the mark-up and the profit share, while labour market competition affects the distribution of the wage bill across workers and managers. Modelling this requires respecifying the IS relation so that it includes managerial pay. The mark-up side of the model, as represented by the MM schedule, remains unchanged. Analytically, the effect is to introduce labour market conflict into the model via the IS schedule. The logic is that labour market conflict affects the wage distribution, and the wage distribution in turn impacts AD. Finally, in addition to decomposing the wage bill into wages paid to workers and manager capitalists, the model also introduces profit retentions as a way of financing investment. Such retentions have firms saving on their own behalf to finance investment, and it can have important macroeconomic implications - yet, it has traditionally been ignored in Cambridge distribution theory analysis. Aggregate income, wages, profit and ownership satisfy the following adding-up constraints: Y=W

+P

Ww + WK = W

(10.10a) (10.10b)

PW + PK + R = P

(10.10c)

zw + zK = 1

(lO.lOd)

where W = wage bill, Ww = wage bill paid to workers, WK = wage bill paid to manager-capitalists, Pw = profits attributable to workers, PK = profits attributable to manager-capitalists, R = corporate retained profits, zw = workers' ownership share, and zK = manager-capitalists' ownership share. Profits distributed to workers and manager-capitalists are given by: Pw = zw[P-R]

(10.11a)

PK = zK[P-R]

(10.11b)

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232 Class Conflict and the Cambridge Theory of Income Distribution

Note that ownership of the capital stock has a critical impact on distribution by affecting the distribution of profit. This is a feature that has also been ignored in Cambridge models of income distribution, and it is an issue that is discussed further below. To these accounting relations is now added behavioural content. First, the ratio of workers' wage bill to that of manager capitalists is given by: WW/WK = y

(10.12)

y is treated as parametric for purposes of comparative static analysis. In practice, this ratio depends on the state of technology which determines the ratio of non-supervisory to supervisory labour.10 It also depends on bargaining power, union density, workers' militancy, labour market policies concerning employee rights at work, minimum wage laws, unemployment insurance compensation, and the scope of the social safety net. The effect of this distributive parameter is to create a channel for labour market distributional impacts that is separate and distinct from the impact of product market competition on the mark-up. The second behavioural relationship concerns firms' profit retentions. This is assumed to be governed by: R = $(t,a)P

0 < p < l , (3f>0

(10.13)

where p = retained profit ratio, t = dividend tax rate, and a = exogenous shift factor. The level of retentions is a positive function of profits. In addition, the retained profit ratio is positively related to the dividend tax rate, with a higher tax encouraging firms to hold on to profits. The IS schedule for the expanded model is then given by: sw[Ww + Pw] + sK[WK + PK]+R = I

(10.14)

where sw = workers' saving propensity, and R = level of profit retentions. Using the relations given by (10.10a)-(10.10d), (lO.lla)-(lO.llb), (10.12) and (10.13), this IS schedule can be restated as: I/Y= a 0 + nxP/Y

(10.15a)

I/K = n0k(u) + VL^/K

(10.15b)

where fl0 = [swy+sK]/[l+y] andfli = {sw[l-zK] + sKzK + [1 - s ^ l - z ^ ] SKZKW*, a) - [s^r+sJ/[H-y]}. The term [ 1 - s ^ [ 1 - z ^ - s ^ z J attaching

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Thomas I. Palley 233

to /3(£, a) is the net increase in aggregate saving coming from an increase in retained profit. Retained profits increase corporate saving, but they diminish household sector saving by reducing distributed profit income. Substituting equation (10.8), determining the I/K ratio, into (10.15b) then yields an IS schedule in [u, P/K\ space given by: P/K = {a0 + axu + a3m(u, c)]/[l + m(u, c)] - Ci0k(u)}/[Ci0 - a2] (10.16) The critical feature of this IS curve is that it embeds the labour market conflict parameter y, which affects AD. This is consistent with the logic of class conflict affecting AD, and is distinct from product market competition effects on the mark-up and profit share. Note, however, that these product market effects still affect AD through the term a3m{u, c)/[l+m(u/ c)]. This is because investment spending, per equation (10.7), is assumed to be positively related to the profit share. The slope of the IS schedule is ambiguous, and more likely to be negatively sloped if investment is very sensitive to the profit rate (that is, a2 is large). The full model now consists of equation (10.16), describing the IS schedule, and equation (10.6) describing the MM schedule. The general reduced forms for these equations are given by: P/K = M(u,c) P/K = I(a0, alf a2, a3, u, c, sw, sK, y , zK, ~t, a)

(10.17a) (10.17b)

Signs above functional arguments are signs of partial derivatives. The graphical analogue of the model, under the assumption of a negatively sloped IS schedule, is similar to Figure 10.3. Stability analysis, comparative statics and policy The stability of the model is analysed in the Appendix for the case where the IS is positively sloped in [u, P/K] space. The model can be either stable or unstable. Stability is impacted by whether the economy is wage-led or profit-led (see Bhaduri and Marglin 1990). In the profit-led case, capacity utilization increases when the profit rate is above that needed for goods market equilibrium. In the wage-led case, capacity utilization decreases when the profit rate is above that needed for goods market equilibrium. As shown in the Appendix, stability also depends on the relative slopes of the IS (goods market) and MM (mark-up) equilibrium schedules.

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234 Class Conflict and the Cambridge Theory of Income Distribution

Comparative statics yields the following conclusions. An exogenous increase in investment, represented by an increase in the coefficient a0, shifts the IS schedule up. Both the profit rate and capacity utilization rate increase. This is consistent with the standard Keynesian construction of the macroeconomy. Increases in the coefficients alf a2, a3, all of which increase the sensitivity of investment, also shift the IS up and result in a higher profit rate and higher rate of capacity utilization. Increases in the propensity to save of capitalists or workers, sw and sK, shift the IS schedule down. This lowers the profit rate and rate of capacity utilization. Increased saving is therefore contractionary, the standard Keynesian result. Figure 10.4 illustrates the case of an exogenous increase in the level of product market monopoly power (that is, a decrease in c) that raises the mark-up, perhaps brought about by a merger wave. This shifts up both the MM and IS schedules, so that the effect on the profit rate and capacity utilization is ambiguous. Note, the IS shifts up because investment is a positive function of the profit share. If this profit share effect on investment is weak (that is, a3 is small), the upward shift of the IS schedule will tend to be small, and it is more likely that the profit rate and capacity utilization fall. This corresponds to a wage-led construction of the economy, in which worsening of the functional distribution of income lowers AD and economic activity. Alternatively, if the profit share effect on investment is strong (that is, a3 is large), then the IS shift will be large and it is more likely that the profit rate and capacity utilization will rise. This corresponds to a profit-led construction of the

MM' MM

B 2 P*/K CL

Li"

Capacity utilization

Figure 10.4 Ambiguous effect of an exogenous increase in the degree of monopoly power in the Kaldor-Pasinetti-Kalecki model

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Thomas I. Palley 235

236 Class Conflict and the Cambridge Theory of Income Distribution

/ / M M

CD 03

O

P*/K

-•

Capacity utilization

Figure 10.5 Expansionary effect of a redistribution of the wage bill to workers in the Kaldor-Pasinetti-Kalecki model

economy, in which worsening of the functional distribution of income raises AD and economic activity by stimulating investment. Figure 10.5 illustrates the effect in worker bargaining power which raises y and shifts the wage distribution towards workers. This shifts right the IS schedule, leading to an unambiguous increase in the profit rate and capacity utilization.11 Distinguishing the wage share from the distribution of wages is a critical policy distinction. Improving the distribution of the wage bill is always expansionary. This is because it positively impacts consumption, but has no impact on investment since the profit share and profit rate are left unchanged. As such, improving the wage distribution should be the principal focus of progressive macroeconomic policy. In contrast, increasing the wage share can be contractionary if the economy is profit-led in character. Focusing on the wage share therefore constitutes more complicated policy. Finally, from a theoretical perspective, distinguishing between the wage share and the distribution of the wage bill allows the economy simultaneously to exhibit wage-led and profit-led characteristics. This contrasts with existing constructions of the Cambridge growth and distribution model which impose an either or condition. The labour conflict channel, operating through the wage distribution, is always wage-led - so that shifts in the wage bill towards workers are expansionary. However, investment may be profit-led, exhibiting a strong dependence on the profit share - so that shifts in the functional distribution from wages to profits raise investment and economic activity. This dual construction helps make sense of developments in the US economy over

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J S ......IS'

Q:

the last 25 years. Changes in the distribution of the wage bill, exemplified by the explosion of CEO pay, have been contractionary.12 Side-byside, shifts in the functional distribution of income towards profits may have been expansionary since there is some evidence that investment spending in the USA is exhilarationist - that is positively influenced by the profit share (Gordon 1995). Increasing capitalists' ownership share, zK, shifts the IS schedule down so that the profit rate and capacity utilization fall unambiguously. This suggests that measures to change the distribution of wealth in a progressive direction, through wealth or inheritance taxes, may be expansionary. If saving falls in response to such taxes, this would make them even more expansionary. However, all bets are off if investment also falls in response to wealth and inheritance taxes. Then, they could be counter-productive and lower capacity utilization and growth. Lastly, consideration of ownership shares also suggests why worker pension plans can exert a long-run favourable impact in that they shift ownership and profit income over to workers, thereby having a long-run favourable impact on AD and the economy. A final experiment concerns dividend taxes, t, and exogenous changes in firms' decisions about retained profit, a. This experiment has implications for the debate over reducing double taxation of dividends. Increases in the dividend pay-out, resulting from lower taxes on dividends or a change in firms' decisions, shift the IS schedule up. They are therefore expansionary, raising the profit rate and capacity utilization. The economic logic of this effect is easily understood in terms of equation (10.14). Increased dividend payouts reduce firms' saving by a full dollar, but households only save a part of the increase in dividend saving. Consequently, aggregate saving decreases and AD increases. The above argument suggests that recent US tax changes reducing double taxation of dividends may be expansionary, to the extent they induce higher dividend payouts.13 However, there is an important caveat to this. The justification for including P/Y in the investment function is that it proxies for some form of cash-flow variable. In this case, the aggregate investment function is better stated as: I/K = a0 + axu + a2P/K + a3R/Y

av a2f a3>0

(10.7')

Investment therefore depends on retained profits as a share of GDP, rather than total profits. Now, if firms increase dividend payouts they will reduce investment spending. If a 3 is large, the net effect could be to shift the IS down and lower the profit and capacity utilization rates.

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Thomas I. Palley 237

The second caveat concerns balance-sheet effects that are not modelled here. Changing dividend tax rates may just induce a shift between debt and equity financing, leaving net payments unchanged. In this case there would be no change in net corporate retentions, and only the government budget would be impacted. This would result in larger budget deficits, which are expansionary. However, these issues push beyond the scope of the current chapter which has not addressed the government sector and its relation to the household and corporate sectors. Ownership A last issue concerns that of ownership, which is relevant for income distribution because it affects the distribution of dividend income. This is an issue that is important for Cambridge theory but has not been addressed. The above analysis was conducted on the basis of constant ownership shares (unchanged zK and zw), the traditional assumption of Cambridge theory. However, ownership is endogenous, and may change as part of the adjustment process. The reason why ownership matters is simple. Cambridge theory emphasizes how income distribution adjusts to bring AD into alignment with output. There are two ways to do this. One is to change the profit share, which redistributes income between wages and profit. The other is to change the pattern of ownership, thereby changing the distribution of profit income between workers and capitalists.14 Cambridge theory has always operated under the assumption that income distribution alone does the adjustment via a changed mark-up - that is by adjustment of the profit share. However, when there is investment-saving imbalance ownership shares will also be changing. If capitalists are saving too much and there is excess saving, then their ownership share will be rising. The reverse holds when workers are saving too much. The process of changing ownership shares operates through background financial variables. Thus, if capitalists have excessive saving, these savings can be thought of as being directed to equity purchases. This drives up the price of equities and reallocates equity ownership to capitalists. Consideration of these financial effects is beyond the scope of the current chapter. Instead, the intention is to point out that saving patterns impact ownership shares, and ownership shares impact the distribution of income and aggregate demand. The addition of ownership concerns introduces an additional steady state equilibrium condition. Now, in steady-state, capitalists must be

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238 Class Conflict and the Cambridge Theory of Income Distribution

Thomas I. Palley 239

SK {W/[l + y] + zK[P ~ R]} = zK[I ~ R]

(10.17)

If capitalists receive no wage income the condition reduces to: sK{zK[P - R]} = zK[l - R]

(10.17')

This quickly generates amended Pasinetti-style conditions for income distribution in an economy with corporate saving given by: P/Y = I/sKY + R[l - l/sK]/Y

(10.18a)

P/K = I/sKK + R[l - l/sK]/K

(10.18b)

Corporate retentions, R, therefore reduce the profit share and profit rate. The logic is that corporations are saving on behalf of capitalists, thereby reducing the need for profit income to finance investment. This simple derivation also illustrates how the Pasinetti conditions are in fact a form of steady-state ownership condition. Appropriate substitution into equation (10.17) combined with simple algebraic manipulation yields: ZK={sKk(u)/[l + -

+ y]}/ -

+n

a0 + axu + a2P/K + a3m(u, c)/ [1 + m(u,c)] - [1 +sK][l -p\P/K

+/?

z(s.y,P,P/K, u) u, V 7 , p , i / i x ,

( 1 0 1 9 )

Signs above functional arguments represent signs of partial derivatives. From a partial equilibrium standpoint, increases in capitalists' propensity to save increase capitalists' ownership share. Increases in workers share of the wage bill decrease capitalists' share, and increased firm profit retention ratios also decrease manager-capitalists' share.15 However, on top of this there are general equilibrium effects, because changes in ownership shares impact AD, the profit rate and capacity utilization that in turn feedback to influence ownership patterns. If an increase in capitalists' propensity to save drives down the profit rate and the utilization rate, this may induce negative manager-capitalist income effects that outweigh the effect of an increased propensity to save, so that the capitalist ownership share may fall. In other words, capitalists

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saving just enough to finance their share of investment, thereby maintaining their ownership share. This imposes the following steady-state ownership condition:

240 Class Conflict and the Cambridge Theory of Income Distribution

Conclusion: further issues and future research This chapter has expanded the CPK-Kaleckian model of distribution to include a labour market conflict channel that is distinct from the product market competition channel. This labour channel works through conflict over distribution of the wage bill, whereas product market competition impacts the profit share. Kaleckians have long emphasized the significance of both product market competition and labour market conflict for income distribution; however, these two forces have been conflated under the degree of monopoly, and the Kaleckian paradigm has not been able to disentangle them. The addition of the new channel enriches the structure of the model, allowing it to simultaneously exhibit both wage-led and profit-led tendencies. The model speaks to real-world concerns in that there have been significant changes in the distribution of the wage bill, as well as changes in the functional distribution of income. Both types of change matter for macroeconomic outcomes, and the model captures both types. The distinction between wage-share and wage-bill distribution has important theoretical and policy implications. At the theoretical level, it explains why economies can exhibit both wage-led and profit-led characteristics. Redistribution of the wage bill to workers always raises AD and economic activity by raising consumption. However, if the economy is profit-led, lowering the profit share can retard activity by lowering investment spending. At the policy level, this suggests that progressive policy should focus on altering the distribution of the wage bill, rather than the profit share as has been the traditional focus. Redistribution from managers to workers is always expansionary. Redistribution from profits to wages is expansionary if the economy is wage-led, and contractionary if it is profit-led. In the latter case, this generates a growth versus equity trade-off. Unions may do a bit of both types of redistribution - that is from managers to workers, and from profits to the wage bill. This is strongly expansionary if the economy is wage-led, but the effect is ambiguous if the economy is profit-led. This dual wage-led-profit-led characteristic also helps make sense of developments in the US economy over the last three decades. The deterioration of the wage distribution has reduced AD (though this effect has also been masked by increased household borrowing), but this has been

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can conceivably save themselves out of ownership. This is the asset stock equivalent of the Kaleckian dictum that 'workers spend what they earn, while capitalists earn what they spend'.

offset by the positive impact on investment from a rising profit rate and profit share. This helps explain why some pessimistic macroeconomic prognostications regarding the effects of worsening income distribution have not been realized.16 Finally, the model also addresses sociological criticism of Pasinetti's model regarding its lack of a managerial capitalist class that draws income from both profits and wages. The fact that both classes now have two different sources of income also allows for reconciliation between the Kaldor-Kalecki approach to saving behaviour, and that of Pasinetti. Kaldor and Kalecki assumed different propensities to save out of wage and profit income, a pattern of behaviour that can be justified on behavioural rule of thumb grounds. People tend to consume most of their wages, while leaving their savings accounts to compound. Pasinetti emphasized different propensities to save across classes, but classes saved at a common rate regardless of source of income. Now, it is possible to have behavioural rule of thumb saving within classes, and these rules can vary across classes. One possible configuration is 0 <sww <sKW <sWP<sKP
(10A.1)

P/K =tyEM(u,P/K)

(10A.2)

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Thomas I. Palley 241

242 Class Conflict and the Cambridge Theory of Income Distribution These equations can be linearized around the local equilibrium as: (10A.3) (10A.4)

The profit-led case corresponds to EDGP/K > 0. Graphical analysis of stability for this case is provided in Figures AlO.l and A10.2. In Figure AlO.l the MM curve is flatter than the IS curve, and the model is cyclically stable. There is some casual evidence that this configuration applies in the USA, since investment spending has some profit-led tendencies, and firms' mark-up appears fairly constant over the business cycle. The wage-led case corresponds to EDGP/K < 0. Graphical analysis of stability for this case is provided in Figures A10.3 and A10.4. In Figure A10.3 the MM curve is

IS

n

r CD

MM

co

*t • Capacity utilization

Figure AlO.l

Profit-led dynamics with IS steeper than MM

MM

r

IS

CD CO

*y

-r • Capacity utilization

Figure A10.2

Profit-led dynamics with IS flatter than MM

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u =
Thomas I. Palley 243 L

/

IS

MM

7^

•

Capacity utilization Figure A10.3 Wage-led dynamics with MM flatter than IS

IS o

Capacity utilization Figure A10.4 Wage-led dynamics with MM steeper than IS

flatter than the IS curve, and the model is saddle-path stable. In Figure A10.4 the MM is steeper than the IS, and the model may be cyclically stable or explosive.

Notes 1 The introduction of managerial wage income muddies the functional definition of 'workers' to be sure. The notion of what it means to be a worker in this context, however, is beyond the scope of the chapter. 2 This distinction is attributable to Bhaduri and Marglin (1990). They term wage-led economies as 'stagnationist', and profit-led economies as 'exhilarationist'. 3 Gordon (1995) reports that the US economy appears to have profit-led tendencies in that investment responds positively to the profit share, while consumption is impacted by income distribution variables.

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^/±t

4 In the short-run Kaleckian model the distribution of income is determined by the exogenously given mark-up. 5 This condition is needed to prevent workers out-saving capitalists, and thereby driving them out of existence. 6 The simple logic of Pasinetti's result is that in equilibrium workers' and capitalists' ownership shares of the capital stock are constant. This means that the profits must adjust so that, given capitalists' propensity to save, capitalist saving exactly equals the share of investment they must finance to maintain their ownership share. 7 The IS equation is given by P/K = {a0 + axu + a3m(u, c)/[l + m(u, c)]}/ ISK ~ a2]- Differentiating totally with respect to P/K and u yields h(P/K) = {«i + «3[[1 + ™\mu - mrnu]/[l + m]2}8u/[sK - a2] so that 8(P/K)/(u ={ax + a3[[l + m]mu - mmJ/fl + m]2}/[sK - a2]. The numerator is positive. The entire expression, the slope of the IS, is positive if sK > a2. 8 Domowitz et al. (1986) and Chirinko and Fazzarri (1994) find acyclical or mildly pro-cyclical mark-ups. Bils (1987) reports counter-cyclical mark-ups. When a real-wage labour market closure (Dutt 1992) is used instead of a product market closure, the mark-up is implicitly assumed to be countercyclical since the real wage rises with capacity utilization. In effect, the MM schedule is negatively sloped rather than positively sloped. 9 Because of the inherent ambiguity of the slope of the IS schedule, these results are only illustrative. 10 Technology is usually viewed as exogenous. Neo-classical Marxists, such as Bowles and Gintis (1990) and Skillman (1991), emphasize that technology is endogenously selected by capital, which controls the production process. This choice influences the ratio of non-supervisory to supervisory workers, a feature emphasized by Gordon (1996). 11 The necessary condition is that sw < sK, which is the normal assumption in Pasinetti growth models, being needed to stop worker-saving from driving capitalists into extinction. 12 Their adverse impact on AD has been offset by rising household borrowing. However, such borrowing is an unsustainable process, and the stagnationist impulse must eventually come out in full (Palley 2002b). 13 This argument is in addition to the fiscal stimulus argument, whereby lower dividend taxes raise the government budget deficit. 14 This claim is easily understood by examining the expression for AD in the standard Kaleckian model, given by: yd =cwwN + c^jnwN + ckzkmwN + I + G, where cw = workers' propensity to consume, cK = capitalists' propensity to consume, w = wage level, and G = level of government spending. AD consists of worker spending out of wages, worker spending out of worker income, capitalist spending out of profit income, plus investment and government spending. In the Kaleckian macro model, ownership shares and the mark-up are constant, and output adjusts to AD. In the Kaldor-Pasinetti model, output is fixed at potential, and AD adjusts to ensure balance. This can be done either by adjusting the mark-up (m) or by adjusting ownership shares (zk, zw). 15 Increased firm retentions decrease managers' ownership share because firms now do saving on behalf of workers. If profits were paid out, workers would tend to consume more of the payout than managers, thereby reducing their ownership share.

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244 Class Conflict and the Cambridge Theory of Income Distribution

Thomas I. Palley 245

References Baranzini, M. (1982) 'Can the Life-Cycle Help in Explaining Income Distribution and Capital Accumulation?', in M. Branzini (ed.), Advances in Economic Theory (New York: St Martin's Press). Bhaduri, A. and Marglin, S. (1990) 'Unemployment, the Real Wage: The Economic Basis of Competing Political Ideologies', Cambridge Journal of Economics, 14: 375-95. Bils, M. (1997) 'The Cyclical Behavior of Price and Marginal Cost', American Economic Review, 77: 838-57. Bowles, S. and Gintis, H. (1990) 'Contested Exchange: New Microfoundations for the Political Economy of Capitalism', Politics and Society, 18: 165-222. Chirinko, R. and Fazzari, S.M. (1994) 'Economic Fluctuations, Market Power, and Returns to Scale: Evidence from Firm-level Data', Journal ofApplied Economics, 9: 47-69. Dalziel, PC. (1991) 'A Generalisation and Simplification of the Cambridge Theorem with Budget Deficits', Cambridge Journal of Economics, 15: 287-300. Domowitz, I., Hubbard, G. and Petersen, B. (1986) 'Business Cycles and the Relationship between Concentration and Price-Cost Margins', Rand Journal of Economics, 17: 1-17. Dutt, A.K. (1984) 'Stagnation, Income Distribution, and Monopoly Power', Cambridge Journal of Economics, 8: 25-40. Dutt, A.K. (1990) Growth, Distribution and Uneven Development (Cambridge: Cambridge University Press). Dutt, A.K. (1992) 'Conflict Inflation, Distribution, Cyclical Accumulation and Crises', European Journal of Political Economy, 8: 579-97. Fazzari, S., Hubbard, R.G. and Petersen, B. (1988) 'Financing Constraints and Corporate Investment', Brookings Papers on Economic Activity, 1: 141-95. Gordon, D. (1995) 'Putting the Horse (Back) before the Cart: Disentangling the Macro Relationship between Investment and Saving', in H. Gintis and G. Epstein (eds), Macroeconomic Policy after the Conservative Era: Studies in Investment, Saving and Finance (New York: Cambridge University Press): 57-108. Gordon, D. (1996) Fat and Mean: The Corporate Squeeze of Working Americans and the Myth of Managerial Downsizing (New York: Free Press). Kaldor, N. (1956) 'Alternative Theories of Distribution', Review of Economic Studies, 23: 83-100. Kalecki, M. (1942) 'A Theory of Profits', Economic Journal, 52: 258-67. Keynes, J.M. (1936) The General Theory ofEmployment, Interest and Money (London: Macmillan, now Palgrave Macmillan). Lavoie, M. (1995) The Kaleckian Model of Growth and Distribution and its Neo-Ricardian and Neo-Marxian Critiques', Cambridge Journal of Economics, 19: 789-818.

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16 The effects of worsening income distribution may also have been masked by a series of non-repeatable adjustment mechanisms including consumer borrowing, a rising stockmarket and disinflation that has reduced household mortgage burdens. These different channels of alleviation are examined in Palley (2002a).

Palley, T.I. (1996a) 'Inside Debt, Aggregate Demand, and the Cambridge Theory of Distribution', Cambridge Journal of Economics, 20 (July): 465-74. Palley, T.I. (1997) 'Money, Fiscal Policy, and the Cambridge Theorem', Cambridge Journal of Economics, 26 (September): 633-9. Palley, T.I. (2002a) 'Financial Institutions and the Cambridge Theory of Distribution', Cambridge Journal of Economics, 26: 275-7. Palley, T.I. (2002b) 'Economic Contradictions Coming Home to Roost? Does the US Economy Face a Long-Term Aggregate Demand Generation Problem?' Journal of Post Keynesian Economics, 25 (Fall): 9-32. Pasinetti, L. (1962) 'Rate of Profit and Income Distribution in Relation to the Rate of Economic Growth', Review of Economic Studies, 29: 267-79. Ricardo, D. (1965) Principles of Political Economy and Taxation, [1821, 3rd edn] (London: Dent Dutton). Rowthorn, R.E. (1982) 'Demand, Real Wages, and Economic Growth', Studi Economici, 18: 3-53. Skillman, G. Jr. (1991) 'Efficiency vs Control: A Strategic Bargaining Analysis of Capitalist Production', Review of Radical Political Economics, 23: 12-21.

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246 Class Conflict and the Cambridge Theory of Income Distribution

The Dynamics of Profit- and Wage-led Expansion: A Note Amit Bhaduri

Any redistribution of income between profits and wages would have contradictory effects in terms of aggregate demand, so long as the propensities to consume are different for the two classes. For instance, the lowering of the real wage rate would tend to depress total consumption expenditure by redistributing income against the wage-earners with a higher propensity to consume. At the same time, it might also encourage investment by increasing the margin of profit per unit of sale. Depending on which effect dominates quantitatively, two alternative regimes or paths both led by demand emerge: the consumption- or wageled path which has also been called 'stagnationist', and the investmentor profit-led path called 'exhilarationist' (Bhaduri and Marglin 1990; Marglin and Bhaduri 1990). The essential formalism is simple. With full capacity (potential) output normalized at unity, the saving of the economy is written as: S = shz,

l > z , h>0

(11.1)

where 5 is the saving propensity out of profit, and all wage is assumed to be consumed for expositional simplicity; h = P/Y is the share of profit in output; and z = Y/Y* is the degree of capacity utilization, with Y* = 1, that is the normalized level of full capacity output. We assume investment depends positively on both capacity utilization (z) and the profit margin (m) or the profit share (h), which are by definition positively related as: h = m/(l + m). Assuming for expositional simplicity, static expectation, the investment function is written as: I = I(z,h),

I2>0,

4>0

(11.2) 247

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11

248 The Dynamics of Profit- and Wage-led Expansion

From (11.1) and (11.2), the slope of the locus of saving-investment equality, the IS-locus, is derived through total differentiation as: sh - Iz

The positive slope of (11.3) indicates that a higher profit share (h) results in higher capacity utilization (z), placing the economy in the exhilarationist regime. In this case the stimulating effect of the higher profit share on investment expenditure outweighs its depressing effect on consumption expenditure. When the slope of (11.3) is negative, the economy is said to be in the stagnationist regime for the opposite reason. However, the two regimes have normally been distinguished by assuming as valid the stability condition of the one-variable income adjustment process through the Keynesian multiplier mechanism. This requires saving to be more responsive than investment to changes in income, making the denominator of the right-hand side of expression (11.3) positive: sh-Iz>0

(11.4)

Consequently, lh-sh>0

(11.5)

implying that investment is more responsive than saving to the profit share, sets the economy on a profit-led exhilarationist path. If, on the other hand, lh-sh<0

(11.6)

the economy is on a wage-led stagnationist path for the opposite reason. However, this analysis remains valid only so long as the distribution of income (h) is treated as an exogenous variable. In effect, this makes the underlying dynamical system correspond to the usual single variable income adjustment process of Keynesian theory with income distribution given, but capacity utilization (z) adjusting to excess demand or supply in the product market. With capacity utilization (z) as the only endogenous variable in the system, the dynamic adjustment equation, in view of (11.1) and (11.2) becomes: ^ = a[l(h,z)-shz]

(11.7)

where a > 0 is some arbitrary positive speed of adjustment.

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dh

However, the above argument could be reversed by making income distribution (h) the endogenous variable adjusting to excess demand or supply in the product market, while the degree of capacity utilization is assumed exogenously fixed, say at the full employment or full capacity level. In this case an excess of demand in the product market would raise the price level; and, if the money wage rate failed to keep pace in percentage terms, the real wage rate would fall, the margin and share of profit would rise. This would tend to close the gap between investment and saving at the exogenously given full employment or full capacity level of output. This theory of distribution, sketched originally by Keynes (1930, see also 1936: vii), was developed later as the Keynesian theory of distribution (Kaldor 1956; Pasinetti 1962; Robinson 1962; Marglin 1984). The theory presumes not only full employment, but also 'forced saving' by the workers, even in a situation of full employment. On the other hand, if this latter assumption is abandoned, the possibility of a 'profit squeeze', rather than 'forced saving' by the workers, has to be included in the analysis. In this case the money wage rate would rise faster than the price level, and the share of profit would fall rather than rise in response to excess demand in the product market. Thus, a more general version of the dynamic adjustment equation for the 'Keynesian' theory of distribution might be written as: ^

= p[l(h,z)-shz]

(11.8)

where the speed of adjustment is /3 > 0 in the case of 'forced saving' by the workers, but /3<0 in the case of a 'profit squeeze'. Note the central difference between adjustment equations (11.7) and (11.8). In the former, the profit margin as well as the profit share are given which makes the real wage inflexible, so that the entire burden of adjustment falls on capacity utilization (Kalecki 1971). In the latter case, the margin is flexible but capacity utilization is fixed by assumption, making adjustment work exclusively through the real wage rate, that is income distribution. Consequently in a more general case in which neither the profit margin and share (h) nor the degree of capacity utilization (z) is treated as exogenous, and both are endogenous variables reacting simultaneously to an excess demand or supply in the product market, we have a coupled dynamical system consisting of (11.7) and (11.8). The product market clearing, equilibrium path of the system depicted by the IS-curve with its slope given in (11.3) still remains the same. However, the stability

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Amit Bhaduri 249

property of this two-variable dynamical system need no longer correspond to the one-variable stability condition (11.4) of the usual Keynesian system. Moreover, since both z and h are assumed to be endogenous, for a and P positive, a positive relation between z and h leading the trajectory of the economy to the profit-led exhilarationist regime. This means that 'forced saving' by the workers implies that the economy is necessarily on an exhilarationist path. Obversely, with a > 0 , but /3<0 in the 'profit squeeze' case, the economy is necessarily placed on a wage-led stagnationist path. This can be seen easily from dividing (11.7) by (11.8) to obtain the integral curve with the slope:

I=I

<»*>

where a>0, but /3 can be positive or negative. The stability of the dynamical system (11.7) and (11.8) may be examined by considering the function: V(t) = | [I(h, z) - shz]2

(11.10)

The function V is a Liapunov function with all the desirable properties. It enjoys stability in the large, that is positive definiteness and unboundness as (I-S) tends to infinity, provided also dV7dr<0 (see for example LaSalle and Lefschetz 1961; Minorsky 1962; Gandolfo 1995). This last condition can be checked by differentiating (11.1) and (11.2) with respect to time, and substituting from (11.7) and (11.8) to obtain: ^

= [/ - S]2[p(Ih - sz) - a(sh - Iz)]< 0

(11.11)

Therefore, global stability requires: P(Ih - sz) < a(sh - Iz)

(11.12)

Using (11.3) and (11.12), a complete classification of the various cases of profit-led or exhilarationist as well as wage-led or stagnationist sub-regimes according to their stability property becomes possible (Table 11.1). Note, however, that this classification is done in two successive

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250 The Dynamics of Profit- and Wage-led Expansion

Amit Bhaduri

251

Table 11.1

Classification of regimes (a > 0, p > 0 or p < 0)

Cases

Sign of dz (Ah from (11.3)

Nature of regime

Al sh-Iz>0 and Ih-sz > 0

Positive

Profit-led

Stablity ambiguous, and more likely the larger is —

Unambiguously stable, but not possible from (H-9), since z and h are endogenous

A2 5/2-4 > 0 and lh-sz<0

Negative

Wage-led

Unambiguously stable, but not possible from (11-9), since z and h are endogenous

Stability ambiguous, more likely, the larger — '™

Bl sh-Iz < 0 and Ih-sz < 0

Negative

Wage-led

Unambiguously unstable, but not possible from (11.9), since z and h are endogenous

Stability ambiguous less likely, the larger a

B2 sh-L < 0 and Ih-sz < 0

Positive

Profit-led

Stability ambiguous, and less likely the a larger is —

unambiguously unstable, but not possible from (11.9), since z and h are endogenous

For/3>0 ('forced savings'of workers)

For (3<0 ('profit squeeze')

* See Appendix for explanation of Al, A2, Bl and B2.

steps to highlight the difference between a single endogenous variable stability analysis given by conditions (11.3) to (11.6), and the stability analysis in the case of the dynamical system (11.7) to (11.9) when both the variables, h and z are endogenous. In the case of the general dynamical system with both variables endogenous, it emerges as a general result that neither the profit-led nor the wage-led path of expansion is unambiguously stable. The stability depends critically on the relative magnitudes of the speeds of adjustment, that is the absolute value of the ratio (a/p). Thus, when p >0, that is the case of 'forced saving' by the workers, only the profit-led path is relevant, and the usual one-variable Keynesian stability condition (11.4) may or may not matter in determining the stability of this profit-led regime depending on the ratio of the relative speeds of adjustment. The

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Stability property from (11.11)

higher (lower) is the ratio, implying faster (slower) speed of adjustment of capacity utilization relative to that of income distribution, the more (less) likely is the stability of the profit-led regime, depending on whether the sensitivity of saving is more (less) than that of investment to changes in income (that is, condition 11.4 satisfied or not). In a similar manner, in the case of 'profit squeeze', that is p < 0, leading to wageled expansion, again the Keynesian stability condition may or may not be relevant depending on the (absolute) value of the relative speeds of adjustment. It follows, the Keynesian stability condition is neither necessary nor sufficient without considering simultaneously the relative speeds of adjustment of capacity utilization and of income distribution. The critical role played by the relative speeds of adjustment points towards an interesting possibility of extending this analysis. It is often argued that Keynesian analysis neglects the 'supply side'. One way of taking into account the supply side would be to incorporate into the analysis the fact that the speed of adjustment of capacity utilization tends to decrease as the degree of utilization increases, and various bottlenecks begin to appear on the supply side. This means a can be treated as a decreasing function of z to partly incorporate considerations on the supply side. This would lead to non-linearities which we have avoided dealing with in this chapter, and which must remain a matter of future research. Appendix The 'profit-squeeze' case z = a[l(h, z) - shz];

h =- /x [/(ft, z) - shz]

2

V(t)=±(I-S)

^ = (I - S)\lhh + Izz - szh - shz] at = (I-S)[(Ih-sz)h+{Iz-sh)z] = (I - S){(Ih - sz)[ - /*(/ - S)] + (Jz - sh)a(I - S)} = (I - S)2[ - /x(4 - SZ) + a(Iz - Sh)]<0 For ^ < 0 => - fi(Ih - sz) + a(Iz - sh) < 0 dr - fi(Ih - SZ)<-

or

a(Iz - Sh)

fi{sz - Ih) < a(sh - Iz)

(11.12a) instead of (11.12): a(sh - Iz) > fi(sz - Ih);

\p\ = /i > 0

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252 The Dynamics of Profit- and Wage-led Expansion

Amit Bhaduri 253 Cases Al: LHS > 0; RHS < 0 .-.unambiguously stable.

Bl: LHS < 0; RHS < 0 .-.stability ambiguous, larger 1^1 stability less likely. B2: LHS < 0; RHS > 0 .-.unambiguously unstable. LHS=left-hand side; RHS=right-hand side.

References Bhaduri, A. and Marglin, S. (1990) 'Unemployment and the Real Wage: The Economic Basis for Contesting Political Ideologies', Cambridge Journal of Economics, 14: 375-93. Gandolfo, G. (1995) Economic Dynamics, 3rd edn (Berlin: Springer). Kaldor, N. (1956) 'Alternative Theories of Distribution', Review of Economic Studies, 23: 83-100. Kalecki, M. (1971) Selected Essays in the Dynamics of the Capitalist Economy (Cambridge: Cambridge University Press). Keynes, J.M. (1930) A Treatise on Money, 2 vol. (London: Macmillan, now Palgrave Macmillan). Keynes, J.M. (1936) The General Theory ofEmployment, Interest and Money (London: Macmillan, now Palgrave Macmillan). LaSalle, J.P. and Lefschetz, S. (1961) Stability of Liapunov's Direct Method with Applications (New York: Academic Press). Marglin, S.A. (1984) Growth, Distribution and Prices (Cambridge, Mass.: Harvard University Press). Marglin, S. and Bhaduri, A. (1990) 'Profit Squeeze and Keynesian Theory', in S. Marglin andJ.B. Schor (eds), The Golden Age of Capitalism (Oxford: Clarendon Press). Minorsky, N. (1962) Nonlinear Oscillations (New York: Van Nostrand). Pasinetti, L. L. (1962) 'The Rate of Profit and Income Distribution in Relation to the Rate of Economic Growth', Review of Economic Studies, 29: 267-79. Robinson, J. (1962) Essays in the Theory of Economic Growth (London: Macmillan, now Palgrave Macmillan).

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A2: LHS. > 0; RHS > 0 /.stability ambiguous; larger f ^ j more likely stability.

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Notes: f = figure; n = note; t = ta heading/word emphasized in the main

African Americans 120-1 ageing pensions and income distribution 6, 181-205 ageing and cost of 'pay-as-you-go' social security organisation 196-201, 2 0 4 ( n l 0 - l l ) ageing and labour market 187, 189-95, 203-4(n3-9) demographic changes (impact on labour market) 193-5, 203-4(n6-9) labour-supply and dependency-ratio scenarios 187, 189-93, 203(n3-5) aggregate demand (AD) 6, 7, 50, 53, 57, 58, 86(n5), 117, 127, 132, 202, 207, 224, 226, 231-2, 234-40, 244(nl2, n l 4 ) , 247 aggregate governance indicator 157 aggregate investment function 237 agriculture 95, 102, 153, 157, 215 'alliances for jobs' 79, 84, 88(n23) assets 72, 124, 128, 129, 133, 134t, 141 Atkinson's inequality measure 135, 136t, 137, 138t, 139t, 140t, 144t, 146(n9) Australia 175t, 190t, 192t, 197t unemployment: causes (sclerosis versus macroeconomic policy) 23-7, 37t, 41t, 45 Austria 23, 24t-26t, 37t, 4It, 46, 59, 60t-61t, 103, 175t, 190t, 192t, 197t baby-boom generation 182, 183, 186 balance of payments 12, 72, 106

bold = extended

discussion

or

balanced budget 11 bankruptcy 5, 68, 125, 141-5 banks 68, 71, 73, 231 bargaining 94, 99, 107-9, H l ( n 7 ) , 224, 233 collective bargaining 2 2 , 5 1 , 77-84, 88(nl8-23) see also wage-bargaining 'beggar-my-neighbour' policies 9 Belgium 59, 60t-61t, 176t, 190t, 192t, 197t, 2 0 4 ( n l l ) unemployment: causes 23, 24t-26t, 37t, 37, 41t, 46(n2) benefit duration 25t, 27, 28t, 30t, 32, 33, 35, 36, 43, 45, 52 Bhaduri-Marglin model (1990) 234, 243(n2), 247 effect of profits on investment and employment 6, 2 0 6 - 2 2 borrowing 16, 124, 124t, 125n, 133, 137 Britain see United Kingdom budget deficits 11, 12, 15, 2 1 , 113(nl8), 196, 238, 244(nl3) budget surplus 114(n26) business cycle 2 1 , 109, 124, 124t, 125t, 127, 134, 199, 230, 242 business sector 95, 97-9, lOOt, 108, 213, 221(n2) Cambridge Post-Keynesian (CPK) theory of income distribution 6-7, 223-46 Kaleckian extension 224, 2 2 8 - 3 1 , 244(n7-9) key insight/core idea 224 revisited 226-8, 244(n4-6) see also class conflict

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Index

Cambridge savings function 208, 209t Canada 51, 56, 176t, 186, 190t, 192t, 197t unemployment: causes 23-9, 35, 37t, 41t, 46, 47(n5, n7, 9) capacity utilization 6, 7, 56, 58, 59, 63, 207-13, 215-17, 230, 230f, 234-7, 239, 241, 242f, 243f, 244(n8), 247, 248, 249, 252 capacity utilization rate 229, 231 capital 5, 63, 87(nl3), 112(nl2), 128, 138, 173, 202, 203(nl), 244(nl0) balance of power (vis-a-vis labour) 177(nl6) constant 194 demand for 127 entrepreneurial 87(nl2) external 87(nl2) financial 199 fixed 134n intangible 55 and labour (degree of substitutability) 53-4 capital accumulation 54, 57, 193-4, 196, 203, 203(n6), 206-13, 215-17,220 effect of demand 219 export-led 21 It, 216t per labour hour 55 rate 208 capital expenditures 125, 125t capital flows 9, 13 capital income 124, 135, 139, 141 capital liberalization 106,173 capital markets 8 7 (n 12) deregulation 11, 12 imperfect 2, 87(nl2) liberalization 12 capital mobility 129 capital productivity 221 (n2) capital shortage 53, 54, 56-7 capital stock 2, 4, 208, 209t, 233, 244(n6) business sector 59, 60t, 63 physical and intangible, 55 capital stock: relation to unemployment 4, 49-66 capital-labour power relations 87(nl3)

capital-labour ratio 54 capitalism 3, 6, 18, 69, 194, 195, 241 conflictive/cooperative 10 capitalists 195, 202, 208, 224, 227, 231, 238-9, 244(n5, n i l ) cash flow 229, 237 catering lll(n3) central bank experts 221 central bankers 38-40 central banks 12, 23, 70-2, 87(n8) charge-off rates 125, 141-5 children 122, 123, 194 City of London 9-10 civil society 152 class 123, 195, 199, 203(nl), 219, 224, 227, 231-4, 241, 244(nl0) middle class 113(n20), 129, 130 ruling classes 182 class conflict 6-7, 40, 224, 231, 234 class conflict and Cambridge Theory of Income Distribution 6-7, 223-46 caveats 237-8 CPK model revisited 226-8, 244(n4-6) Kaldor model 227f, 227 Kaleckian dictum 240 Kaleckian extension of CPK model 228-31, 244(n7-9) national income tree 225f ownership 2 3 8 ^ 0 , 244(nl4-15) significance of income distribution 223-4 stability analysis 234-8, 244(nll-13) theoretical innovations 225-6 class structure 227 Cobb-Douglas production function 53,54 Cold War 10 collateral 135, 136, 137 collective agreements 97, 111 (n3) commodities 70-3, 193 companies/firms 18, 20, 58, 59, 73, 83, 84, 101, 103, 105, 108, lll(n2), 112(nl0, 15), 125, 130, 173, 219, 221, 244(nl5) cost structure 230 domestic 74 manufacturing 106

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256 Index

companies/firms - continued multinational corporations (MNCs) 172-4,221 price-setting 75 profit-retention 233 state-owned 173 comparative advantage 151-2,153, 167, 171, 172 'compensation' see wages competition 3, 10, 17, 18, 202, 231-2 financial 133 imperfect 54 inter-firm 231-2 international 102, 105, 216 labour market 232 perfect 15 product-market 6-7, 224, 225 'competitive corporatism' 4, 79 competitiveness 4, 106, 113(n25), 217, 220 construction 102, lll(n3) consumer credit 124t, 124n, 141-5, 145(n6) consumer debt/consumer borrowing 5, 117, 125, 132-45, 145-6(n4-9), 245(nl6) see also credit-card debt consumer price index (CPI) 67, 82n, 86(nl) consumer prices 45, 68, 156 consumer spending 127, 134t, 134n, 145(n4) consumers 71, 72, 85, 86(n5), 141 consumption 7, 12, 72, 73, lll(n3), 118, 124, 132-4, 218, 236, 240, 243(n3) domestic 210 mass 10 negative domestic effect 210 private 74f, 75f consumption expenditure/spending 134n, 134, 247, 248 consumption growth 126t, 127, 132, 134 consumption-led regime 12 'COORD' (coordination index of wage bargaining amongst union and employers) 27, 28t, 30t, 32-6, 43-5, 47(n6-7)

corporate governance 128 corporations 12, 125, 239 internal resources 125t, 125n productive uses 125t US 127 use of non-financial resources 125t corruption control 157 cost-of-living index 103, 111 (n3) counter-cyclicality 21, 22 credit 68, 72, 73, 104 endogenous 137 non-bank 5, 133, 145 credit cards 5, 133, 141, 144t credit supply 132, 133, 135, 136, 142 credit-card debt (CCR) 124n, 133, 137-41, 143-5, 145(n6) see also debt creditors 72, 73 culture 182 currencies 106 attacks on 174 devaluations 5, 9, 101, 106, 108 domestic 72 national 113(n25) currency depreciation 106, 107, 113-14(n25) currency market concerns 21 currency speculation 21 Cyprus 176t Czech Republic 190t, 192t, 197t debt 5, 68, 72, 133, 134, 141, 146(n8), 196, 198 see also household borrowing/debt debt composition 142, 143 debt deflation 69, 72, 73 debt and equity financing 238 debt service 142, 143, 144t debt-to-income ratio 16 debt-service costs 133 debt-servicing 16, 141-3, 231 debtors 68, 72, 73 decentralization 17 'decentralization of production' 101, lll(n2) default 141, 143 deficit-financing 11 deflation 2, 6, 71, 72, lll(n3) actual 86 demand-led, sustained 68

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Index 257

deflation risks: role of wages and wage-bargaining 4, 67-92 deflationary policies/choices 106, 113(n22), 202 deflationary processes/tendencies 4, 68, 69, 71 demand 16, 59, 132, 213, 219 composition 17 domestic 12, 85, 209, 217, 218, 220 and employment 215, 220 effect on unemployment and wages 62 effective 189 excess 241, 248-9 foreign 72 insufficiency 14, 17 international 210, 215, 218 over-contraction 12 short-term, long-term 14 see also aggregate demand demand deficiencies 206 demand growth 118, 209 demand shocks 4, 50, 55 temporary 68 demand-led expansion dynamics of different regimes 7, 247-53 'profit-squeeze' case 252 demand-management 3, 9, 10, 11, 12-13, 14, 221 democracies 9, 10, 15 demographic changes impact on labour market 193-5, 203-4(n6-9) demographic transition 183, 185 demographic trends 182-7, 188-9t, 194, 203(n2) global scenarios 182-5 replacement migration 186-7, 188-9t Denmark 176t, 190t, 192t, 197t, 204(nll) unemployment: causes 23, 24t-26t, 35, 37t, 4It, 37, 46 dependency-ratio scenarios 187, 189-93, 203(n3-5) see also old-age dependency ratio dependent population 202 changing composition 201 rising cost 202

deregulation 129, 151 developed countries 22, 109, 182-7, 201-2, 206-7, 212-14, 217-18, 221 see also OECD countries developing countries 22, 152, 156, 167, 177(nlO), 183, 185, 206, 207, 212, 218, 220, 221 effects of economic liberalization on income distribution 5 development 101, 151 development level 16, 153, 167, 170, 177(nl3) disinflation 3, 4, 22, 27, 32, 43, 70-2, 80, 84, 245(nl6) dividend taxes 233, 237, 238, 244(nl3) dividends 118, 125, 125t, 128, 225f, 225, 238 division of labour 18 downsizing 16, 128 downturns 73, 80, 95 Earned Income Tax Credit 130 earnings 102, lll(n3), 129 actual (per employee hour) 8It, 82t actual rates of change 97 aggregate lll(n3) gross 88(nl8), 95, 96, lll(n4) real net lll(n4) see also employee remuneration economic activity 4, 7, 49, 63, 68, lll(n6), 235, 236, 240 cyclical fluctuations 10 real 50 economic growth 1-8, 22, 73, 78, 80,95, 118, 130, 131, 151, 165, 173, 181, 199, 202, 208, 212, 215, 218-19, 226, 237, 241 country rates 46 cross-country spillover effects 29 'endogenous' 18 export-oriented 5, 153, 167, 207, 215, 216, 217, 220 full-employment steady-state 227 growth rate 16, 18 labour-market flexibility 2-3, 9-19 real 200 slow/sluggish 43, 84, 172 sustainable 152

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258 Index

economic liberalization effects on income distribution 5, 151-80 economic policy 68, 102 domestically oriented 9 flexible and counter-cyclical fluctuation 21 theories and counter-theories 13-16 economic recovery 85 economics 2, 203 ( n l ) classical 4, 6, 93, 94, 181, 228 classical-Kaleckian 195 classical-Keynesian 181, 194, 202 mainstream 207 monetarist 70 new classical 1, 7(nl), 70, 177(nl4) New Keynesian 1, 7(nl), 177(nl4) non-conventional 202 see also Keynesianism; neoclassical economics economists 14, 56, 68, 121, 199, 203(n6), 241 classical 193, 194, 203(n6) conventional 199 mainstream 203(n3) neo-classical Marxist 244(nl0) economy/economies 8 7 (n 11) capitalist 200 closed 9, 71, 77 credit money 70-3 domestic efficiency/efficient organization 151-4, 165, 167, 171, 172, 174 international 20 monetary 69 open and globalized 3 education 157, 171, 177(nl2), 199 educational attainment 120, 121, 129, 131, 167, 191 educational inequality 121 effective demand 2, 14, 72, 86, 94, 181, 194-6, 213 elasticity of substitution capital and labour 53, 54, 112(nl2) elections 9, 15 Emergency Home Finance Act (USA, 1970) 133 emerging markets 152

259

employee contributions 96, lll(n4-5) employee protections 20, 21 employee remuneration 80, 8It, 82t see also wages Employee Retirement Income Security Act (ERISA) (USA, 1974) 128 employees 10, 55, 69, 70, 83, 84, 87(nl5), 88(nl8-19), 95, 96, 97, 98t, 101, 108, l l l ( n 5 , n7) public sector 113(n20, n23) real hourly average earnings 59 rights at work 233 see also labour employers 10, 70, l l l ( n 2 - 3 , n 5 , n7), 129 paying low wages 130 social security contributions 79n, 88(nl8) employment 1^8, 22, 43, 50, 53, 57, 63, 64, 68, 70-3, 84, 86, 86-7(n5-12), lOOt, 101, 108, 112(nl5), 114(n26), 118, 151-4, 156, 157, 167, 172-4, 193, 194, 196, 200-2 effect of profits (Bhaduri-Marglin model) 6 , 2 0 6 - 2 2 effects of wage moderation, 113(nl8) equilibrium level 54 export-led 21 It, 216t, 217 high 75 income distribution effects 168-71 industrial 97, 103-7, l l l ( n 8 ) irregular 102 large firms 102 limited duration 102, 113 (n 17) manufacturing 127 'natural' level 189 'peculiar paradox' 13 policies 16-18 short-term barrier 72 temporary 102 total 105f, 107 employment conditions 228 employment creation/growth 13, 101, 206 employment legislation 1, 50, 51 employment protection 1, 22, 40, 50,51

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Index

Index

employment rates 124, 191, 204(n7) employment share 221 (n2) employment trends 80, 96 'England' see United Kingdom entrepreneurs/entrepreneurship 63,104 'equilibrium' 15 euro 13, 21 Euro-sclerosis 22 euro-zone area 20 Europe 12, 21-2, 27-8, 34-7, 44f, 44, 46, 50, 52, 55, 57, 79, 94, 108, 188t, 189t, 195, 202, 203(n4), 206 economic interdependence 33 Southern 186, 189 Western and Northern 186 European Central Bank (ECB) 13, 2 1 , 38, 67, 85, 86, 8 8 ( n l 9 , n26) monetary policy ('anti-growth bias') 84 European Commission 113(n25) European Economic C o m m u n i t y 52 European Monetary System (EMS) 104, 106, 110 European Monetary Union (EMU) country sample (Austria, Belgium, Germany, Spain) 49, 50, 63 deflation risks: role of wages and wage-bargaining 4, 67-92 inflation rate 78f labour income share 75-6 larger countries 80, 85 monetary and fiscal policies 70 remuneration of employees 79f restrictive policy mix 85, 88(n24) smaller countries 80 unit-labour-cost growth 78f unit-labour-cost growth and inflation rate 75f wage policy dilemma 84-6, 88(n24-7) wage trends and extent to which scope for distribution is exploited 8 It European Union 9, 20, 29, 87(nl4), 187, 188t, 189t, 200, 221 exchange rate depreciation 219 new 103

nominal 103 official 219 rates of change 107t real 58, 103, 105, 106, 113(n25) exchange rate agreements 108 exchange rate markets 174 exhilarationist regimes 210, 237, 243(n2), 248, 250 export competitiveness 217 export demand 212 export growth 22, 172, 217 export markets 13 export performance, productivity-led 220 export prices 103, 106 export sector 152 export surplus 11-12, 13, 16, 86 export-led expansion 1 6 , 1 7 4 exports 35, 46, 104, 113(nl9), 151, 171,211,215 capital-intensive (or not) 127-8 income distribution effects (by sector) 167-8, 177(nl3) 'increase labour d e m a n d ' 21 I t merchandise 156 net 208, 209t, 210 profit-led 21 It, 216t factor demand schedules 93 factors of production 223 fairness/equity 152, 223 families 121, 130, 175t, 193, 202 high-income 122 low-income 118, 123 unpaid work 215 see also households family income 118, 121, 122, 124 family subsidies 113 (n23) Federal Home Loan Mortgage Corporation ('Freddie Mac', USA) 132 Federal National Mortgage Corporation (FNMA, 'Fannie Mae', USA) 132 financial crises 152 financial distress 132-45, 145-6(n4-9) financial institutions 133 financial intermediaries 68, 73

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260

financial liberalization 199 financial markets 12, 17, 38, 129 financial services 128 Finland 23, 24t-26t, 35, 37t, 37, 41t, 176t, 190t, 192t fiscal convergence criteria 21 fiscal discipline 5 , 1 5 3 , 1 5 6 , 1 7 1 fiscal policy 10, 2 1 , 22, 70, 73, 104, 110, 172, 213 expansionary 12 pro-cyclical 85 restrictive/tight 2, 13, 114(n26), 221 fiscal retrenchment 172 fiscal stimulus 244(n 13) forced saving 249-52 foreign direct investment (FDI) 5, 153-56, 164, 171, 174 foreign exchange reserve 12 France 56, 57, 80, 104, 106, 176t, 188t, 190t, 192t, 197t, 200, 2 0 4 ( n l l ) , 207, 213, 214t unemployment: causes 23, 24t26t, 35, 36, 37t, 41t freedom of association 22 Friedman, M. 11 full employment 3, 9, 10, 4 3 - 5 , 47(n9), 53, 55, 103, 113(nl8), 181, 189, 199-201, 224, 226, 227, 249 fund managers 128 GDP 35, 46(n3), 47(n4), 104, 126t, 156, 157, 163, 164, 215 GDP deflator 58, 59, 62t, 67, 86(nl) GDP at factor costs 76f, 87(nl5) GDP growth 23, 24t, 196, 221(n2) real 45, 126t gender inequality 120 geography 16, 165 Germany 9, 13, 56, 57, 59, 60t-61t, 62t, 103, 104, 106, 188t, 190t, 192t, 197t, 200, 2 0 4 ( n l l ) collective bargaining system 83, 88(n21) consumer price index 82n deflation risks: role of wages and wage-bargaining 4, 67-92 eastern 83

261

economic institutes 64(n2) 'exit' from poverty 129 inflation rate (consumer prices) (1991-2003) 78f labour income share (1960-2003) 75-6 'largest economy in EMU' 84 post-reunification boom 80 productivity, labour costs, exchange rates (1979-2000) 107t remuneration of employees (1991-2003) 79f reunification 78 unemployment: causes 20, 23, 24t-26t, 35, 36, 37t, 41t unit-labour-cost growth (1991-2003) 78f unit-labour-cost growth and inflation rate (consumer prices) (1961-2003) 74f wage policy dilemma 84-6, 88(n24-7) wage trends and extent to which the scope for distribution is exploited (1996-2003) 82t wages policy 69 western 83 globalization 3, 11, 12, 15, 129, 152 goods market 6, 87(nl3), 206-7, 208, 210-13, 217, 230, 234, 241 'determines labour market' 21 It interaction with labour market 212 governance 152, 153, 162, 163t, 163, 165-8, 171, 174, 177(nl3) government insurance and pension reserves 134n Government National Mortgage Association (GNMA, 'Ginnie Mae', USA) 132 government saving 227 government size income distribution effects 168-71 governments 38, 59, 130, 172, 244(nl4) economic credibility 16-17 economic policies 12 effectiveness 157 Great Depression (1929-) 69 Greying countries 189-93

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Index

Index

health 129, 177(nl2), 198 high employment (debate over causes) 20-3 household borrowing/debt 118,134, 137, 240, 244(nl2) regression results (1980-2003) 136t total 140, 141 see also indebtedness household economic distress 141-5, 145-6(n7-9) household income 5, 42, 117, 123, 132-3, 137, 141-5, 155-6, 175t households 73, 175t, 237, 238 bankruptcy 125 economic distress 5 , 1 1 7 - 5 0 top versus bottom/middle (income strata) 122 total number (HH) 142, 145(n7) see also families housing 12, 145(n7) Housing Price Index (HPI) 135, 136t, 138t, 139t, 140t, 144t Housing and Urban Development Act (USA, 1968) 132 h u m a n capital 2, 120, 152-4, 157, 165, 171, 172 h u m a n development 185 hyperinflation 164, 171, 1 7 7 ( n l l ) hysteresis effects 54, 209 immigration 6, 123, 129, 186, 191, 194, 201 import costs 58 import prices 74 import surplus 11-12, 13, 16, 86 imports 151, 156, 209, 215 labour-intensive (or not) 127-8 impulse response analysis 213, 214t, 215, 216t income 2, 86 aggregate 232 disposable 124t, 125, 126t, 132-41 national 132 net real 198 personal 129, 134n, 134 post-tax 218 pre-tax 218

income distribution 1-8, 10, 44, 58, 81t, 82t, 94, 110, 117, 122, 206, 208-13, 215, 217-20, 248, 249, 252 Cambridge Theory 6-7, 223-46 cross-country 40, 47(n8) effect on growth 21 It, 214t, 216t effects of economic liberalization 5 effects of labour-market conflict 224 functional 75, 87(nl4), 227, 235, 236, 237, 240 pensions 6, 181-205 profit-wage functional 232 significance 2 2 3 - 4 steady state 228 unequal 2 income growth 134, 143 income inequality 44, 47(n8), 123, 126t, 137, 154-6, 166 labour-market institutions and 4 0 - 3 , 47(n8) income tax 96, l l l ( n 5 ) indebtedness 73, 87(nl2) see also mortgage debt individuals 14, 15, 16 industrial pay inequality 155 industrial policy 113(nl9), 219, 220 industrial relations 79, 101-4 industrial restructuring 110 industrial sector 71 industrialization 154 'new Keynesian'view 172, 177(nl4) industries 75, 130, 219 domestic 10, 173 'Industry' 95, 96-7, 99, 100, 102, l l l ( n 4 ) , 112(nl5), 157 composition l l l ( n 3 ) 'leading role played by wage-setting' 97 real gross and net wages (1972-2000) 96f inequality 152, 164 across- and within-group 120, 121 capital versus labour 118, 127, 128, 135, 136, 140-5 consumer debt and financial distress 132-45, 145-6(n4-9)

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262

inequality - continued explanation for rise 127-30 household troubles (USA) 5 , 1 1 7 - 5 0 within labour 118, 128, 132, 136-7, 140-5 and macro-economy 124-7, 130-2, 145(n3) trends 118-24, 145(nl-2) inflation 5, 10, 24t, 40, 49, 53, 56, 58, 67, 80, 81t, 82t, 87(n8), 108-9, 113(n20), 153, 156-7, 162, 168, 171, 174, 219 annual rates 45 government-targeted 105 inflation targets 85-6, 87(n5), 221 inflationary expectations 11 inflationary pressure 3, 59 inflationary processes 71 inflationary tendencies 68 inheritance tax 237 innovation 68, 130-1 labour-substituting 195 link with rising inequality 5, 145 institution-building 152 institutional changes 102-8, 113-14(nl8-26) institutional investors 127, 128, 174 institutions 218, 219, 220 multilateral 152, 176(nl) insurance companies 128 insurance funds 18 interest 118, 133, 134 interest costs 87(n7) 'action parameter of monetary policy' 70 equilibrium real 87(n5) nominal 87(n5) real 86(n5) tool of monetary policy 70 interest rates 3, 12, 2 1 , 22, 24t, 27, 71, 72, 104, 114(n26), 134, 173, 196 CPI 45 long-term 57 nominal 85, 106 real 16, 24t, 38-40, 43, 47(n4), 56, 85, 105, 219 short-term 23, 45 International Monetary Fund (IMF) 50, 67, 68

263

invalids 195, 204(n9) inventory valuation adjustment 125n investment 2, 4-7, 12, 50, 52-4, 56-7, 59, 64, 73, 118, 130, 134n, 151, 152, 154, 157, 174, 195, 202, 231, 232, 235, 236, 239, 241, 243(n3), 244(n6, n l 4 ) , 247, 249, 252 demand-effect 207 domestic 173 effect of profits (Bhaduri-Marglin model) 6, 2 0 6 - 2 2 full-employment 227 Kaldor model 227f, 227 private 72, 103, 172 profit-effect 207 public 85, 103, 172 slowdown 127, 207 investment rates 53, 215-16, 219 investment-saving (IS) balance 227, 230-8, 242, 242f, 243f, 244n(9), 249-9 Ireland 23-9, 3 2 - 3 , 37t, 4It, 43, 45, 46, 46(n2), 47(n7), 5 1 , 52, 80, 176t, 190t, 192t IS-MM model 241-3 Italy 4, 57, 80, 112(nl0), 176t, 188t, 190t, 191, 192t, 196-8, 201, 204(nll) rates (1979-2000) 107t unemployment: causes 23, 24t-26t, 36, 37t, 41t Japan 13, 67, 176t, 186, 188t, 190t, 191, 192t, 197t, 198, 201, 204(nll) unemployment: causes 23, 24t-26t, 37t, 4 I t 'job-less'recovery 118,127 Kaldor model 227f, 227 Kaldor-Pasinetti model 244 (n 14) Kaldor-Pasinetti-Kalecki model 235f, 236f Kaleckian models 6f, 207, 217, 226, 228-9, 231-2, 244(n4, 14) Kaleckians 224, 240 Keynesian multiplier 29, 46, 248 Keynesian-Kaleckian model 213 hypotheses confirmed 217

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Index

Index

Keynesianism 6, 16, 17, 46, 57, 68, 172, 196, 248-52 Korea, Republic of 176t, 188t, 189t, 190t, 192t, 197t, 207, 214-17, 218 multi-foreign exchange system 219 structural problems 220 labour 5, 53-4, 112(nl2), 127, 138, 152, 173, 177(nl6), 181, 194 bargaining position and power 129, 193, 195, 209 constant average product 229 exploitation 203 (n6) share of national income 137 'unreasonable' demands 130 unskilled 127, 152, 153, 167, 171, 172, 177(nl3) see also workers labour costs 71, 84, 217 actual 102 non-wage 88(nl8) rates of change (1979-2000) 107t trends 80 labour demand 15, 93, 127, 189, 193, 195, 203(n6), 215, 217, 218 diminished 194 labour force/workforce 16, 55, 157, 172, 195 down-sizing 12 domestic 6 family members (number) 123 inadequately skilled 50 participation 189, 200, 201 reproduction 193 total 102 labour income 118, 135-8, 145(n3), 172 labour income share 75, 76f, 85, 87(nl5), 118, 119t, 132, 135, 140, 141 labour market/s 1, 17, 29, 54, 64, 101, 204(n7), 215, 217, 224, 231 ageing (economic impact) 201 demand-driven 208 deregulation 50 female 196 impact of ageing 6

impact of demographic changes 193-5, 203-4(n6-9) imperfect 70 interaction with goods market 212 internal 130 Italian 102 malfunctioning 14 neoclassical hypotheses 6, 21 It, 213-14, 214t, 216t people voluntarily outside 203(n3) persons outside 195 rigidities/sclerosis 20, 23, 50, 52 structural characteristics/factors 2, 70 USA 130 labour market, demand-led (hypothesis) 21 I t 'strong support' 213, 214t, 216t labour reserve army 11, 193, 194, 195, 201, 203(n6) 'industrial reserve army' 6, 182, 195, 202 labour scarcity 182, 194, 195 labour supply 6, 54, 94, 112(nl2), 124, 182, 193-6, 201, 203(n6) abundant 189 additional sources 202 effective 203(n3) potential 187, 196, 203(n3) scarce 189 scenarios (2000-50) 190t shrinking 202 labour supply shocks 209 labour surplus 194 labour unions see trade unions labour-market bargaining power 225 labour-market conditions 4, 93, 94, 96, 98, 108-10, l l l ( n 2 , n6), 113-14(n25), 217 broader view 100-2, 112-13(nl5-17) labour-market conflict 224, 228, 232, 234, 236, 240 labour-market deregulation 206 'not sufficient condition for improvement in employment' 52 labour-market 'distortions' 206

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labour-market flexibility 1, 20-2, 50-3, 6 4 ( n l - 2 ) current focus 'overstated' 64 labour-market flexibility and economic expansion 2 - 3 , 9-19 policies for high employment 16-18 theories and counter-theories for economic policies 13-16 labour-market institutions 3, 22, 23, 27, 25t-26t, 32-7, 44, 45, 49, 50, 52, 69, 195 microeconomic 23 and income inequality 4 0 - 3 , 47(n8) labour-market policies 46(n3), 233 labour-market reforms 51, 52, 54 current focus 'overstated' 64 'failed to reduce u n e m p l o y m e n t ' 51 Germany 64(n2) labour-market regulations 206 labour-market spending 26t labour-standards, international 22 labour-supply scenarios 187, 189-93, 203(n3-5) laissez-faire 27, 44f, 45, 113(nl8) laws/legislation 1, 49, 50, 51, 102 'Leontief's Paradox' 127-8 Liapunov function 250 liberalization 151, 152 life-cycle 195, 228 life-expectancy 186 lira 103 devaluation (1992) 5, 101, 106, 108 nominal exchange rate (1971-6) 113(n25) loans 73, 125, 133, 141, 142, 176(nl) non-bank 143 Luxembourg Income Study 155, 175t Maastricht Treaty 13, 108, 114(n26) macroeconomic balance 163 conditions 27 consequences 5 data 24t, 132 discipline 151, 152, 153

265

disequilibria 153, 163, 164 efficiency 156 environment 219 factors 3, 22, 36, 52 forces 37 imbalance 164 mismanagement 165 outcomes 36, 240 perspective 13 policy instruments 174 problems 78 prognostications 241 theory 14, 16 variables 23, 28, 29, 38, 43 macroeconomic background, unequal fortunes, unstable households (USA) 124-7, 145(n3) macroeconomic policy 1-3, 21-3, 29, 38, 44f, 47(n4), 152, 236 dysfunctional 22 expansionary 43, 44 external constraints and institutional changes 102-8, 113-14(nl8-26) need for coordinated international expansionary 221 restrictive mix 84, 88(n24) macroeconomic stability 153, 154, 162, 165-6, 167, 171, 174 proxies 156-7 macroeconomics 15-16, 17, 224, 232 macro-economy inequality and 130-2 Keynesian construction 235 manager-capitalists 225f, 225, 232, 239, 241, 244(nl5) managerial pay 232 managers 15, 127, 131, 226, 240 professional 128 rising power 128 manufacturing 56, 57, 107t, l l l ( n 3 ) , 127-8, 130, 153, 156, 172 marginal productivity theory 223 marginal propensity to consume 132 marginal propensity to save 208 marginal theory 194 marginalist theory 112(n 12)

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Index

Index

mark-up 71, 73, 74, 87(nl3), 209, 228-35, 241, 242, 244(n4, n l 4 ) counter-cyclical/pro-cyclical 244(n8) mark-up pricing 71 market efficiency 221 market failure 54 market forces 151, 152, 171 competitive 223 'natural' 196 market ideology 15 market mechanism 1 5 , 1 5 1 market share, international 77 market system 69 'market worth' 15 markets 10, 151, 165 domestic/internal 11, 12, 18, 172 foreign/external 11, 18 flexible 2 limited global 220 proxies representing 156 unregulated 176(nl) world 221 marriage 129 Marshall Plan 10 Marshall-Lerner condition 72 Marxism 11, 208, 224 mergers and acquisitions 173, 177(nl5), 235 metalworkers' trade unions 104 methodological individualism 3, 14, 15, 16 microeconomic data 132, 145 factors 3, 52 institutional settings 36 labour-market institutions 22, 32 models 120 policy 44 pricing decisions 230 variables 28, 43 migration 182, 185-7, 194, 195, 203(n4) scenarios 188t m i n i m u m wage 51, 69, 129, 233 MM (mark-up model) 230f, 235f, 236f, 242-3, 244(n8) 'denotes profit-rate equation' 230 equilibrium schedule 234 monetarism 11

'monetary constitution' 104 monetary policy 12, 2 1 , 22, 49, 68, 70, 84, 86(n2-3), 87(n7), 88(n26), 85, 110, 174,213 deflationary 104 expansive 72 growth-friendly 86 national 173 political economy 3 8 - 4 0 restrictive 2, 13, 104 symmetrically effective 73 tight 221 m o n e y 72, 77, 100 endogeneity in a credit m o n e y economy 71 m o n e y aggregates 68 m o n e y demand 72 money market rates 45 m o n e y supply 70, 71, 72 m o n e y wage rate 249 monopoly power 235, 235f mortality 183 mortgage debt 124t, 124n, 125, 132, 133, 137, 138, 140, 245(nl6) real 135, 136t, 138t regression results 138t see also consumer debt multipliers cross-country Keynesian 46 trade-based cross-country 43 mutual funds 128 NAIRU see Non-Accelerating Inflation Rate of Unemployment national income 5, 53, 136t, 138t, 139t, 140, 140t, 144t, 145, 225f labour share 135 natural resources 153, 167, 171, 172, 177(nl3) neo-Kaleckian models 208, 221(nl) neo-Keynesians 14 neo-liberalism 3 neo-Malthusianism 195 neoclassical economics 167,172, 181, 189, 194, 195, 199, 204(n8), 206, 212, 215 hypotheses 6 long-term growth theory 14

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neoclassical economics - continued substitution mechanisms 93, 110(nl) synthesis 70 theory 8 7 ( n l l ) two-factor models 151 neoliberalism 156, 164, 172, 174, 206, 207, 220, 221 distinguishing features 13-15 net capital transfers 134n net equity issues 125t, 125n net transfers 133 Netherlands 51, 52, 80, 86, 176t, 190t, 192t, 197t unemployment: causes 23, 24t-26t, 37t, 37, 41t 'new consensus models' 70, 86-7(n5) new growth theories 2, 7(n2) new Keynesianism 68, 70-3 New Zealand 23-7, 37t, 41t, 45, 46, 47(n7), 52, 176t, 190t, 192t, 197t Non-Accelerating Inflation Rate of Unemployment (NAIRU) (Layard, Nickell and Jackman) 4, 11, 49, 50, 52, 53, 55-7, 59, 64, 70, 72, 73, 87(n9), 93, 110(nl) non-agricultural sector 215 OECD (Organisation for Economic Co-operation and Development) 22, 4 6 ( n l , n4), 182 OECD countries 11, 51, 52, 56, 57, 64(nl), 130, 177(nlO), 190t, 191, 192t, 193, 197t, 198 see also developed countries OECD economists 189, 203(n4) OECD u n e m p l o y m e n t (evidence on causes) 23-35, 4 6 - 7 ( n l - 7 ) data 23-7, 45, 46(nl) oil price 10, 55, 58, 59, 103 Okun's law/coefficient 3 5 , 2 3 1 old age 1 7 , 1 8 2 , 1 9 5 old-age dependency ratio 186, 187, 193, 198-201, 202 'overall economic dependency ratio' 200 see also dependency-ratio scenarios

267

oligopoly 74, 173 open economies 72, 202, 208, 221(nl) 'opening clauses' 83, 88(n22) openness 16, 29, 46, 77 Organisation for Economic Co-operation and Development see OECD organizational learning 130 Origo, F. 114(n29) output 16, 53, 55, 70, 181, 194-6, 200, 238, 244(nl4), 249 average hourly real wage per unit of 63 full capacity 71, 247 full employment level 224, 226, 227 per capita 198 real wage per unit of 63 social 202 output gaps 68, 87(n5), 213, 221 (n2) output growth 6, 22, 201 per capita 202 real 35 output prices 74 outsourcing 103, 128, 130 overtime 88(n21) ownership 232-3, 237, 238-40, 244(nl4-15) manager-capitalists' share 232 workers' share 232 Pareto-optimality 15 pay-as-you-go (PAYG) 6, 194, 202 ageing and cost of 196-201, 204(nl0-ll) financial imbalances 199 social sustainability 181 pension funds 18, 128 pension plans 237 pension reforms 191, 196, 198 pensions abolition of real indexation to wages 196 fully funded (FF) schemes 181 public 204(nl0) pensions and distribution in an ageing society 6, 181-205 ageing and cost of PAYG 196-201, 204(nl0-ll)

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

Copyright material from www.palgraveconnect.com - licensed to University of Newcastle, Australia - PalgraveConnect - 2014-03-15

Index

Index

pensions and distribution in an ageing society - continued ageing and labour market 187, 189-95, 203-4(n3-9) conventional wisdom 182, 196, 199, 201 demographic trends 182-7, 203(n2) 'economic impact of ageing on labour market and viability of PAYG' 201 Phillips curve 86-7(n5), 109 physical decline 182 Pigou effect 8 7 ( n l l ) plant closures 130 plant and equipment 55 Poland 176t, 190t, 192t, 197t, 204(nll) political economists 87(n8) political economy 182, 223 monetary policy 3 8 - 4 0 political trade cycles 11 population 182, 193, 194, 203(nl) active 200 age structure 182 aged over fifty-five years 196, 198 dependent 200 inactive 186 native 186 trends (global scenarios) 182-5, 203 (n2) scenarios (2000-50) 190t see also working-age population population growth 17 7 (n 12) population replacement level 183-5 Portugal 51-2, 176t, 190t, 192t unemployment: causes 23, 24t-26t, 37t, 41t, 46 post-industrial societies 1 7 , 1 8 post-Keynesian models/approach 4, 70-3, 77 open economy 208, 209t price theories 87(n6) wages 87(n8) Post-Keynesian-Kaleckian growth model 230 post-Keynesians 68, 69, 87(n9), 206

post-war era (1945-) 9, 13, 44, 98, 108, 109, 112(nl2) Post-Washington Consensus (PWC) 5, 153, 154, 156, 165 'second-generation reforms' 152, 171, 174 poverty 195 absolute 172 'exit' from 129-30 poverty reduction 151 price competition 71, 87(n 13) price competitiveness 86 price cuts 68, 72 price equation 112(nl2) price inflation 104 price level 2, 71, 72, 77, 109, 228, 249 price mechanism imperfect functioning 14 price rigidities 72 price stability 1, 69 price system 223, 224 price-indexation 114(n25) price-indexation clauses 106 price-setting 75 prices 4, 5, 18, 56, 58, 62t, 68, 7 0 - 3 , 81t, 82t, 86-7(n5-12), 107, 108, 151, 229 competitive 11 domestic 72 falling 8 7 ( n l l ) pricing 74, 93, 230 primary sector 5, 154 private sector 13, 17, 57, 100, 106 privatization 129, 151, 173 product market 14, 224, 231-2, 248-9 closure 244(n8) product-market competition 228, 229, 233, 234, 240, 241 product-market conflict channel 240 production 101, 108, 128, 173 industrial 103 labour-intensity 217 social act of 203 (nl) technical conditions 194 production costs 106 production process 194

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production workers 95, 111 (n3-4) hourly wages (rates of change) 95f productivity 1-4, 11, 12, 17, 18, 53, 55, 56, 58, 59, 68, 84, 86, 88(nl9), 97, 103, 105, 107, lll(n8), 112(nl2), 121, 127, 131, 172,208,209,213,214, 219, 220 per capita 196, 198, 204(nll) coefficient 99 per employee 8It, 82t 'and unemployment' 2111, 217 rates of change (1979-2000) 107t productivity growth 6,71,75,79, 80, 81t, 82t, 96, 98-9, 100, 106, 108, 117, 118, 126t, 196, 198-201, 202, 209t per capita 201 rate 8In, 82n profit expectations 72 profit income 208, 237, 239, 241 profit levels 71 profit margin 3, 16, 18, 75, 76, 106, 247, 249 per unit of sale 247 profit rate 99, 112(nl3), 130, 220, 226, 227, 229-31, 234-7, 239, 241, 242f, 243f current expected 208 decomposition 208 equilibrium 231 profit retention 238 profit share 6, 7, 54, 75, 76, 118, 119t, 130,208-10,213-18, 221(n2), 225, 226, 228, 230, 232, 234-41, 243(n3), 247-9 appropriateness as measure for income distribution 218 effect on demand 215-16 higher 'increases international competitiveness' 21 It Kaldor model 227f, 227 'profit squeeze' 249, 250, 251t, 252 profit-led regimes 6-7, 207, 208, 210, 21 It, 215, 218, 225-6, 234, 236, 240, 242, 242f, 243(n2-3), 247, 250-2 profitability 13, 57, 213, 218

profits 56, 105, 118, 125, 127, 128, 198, 202, 225f, 239-41, 244(nl4-15) after-tax 125n attributable to manager-capitalists 232, 238 attributable to workers 232, 238 corporate-retained 232 distributed 234 expected rate 72 retained 233, 234, 237 retained (as share of GDP) 237 total 237 profits: effect on investment and employment (Bhaduri-Marglin model) 6,206-22 propensity to consume 195, 244(nl4), 247 propensity to save 224, 241, 244(n6) capitalists 230, 231, 235, 239-40 capitalists (out of profit income) 241 capitalists (out of wage income) 241 capitalists versus workers 227, 244(n5) profit income 226, 227, 247 wages 226 workers 228, 233, 235, 244(nll) workers (out of profit income) 241 workers (out of wage income) 241 property prices 68 proprietors' income 136, 146(n9) 'pseudo-curves' 93 pseudo demand and supply curves 114(n28) 'public choice theory' 11 public expenditure/government spending 16, 104, 153, 219, 244(nl4) allocation 17 cuts 85 ratio of GDP 157, 158, 170 real estate 27, 28t, 3 It, 32-3, 38-9, 46-7(n4), 134n, 137, 141 real-wage labour market closure 244(n8) recessions 20, 21, 55, 73, 75, 86, 127

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Index 269

Index

redundancy 101, l l l ( n 7 ) , 112(nl5) regulatory quality 157 remuneration 83, 88(nl8) growth rate 79 rent 118, 128 replacement migration 186-7, 188-9t 'reservation wage' 14 reserve wage 204(n 7) reserve-army effect (hypothesis) 208, 209, 21 It 'no evidence' (developed countries) 213, 214t 'significant' (developing countries) 216t, 217 resource allocation 172, 174 corporate 128 restructuring 128 retirement 182, 186, 189, 198 early 105, 196 later 6 retirement age 182, 191, 195, 201 retirement savings plans ('401(k)') 128, 132 rule of law 157 safety nets 152 salaries 79n, 87(nl3), 88(nl8), 113(n23), 118 sales 3, 16, 118 sales workers 131 savings 2, 7, 128, 196, 208, 218, 237, 239, 247-9, 252 aggregate 231, 234 corporate 237, 239 domestic 209t, 210 excess 238 foreign 210 Kaldor-Kalecki approach 241 personal 124, 124t savings incentives 132 services 18, 56, 57 Settlement countries 189, 190t, 191, 192t, 201 severance pay 103 share options 225 share prices/price of equities 68, 128, 238 share repurchases 1 1 8 , 1 2 5 , 1 2 8

shareholders/equity ownership 225, 238 shocks 4, 10, 29, 37, 50, 55, 57, 68, 103, 209, 213-15 skills 120, 131, 172 social capital 152 social insurance system 129 social mobility 123-4, 129 social output 6, 200 social pacts, national 79 social programmes 129 social protections 22 social safety net 14, 233 social security 6, 70, 181 social spending/welfare expenditure l l l ( n 5 ) , 114(n26), 172, 173, 181, 199 social stability 223 social transfers 202-3 socialism 3, 10 socio-political norms 152, 153, 154 Spain 23-9, 32-4, 37t, 37, 41t, 43, 46(n2), 51-2, 59, 60t-61t, 80, 176t, 190t, 192t, 197t speed of adjustment 63, 251-2 spillovers 3, 23, 52 stability 248, 250, 2 5 I t stability analysis 234-8, 241-3, 2 4 4 ( n l l - 1 3 ) , 251 Stability and Growth Pact 51, 85 'stable growth' mechanism 55 stagflation 10, 130 stagnation 4, 85, 86, 88(n25), 98, 195 stagnationist regimes 210,216, 243(n2), 244(nl2), 248, 250 'standard labour units' 111 (n3-4) standard of living 10, 193 state l l l ( n 7 ) , 129 distribution claims 73 re-empowerment 152, 157, 170, 171 state intervention/government intervention 2, 14-15 state policies 218, 219, 220 state role 13, 154, 174, 176(nl) state size 153, 157 stockmarkets 135, 245(nl6)

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Stolper-Samuelson theorem 151,167 strikes 58, 59, 60t, 62t, 63, 79, 104 structural adjustment 206 structural reforms 2 subsidies 105, 172, 219 substitution (of labour with capital) 211t hypothesis rejected 214t, 214 supply and demand 9 4 , 1 1 0 , 1 1 8 , 127, 223 supply shocks 68 supply side 2, 49, 196, 252 Sweden 103, 176t, 190t, 192t, 196, 197t, 2 0 4 ( n l l ) unemployment: causes 23, 24t-26t, 32, 35, 37t, 37, 41t Switzerland 23, 24t-26t, 37t, 4It, 190t, 192t 'system of industrial relations' 34 tax base 1 7 2 , 1 7 3 tax burden 3, 10, 22, 35, 43, 173, 182, 196 tax competition 173,174, 199, 202 tax coordination 202 tax incentives 172 tax policy 130 tax rates low 27 marginal 133 net 74 overall 26t tax reduction/cuts 2 1 , 35, 50, 130, 172 Tax Reform Act (USA, 1986) 133 tax returns 122 tax system l l l ( n 5 ) tax wedge 57 taxation/taxes 58, l l l ( n 4 ) , 134n, 198, 199, 218 corporate and capital 173 corporation and income 172 general 199 Taylor rule 87(n5) technical capital productivity 208 technical/technological progress 6, 20, 94, 101, 112(nl2-13), 172, 201, 208, 209, 219

271

technological u n e m p l o y m e n t 2111 hypothesis confirmed 213, 214t technology 233, 244(nl0) 'neutral' 18 new 229 terms of trade 99, lOOt, 100, 112(nl3) trade 5, 12, 129, 151-4, 157, 171, 174, 176(nl), 208, 209t, 212 distributional impact 127 effect o n growth and employment 214 international 9, 3 2 - 3 , 215 source of international competitiveness 214 US 127-8 trade deficits 13, 127 trade intensity 127 trade liberalization 5, 162 trade openness 167 trade theory 127 trade u n i o n density 3, 22, 23, 25t, 27, 28t, 30t, 32, 33, 35, 36, 38-43, 45, 47(n8), 50, 233 trade union representation 128 trade unions 5, 20, 54, 71, 84, 103-5, 108, 110(n2), l l l ( n 3 ) , 112(nl0), 113(nl8-19, n 2 1 , n24), 114(n25-6), 127, 130, 206, 240 bargaining 4, 44, 79, 80, 83, 102 central bank waging war o n 3 8 - 4 0 coordination initiatives 85-6, 88(n27) loss of political power 83 membership 79, 104 militancy 57, 101, 102, 104, 233 wage policy 69 weakness 95 trade volume 156, 170, 177(nlO) changes 165-7 training 17, 35, 121 Turkey 176t, 190t, 192t, 207, 214-17, 218, 219 underemployment 55 unemployed 199 number 60t, 62t temporary 194

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

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Index

Index

unemployment 1, 6, 9-17, 75, 87(nl4), 120, 128, 129, 157, 203(n6), 206, 208, 214, 217,223 adjusted standard 45-6 capital stock and 4, 4 9 - 6 6 cause 2 central cause 14 c o m m o n 46 conventional wisdom 43 definition 101, 105n, 112-13(nl6) disguised l l l ( n 6 ) , 215 effect of demand on 63 emanates from 'self-inflicted dysfunctional macroeconomic policy' 52 'equilibrium' rate 56, 58 high 85 hysteresis effect 209 investment-enhancing policies 'can lead the way in reducing' 64 juvenile 102 long-term 2, 57, 59, 60t, 62t, 63 'lowers wages' 211 mass 14, 79 m o n o t o n i c negative relationship with capacity utilization 231 'natural rate' (Friedman) 11, 21 OECD (evidence o n causes) 23-35, 46-7(nl-7) 'reduced fear of job-loss' 10 'reserve army of labour' 11 'significantly determined by capital shortages' 56-7 standardized 46(nl) structural 172 total 51 voluntary/involuntary 14, 194, 204(n7) unemployment: causes (sclerosis versus macroeconomic policy) 3, 2 0 - 4 8 appendix 4 5 - 6 'caused by macroeconomic factors' 44 country-specific effects 28-9, 32, 43, 47(n4) data 23-7, 46(nl) economic policy m e n u 44f

empirical findings 29-34, 46-7(n3-7) empirical model 27-9, 46(n2) employment (fair and full) 4 3 - 5 , 47(n9) features 33-4 further interpreting the results 34-5 high employment (debate over causes) 2 0 - 3 importance of macroeconomic forces 34 labour-market institutions and income inequality 40-3, 47(n8) macroeconomic variables 28, 32, 33,34 microeconomic variables 28, 33,36 OECD u n e m p l o y m e n t (evidence o n causes) 23-35, 4 6 - 7 ( n l - 7 ) political economy of monetary policy (central bankers versus unions) 3 8 - 4 0 principal contribution of chapter 22, 23, 29 quantifying the cause of changed u n e m p l o y m e n t rates 3 6 - 8 time-series u n e m p l o y m e n t rate regression 3 0 - l t u n e m p l o y m e n t benefits 3, 14, 20,21 duration 22, 27 real 60t, 63 real level 58, 59, 64(n3) value and duration 50 u n e m p l o y m e n t insurance compensation 233 unemployment, productivity, and institutions: influence o n real wage trends (Italy, 1970-2000) 4_5 ; 93-116 cross-regional studies 110, 114(n29) external constraints, macroeconomic policies, and institutional changes 102-8, 113-14(nl8-26) political and institutional factors 110

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unemployment, productivity, and institutions - continued predictive purposes (down-played) 109 socio-political context 102, 106, 108, 110 wages 'not affected by u n e m p l o y m e n t levels' (contradicted) 110 unemployment rate 4, 20-3, 29, 35-8, 45, 46(n3), 55, 62t, 70-2, 87(n9), 96, 97, 99-101, 108, l l l ( n 6 ) , 112(nl0), 112-13(nl6), 142-3, 191, 209t, 209, 213, 221(n2), 231 union wage coverage 26t, 27 unionization 128, 129 unit costs 11, 16, 18 unit labour costs 4, 68-73, 106, 113(n25), 208 causes of observed trends 70, 79-84, 88(nl8-23) growth rate 79, 85 increases (explanation for increases in inflation) 76 lower 'increase international competitiveness' 21 I t stable 71 trends 86(n4) unit-labour-costs growth, inflation and 73-8, 8 7 - 8 ( n l 3 - 1 8 ) United Kingdom 23-7, 37t, 41t, 47(n7), 51-3, 104, 113(n22), 176t, 188t-190t, 192t, 197t, 198, 2 0 4 ( n l 0 - l l ) , 207, 213, 214t unemployment 'significantly determined by capital shortages' 56-7 United Nations 183, 185 United States of America 7, 12, 13, 56, 57, 104, 108, 176t, 186, 188t-190t, 191, 192t, 197t, 203(n4), 207, 213-14, 242 inequality of household income 5 'more wage and income inequality t h a n any other OECD country' 130 productivity, labour costs, exchange rates (1979-2000) 107t real GDP growth rate 46

273

structural changes in economy 129 tax changes 237 unemployment: causes (sclerosis versus macroeconomic policy) 20, 2 1 , 23-9, 35, 37t, 37, 41t, 44f; 44 ; 46 ; 47(n5, n8) inequality 127-45, 145-6(n4-9) inequality trends 118-24, 145(nl-2) macro-economic background 124-7, 145, 145(n3) national income 119t non-financial corporate resources (1953-2004) 125t savings and consumer debt (1949-2004) 124t US economy 226, 236-7, 240, 243(n3) US Federal Reserve 2 1 , 38 Board of Governors (BOG) 69, 135, 141, 143 wage anchor 69, 73 wage bargaining 22, 103, 104, 106, 219 coordination 3, 26t, 27, 71, 87(n8) decentralization 2 deflation risks in Germany and EMU 4, 6 7 - 9 2 see also bargaining wage bill 7, 236f, 236, 237, 239, 240 distribution 225 manager capitalists 232-3 workers 232-3 wage claims 10, 18 wage concessions 97 'wage curve' 94, 112(nl2) wage cuts 172 wage demands 97 wage determination 93, 94, 97, 110, 112(nl2), 226, 232, 240 wage distribution channel 225 'wage drift' 81t, 82t, 113(n24) negative 83, 84, 88(n21) wage flexibility 11 insufficient downward nominal 69 wage growth 71, 108, 130 wage income 208, 232, 241

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

Copyright material from www.palgraveconnect.com - licensed to University of Newcastle, Australia - PalgraveConnect - 2014-03-15

Index

Index

wage increases 80, 88(nl9), 98 margins 99, 112(nl3) wage indexation 103, 105, 113(n20) imperfect (hypothesis supported) 211t, 213, 214t wage inequality 118, 120, 123, 138, 146(n9) wage labour 203 (nl) wage led regimes 6-7, 12, 207, 208, 210, 21 It, 215, 218, 225-6, 234, 236, 240, 243ff, 243(n2), 247, 250-2 wage level 193, 244(nl4) wage moderation 103, 113(nl8-19) wage negotiations 113 (n20) wage policies, dilemma in Germany and Europe 84-6, 88(n24-7) wage-price spiral 107 wage rate 193, 194, 204(n7) direct and social 195 flexibility 195 real 18 wage-replacement rate 27 wage restraint 12, 18, 104 excessive 69, 85, 86 wage rigidities 73 nominal 68, 69 wage-setting procedures 107, 108 wage share 54, 215, 217, 219, 236, 240 wage trends collectively agreed 83 influence of unemployment, productivity, and institutions (Italy, 1970-2000) 4-5, 93-116 wages 1-8, 14, 56, 57, 60t-61t, 7 0 - 3 , 121, 127, 129, 198, 202, 213, 227, 238, 241 actual 84 average 196 average hourly real (per unit of output) 63 check o n 194 collectively agreed 8It, 82t, 84 'compensation' 87(nl5), 117, 118, 119t, 128 consumption assumption 247 contractual 95, 97, 98, 102, lll(n3)

decrease 'increases employment' 21 It (hypothesis rejected, 214t, 217,220) deflation risks in Germany and EMU 4, 6 7 - 9 2 dual function 207 effect of demand o n 63 falling 72 final 196 flexibility 21, 201 gender inequality 120 gross 96 growth patterns 131 hourly 80, 88(nl9), 95f, 121 increase 'leads to substitution of labour with capital which in turn increases productivity' 21 It (hypothesis rejected, 214t, 217) increases 103 industrial 97, 98t, 99f, 108 laggard 118 low 118, 130, 217 manager-capitalists 225f, 225, 243(nl) net 96f nominal 58, 68-75, 107, 229 pivot variable 97 rates of change 97, 98t, 99f, lOOt, 112(nl0) real 10, 11, 18, 53-4, 58, 68-70, 94, 97-103, 105-6, 108, 110, 112(nl2-13), 114(n25), 172, 199, 206, 209, 218-19, 228, 231, 244(n8), 247, 249 real (changes in characteristic behaviour) 109 real (per unit of output) 58 real (Phillips curve) 109, 114(n28) real (rates of change) 111 (n8) real gross 96f relation to capital stock 58 rigid nominal 69 short-term variations (not of interest) l l l ( n 9 ) stagnation 108 'too high' 206 upward pressure 54

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

Copyright material from www.palgraveconnect.com - licensed to University of Newcastle, Australia - PalgraveConnect - 2014-03-15

274

wages - continued workers 225f, 225 see also earnings wages, employment, distribution and growth 1-8 thesis of book 2 wages policy 68-71, 73, 79, 80, 85,86 anchor for combating inflationary/ deflationary tendencies 68 Washington Consensus 22, 45, 152, 156 'first-generation reforms' 174 wealth 2, 72, 73, 87(nll), 113(n20), 124, 135, 237 wealth tax 237 welfare capitalism 3, 10 welfare economics 15 welfare state 1, 10, 14, 130, 181, 199 Western Europe 3, 9, 20, 22, 43 whites (USA) 120-1 women 120, 121, 123, 124, 183, 191, 194, 195, 200 worker rights 22 worker spending out of wages 244(nl4) worker spending out of worker income 244(nl4) workers 3, 10, 44, 96, 104, 112(nl5), 121, 130, 193, 198, 202, 208, 224-7, 232, 236f, 237, 238, 240, 244(n5, nl5), 250, 251t

bargaining power 100, 106, 113(n20, n22), 236 blue-collar (bias against) 128 'forced saving' 249 immigrant 102, 113(nl7) mature 200 median 120 old/older 195, 201 ownership share of capital stock 244(n6) problem of definition 243 (nl) skilled 64, 113(n20) white-collar lll(n3), 113(n20) see also employees working hours/working time 83, 88(n21), 101, lll(n3), 123, 124, 201 short-time 88(n21) total lll(n7) working-age population 10, 12, 182, 187, 189, 191-6, 198, 203(n3), 221 (n2) ageing (developed countries) 185-6 World Bank 156 data-set 155, 175t homepage 45 website 157 World War 11,13 younger generations 187,191 youth 195, 199, 201, 202

10.1057/9780230371781 - Wages, Employment, Distribution and Growth, Edited by Eckhard Hein, Arne Heise and Achim Truger

Copyright material from www.palgraveconnect.com - licensed to University of Newcastle, Australia - PalgraveConnect - 2014-03-15

Index 275