The long-term economic impact of growing inequality

Inequality has been widening across the world. A recent ADB report expressed concern at the rapid rise in inequality in emerging economies and warned that it puts at risk the spectacular recent economic progress of these economies. In this context, Paul Krugman points to an exploration by Lawrence Mishel of the various causes of this widening inequality.  

Mishel attributes the growth in income inequality over the last 30 years in the US to three dynamics - rising inequality of labor income (wages and compensation), rising inequality of capital income, and an increasing share of income going to capital income rather than labor income. More specifically, he argues that divergence between pay and productivity can go a long way towards explaining this widening of income inequality,

Productivity growth has risen substantially over the last few decades but the hourly compensation of the typical worker has seen much more modest growth, especially in the last 10 years or so. The gap between productivity and the compensation growth for the typical worker has been larger in the “lost decade” since the early 2000s than at any point in the post-World War II period. In contrast, productivity and the compensation of the typical worker grew in tandem over the early postwar period until the 1970s.

He has two illuminating graphics that highlight the magnitude of its contribution. The first graphic illustrates the cumulative growth in productivity per hour worked of the total economy (inclusive of the private sector, government, and nonprofit sector) since 1948 and the cumulative growth in inflation-adjusted hourly compensation for private-sector production/nonsupervisory workers (a group comprising over 80 percent of payroll employment). Notice that after 1973, productivity grew strongly, especially after 1995, while the typical worker’s compensation was relatively stagnant.

The next graphic disaggregates the productivity-pay disparity from 1973 to 2011 by charting the accumulated growth since 1973 in productivity; real average hourly compensation; and real median hourly compensation of all workers, and of men and of women. This figure clearly shows the divergence, especially since the early nineties between productivity and different categories of compensation. In simple terms, the share of income received as wages by workers is disproportionately small when compared to the share received by the owners of capital.

In addition, he also finds that workers suffered from adverse terms of trade. In other words, the prices of things they buy (i.e., consumer goods and services) have risen much faster than that of what they produce (consumer goods but also capital goods).

I will leave Mishel to conclude,

Productivity in the economy grew by 80.4 percent between 1973 and 2011 but the growth of real hourly compensation of the median worker grew by far less, just 10.7 percent, and nearly all of that growth occurred in a short window in the late 1990s. The pattern was very different from 1948 to 1973, when the hourly compensation of a typical worker grew in tandem with productivity. Reestablishing the link between productivity and pay of the typical worker is an essential component of any effort to provide shared prosperity and, in fact, may be necessary for obtaining robust growth without relying on asset bubbles and increased household debt. 

Much the same forces are active across the world, including countries like India. The only difference is in its magnitude or severity. 

India's most important structural imbalance in a graphic

A report by Deloitte has this graphic which captures the essence of India's most worrying economic-demographic imbalance.

An oversized 58% of the workforce involved in agriculture contributes just 15% to the GDP. India's biggest challenge in the coming years will be to manage the transition of a large share of this 58% into manufacturing and services. Given the already large share of services sector, manufacturing may have to absorb the major share of those moving out of agriculture.

Evidence of sticky wages

Econ 101 teaches us that prices adjust to clear supply and demand. Accordingly, in the aftermath of an economic boom when wages have risen, as recessions strike and unemployment rates climb, businesses lower wages which in turn lowers production costs and boosts investment and further hiring. In other words, high unemployment rates do not persist since wages fall proportionately to clear any labour market over-supply.

This has been used as a justification to oppose any government intervention to clear markets suffering from recessions. If the markets clear by themselves, it is argued, then where is the need for any discretionary fiscal policy intervention by governments. Though markets may deviate from the equilibrium, it is only a matter of time before the aforementioned dynamics takes over and restores stability.

However, as we have seen with the Great Recession and persistent high unemployment rate in the US, labour markets are not so accommodative. It is obvious that labour market does not clear so easily. In fact, the New Keynesian schools have long talked about "frictions" and "stickiness" with wages and prices which come in the way of markets regaining their earlier equilibrium. Economists like George Akerlof have pointed to downward wage rigidities, especially in conditions of low inflation.

In this context, an excellent study by researchers from the San Francisco Fed highlights the magnitude of this problem. They used individual-level survey data from 1980-2011 from the Current Population Survey (CPS), the monthly survey conducted by the Bureau of Labor Statistics used to measure the unemployment rate, to demonstrate the salience of downward nominal wage rigidity. They write,

Despite a severe recession and modest recovery, real wage growth has stayed relatively solid. A key reason seems to be downward nominal wage rigidities, that is, the tendency of employers to avoid cutting the dollar value of wages. This phenomenon means that, in nominal terms, wages tend not to adjust downward when economic conditions are poor. With inflation relatively low in recent years, these rigidities have limited reductions in the real wages of a large fraction of U.S. workers. 

In the current American context, since inflation is low and therefore keeping wages constant cannot reduce real wages, the only way for employers to lower wages is to actually cut nominal wages. The graphic below is an excellent illustration. The dashed black line shows a symmetric normal distribution, while the blue bars plot the actual distribution of nominal wages in 2011. The blue bar that spikes at zero shows that a large number of workers report no change in wages over a year. The prominence of this psike shows that disproportionately large numbers of employers simply kept wages fixed over the year. This proposition is also supported by the fact that the gap in the normal distribution and the actual wage distribution is much higher on the left side. This gap suggests that the spike at zero is made up mostly of workers whose wages otherwise would have been cut.

Similarly, the researchers also compare the trends in such wage rigidity over the past 30 years. They compared the proportion of workers in the same job who report no year-over-year wage change and find that their share rises in recessions and persist well into the recovery. Further, this proportion has risen sharply in the Great Recession for all categories of workers. They find that from 2007 to the end of 2011, the fraction of workers experiencing no yearly wage change rose to 16% from 11.2%. This is five percentage points higher than the average size of the spike at zero from 1983 to 2007.

The same trend is observed among all categories of workers.

See also Paul Krugman (also here) and Mark Thoma. 

Examining Spain's twenty-plus unemployment rate

Among all the dismal macroeconomic indicators pouring out from the peripheral Eurozone economies, the biggest concern is the high unemployment rates. In an environment of fiscal austerity, high rates of unemployment rates have the potential to severely destablize the society. Nowehere is this a bigger concern than in Spain, which has the highest unemployment rate.



Though, this graphic from Zero Hedge is scary, as Ezra Klein points out, it may not be as depressing as it appears. The vast majority of kids in this age group are in school and therefore should not be considered as part of the workforce.



Historically Spain has had extrteme volatility in its labour market. Its unemployment rate surged since early 2008, mirroring its rise in the first half of the nineties. Ezra Klein writes,

Construction in Spain was a whopping 13 percent of employment during the housing bubble — far bigger than even the United States — which led to an especially big crash. Also, it’s much harder to fire workers in Spain (which in turn makes jittery employers more reluctant to hire in the first place) and much easier to use temp workers.

Temporary workers form 33% of the total employees in Spain, the highest among all major economies. A CEPR study of the labour markets in Spain and France finds that in case of the former, the cost of firing temporary labour is minimal whereas the cost of firing the permanent labour is very high. This temporary-permanent labour contract costs is an important structural imbalance in the Spanish labour market. It has echoes in India's own labour market policies.

Spain's problems can be traced to a real estate bubble and a private consumption boom. Paul Krugman captured Spain's problems succinctly,

There was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

An examination of the macroeconomic indicators highlights Spain's vulnerability. Since the mid-nineties, the Spanish debt-to-GDP ratio has declined gradually to just 36.1% in 2008. However, it has since ballooned to 60.1% in 2011. Gross capital formation has declined from 29% of GDP in 2008 to less than 23% in 2010. Tax revenues as a share of GDP has fallen from slightly below 14% in 2007 to just above 8% for 2009. Since 2007, the structural balance, or output gap, has widened from just above 1% to more than 7% in 2011. Strained by the depressed economy and the resultant fall in revenues, the fiscal balance slipped from a surplus of nearly 2% of GDP in 2008 to a deficit of 9.3% in 2011. If macroeconomic indicators are any reflection, since 2009, the Spanish economy has fallen off the cliff.

The austerity is likely to worsen the situation. However, given its high unemployment rates and the adequate fiscal space available, Spain should be following expansionary policies till recovery takes firm hold.

Which country offers the cheapest labour?

FT charts the minimum wages in all the major economies, adjusted for purchasing power parity.

Graphic linkfest from 2011

Excellent graphics from the Wonkblog, BBC, and the Atlantic. All graphics below highlight important economic and social trends in a most striking manner.

It is no secret that any meaningful attempt to rein in America's debts has to involve addressing the burgeoning public health care expenditure. The graphic below makes this clear. Relentlessly rising health care costs coupled with demographic changes are driving the growth of these programs, while the open-ended structure of these programs is responsible for much of the increase in health care costs.



This graphic captures the extent of political polarization in the US. In the late 1960s, the most conservative Democrats in the House and the most liberal Republicans voted together frequently enough (as shown by the overlap between the two distributions) to make centrist legislating successful. By the late 1980s, that overlap was dwindling and today, it is largely gone.



Inequality is already one of the most important concerns for the US economy. As the graphic shows, corporate profits have not only recovered their post-recession highs, they’ve surpassed it and are growing, even as workers compensation as a share of the economy is declining continuously.



Thomas Gallagher of Scowcroft Group points out from the graphic below that the steep bull market since the early 1980s and the fact that previous such bull markets were preceded by pretty severe bear markets, is reason enough to be minimize expectations for overall stock market gains over the next several years.



Given the extent of job losses during the Great Recession, this Hamilton Project graphic shows that it may be years before the US economy regains the pre-recession level of jobs. If the economy adds about 208,000 jobs per month, which was the average monthly rate for the best year of job creation in the 2000s, then it will take until February 2024 — over 12 years — to close the jobs gap.



The chart below shows the real GDP in the US and the level of total civilian employment from 2002-2011. Its trends are an indicator of the gravity of labour market problem facing the US economy. While the total output has regained the pre-crisis level, the labour market is stuck way below. In other words, the US economy is producing the same output as in Q4 2007 with 6.6 million fewer workers. This jobless recovery points to a combination of increased productivity and labour market shifts (towards jobs which employ fewer jobs).



The graphic below captures the true magnitude of the global macroeconomic imbalance. It highlights the explosion of current account surpluses and official investments of delveloping economies in foreign financial assets, especially US Treasury Bonds. The mirro image of this is the rise in current account deficits in the developed economies.



Tyler Cowen's book, The Great Stagnation, has drawn attention to the stagnation in the Total Factor Productivity (TFP) of the US economy since the early 1970s. TFP is a measure of how much the economy is receiving a boost from innovation and new ideas, as opposed to, say, people working longer hours or taking a second job.



The graphic below highlights the power of the Fed's monetary policy announcements. On August 9, 2011, the FOMC meeting minutes announced that the economic conditions were 'likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013'. The market reaction was impressive.



One of the most powerful measures of the depth of the Great Recession is the output gaps that have emerged in both sides of the Atlantic. Bridging them could take years.




The two illuminating graphics ought to clarify the source of America's current debt crisis. It clearly points to the Bush legacy - tax cuts and Iraq-Afghan wars - as the main drivers of the ballooning deficit. Further, the much maligned stimulus spending and bailout policies have contributed only marginally to the debt stock and deficit. However, the loss of revenues due to the economic downturn has had a very significant effect.

The Global Debt "Minsky Moment"

FT Alphaville points to an excellent speech by Canada’s central bank governor Mark Carney where he points to the inevitability of a prolonged period of deleveraging among the developed economies to shake off the mountains of accumulated debt. He feels that the global "Minsky moment" has arrived, and a combination of debt restructuring, inflation and growth need to be deployed.

The speech contains several superb graphics that beautifully captures the debt trap in which US and Europe have entrapped themselves. The balance sheets of households and governments on both sides of the Atlantic have worsened dramatically over the past decade or so.




Following the bursting of the sub-prime mortgage bubble, net household wealth of Americans dropped spectacularly. This wealth can be regained only through a combination of increased savings and recovery in asset values.



Europe experienced a hugely imbalanced and unsustainable economic growth after the monetary union. Cross-border lending exploded, capital was cheaply available, public spending grew, and booms ensued. This eroded competitiveness, especially among the peripheral economies with respect to Germany. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany.



Financial globalisation, driven by savings glut in emerging Asia and consumption demand in the developed economies, led to the build up of external imbalances. The magnitude of these savings glut, best exepmlified by China's monstrous foreign exchange surpluses, allowed larger debt burdens to persist for longer than historically was the case.



All this was obviously not sustainable. When the bubble burst and Great Recession took hold, the consequences were severe. The World Bank estimates the world GDP output gap to be more than $7 trillion by 2017.



As these graphics reveal, all these economies built-up several critical structural imbalances over the past two decades. In all of them, compared to the previous two decades, public debts rose sharply, household wealth rose spectacularly, cross-border capital flows increased dramatically, and unit labour costs climbed. A fortunate confluence of favorable factors were inflating these bubbles and boosting economic growth.

Now that the bubbles have been deflated and the business cycle has changed direction, all these aforementioned macroeconomic indicators are naturally on the way down to their pre-bubble (not pre-crisis) norms. In many respects, this is a natural correction and there may be little that governments can do to avoid them.

NREGS and mechanisation

Interference with price signals has been the bane of public policy in India. The latest example is the labour market distortions caused by wage guarantee schemes. Business Standard highlights the sharp increases in famr labour wages between January 2007 and April 2011. It is estimated that farm wages have risen by an average of 70% across the country in the past four years due to the success of the National Rural Employment Guarantee Scheme (NREGS) which has been in operation in all Indian districts since 2007.



One happy consequence of scarce and costly manual labour has been the pace of farm mechanisation, as manifested in increased use of tractors, combine harvesters, small tillers, de-weeders and small power-driven sprayers.



The BS article writes about the factors driving increasing mechanisation,

"Such high wages not only squeeze farmers’ margins, but also crimp availability of labour. Factors like MNREGA and the prevalent socio-economic conditions lead to a 30-40 per cent shortage in manpower, which, in turn, leads to escalating costs year after year... the overall harvesting cost of sugarcane in Tamil Nadu has risen from Rs 300 a tonne to Rs 500-600 over recent years. And, that it touches Rs 700 a tonne during peak harvest... a pair of bullocks cost Rs 50,000 and feeding these requires another Rs 5,000 per month. Though used only for a month, they need to be fed for the entire year... bullocks are a hugely expensive proposition in Indian farming."

Superstar effect and skewed labour markets

I have blogged earlier about "superstar" effect wherein a small number of star players, artists, executives and other professionals command a disproportionately higher compensation premium than everyone else in the market. Superstar effect and its consequent out-sized compensations has been a major contributor to amplifying the attractions of financial sector as a career choice.

Chris Dillow has an excellent post where he points to the cognitive biases that exacerbate the "winner-takes-all" effect of such labour markets. Availability bias preys on our mind and makes us feel that the out-sized success of an always-on-television superstar can be emulated more easily than would be the case in real world. Overconfidence bias makes us over-estimate our own talent and conditions and thereby the probability of success. Probability misperception bias causes us to over-weight smaller probabilities (like winning lotteries).

All this results in misallocation of resources atleast in certain labour markets. Conventional wisdom on the cricket's Indian Premier League (IPL) and the numerous television talent shows is that they provide opportunities for talented youngsters to showcase their abilities and thereby make a livelihood in that field. The sudden emergence of these platforms and the sharp increase in the numbers of people benefiting, amplifies all the aforementioned behavioural biases and makes such vocations even more attractive.

Consider talent shows. A typical parent faces several perception distorting trends - there are a large number of vernacular television channels, most with their own heavily promoted talent shows; the strong memory of the ubiquity and fame of all the winners of the superstar shows (among such talent shows) like the Indian Idol; and the strong possibility of being connected to a relative or neighbour or workplace colleague whose child succeeded in a talent show and knowledge about their initial flush of fame and money. They therefore find the attraction of grooming their child to succeed in such talent shows irresistible.

Apart from all the three aforementioned cognitive baises, the parent faces another bias, the representativeness bias. It makes parents over-estimate the probability of their ward's success using available data as opposed to using an objective Bayesian calculation. Such over-estimation works at four-levels. One, given the large number of participants in each channel, parents fail to appreciate that the probability of their child's success is remote even in the particular show. Two, since their child is participating in a particular show, they over-estimate its importance over and above that of its possibly more influential (among talent hunters) competitors. Three, since any success in a talent show is followed by an initial flush of fame and money, parents over-estimate its importance and tend to see this as an inevitable precursor of things to follow, overlooking the strong probability that such a peak is less likely to be sustained. Finally, an increased number of parents now think the same way and try to encourage their children to participate in talent shows, which in turn significantly increases the market competition and thereby lowers the probability of success.

A Bayesian calculation will bear out the true magnitude of risks associated with attaching the fortunes of their children with such talent shows. However, cognitive biases overcome human beings and they unwisely yoke their children's careers to such professional choices. The same assessment would apply to parents encouraging their children to play cricket in the hope of IPL selection and success.

PS: In fact, a more critical assessment of these markets would reveal that even the argument about the market being able to accommodate an increased number of high paying professionals is questionable. True there is a demand for a greater number of singers and cricketers. But the superstars will always remain few in number. The rest will earn only a moderate amount, and that too only for a smaller shelf-life than with a regular occupation.

The Great Wage Stagnation

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

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

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

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



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



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



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

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

Labor market matching problems

Conventional public policy on employment generation is limited to the creation of new jobs and training to equip job seekers with requisite skills to compete in the job market. Since the former is directly related to the larger issue of economic growth, the focus of government driven employment generation programs have been largely confined to the later.

However, this approach, while a necessary requirement in any employment generation policy, may be a limited view of the dynamics of labor markets. I can think of atleast two dimensions of labor market inefficiency that keeps employment market at a sub-optimal equilibrium.

1. Matching unemployed labor to employers - At any time there are unemployed people looking for jobs and buyers of this labor searching for sellers. The problem is how to match them. This is a big challenge with un-skilled and semi-skilled service sector jobs. How do we match demand for specific jobs at a specific location and on specific terms, with sellers who meet all these requirements?

Such first level of matching immediately adds people to the workforce and reduces job-search inefficiencies. Businesses benefit by way of lower search costs for employing required labor (firms incur expenditures varying from 1-3 months salary as the cost of locating the right labor pool). People stay out of workforce for longer than necessary. Can public policy lower this inefficiency?

2. Optimal matching of under-employed labor - This involves matching employed people with jobs appropriate for their skill and capability level. In other words, it enables efficient matching of labor supply and demand.

Consider the case of Ramu, working with a small, single employee mom-and-pop clothes retailer in a city. After two years in the job, Ramu acquires enough skills to assume more demanding responsibilities. He can easily fit into the role of a lower manager in a shopping mall. His place can in turn be taken by a semi-skilled or even unskilled new addition to workforce, Ravi, who recently migrated from the neighbouring district in search of jobs. Everyone benefits - Ramu benefits by way of higher wages, Ravi gets employment, mom-and-pop retailer gets employee at lower cost, and the mall gets an employee with skills and experience. Most importantly, the economy benefits by way of productivity enhancing efficient matching of two people with varying skills with jobs that are most appropriate for them.

When several millions of such matching takes place, the efficiency gains are massive. It translates into the mom-and-pop shops expanding and hiring more labor, the mall increasing its sales, consumption by the new additions to the workforce adding to aggregate demand, and so on. In other words, the removal of such inefficiencies sets the stage for a virtuous circle of economic growth and job creation. How can public policy enable the removal of these inefficiencies and facilitate efficient matching of labor supply and demand?

In both these cases, the fundamental issue is a matching problem - how do we match unemployed or under-employed workers with their potential employers? Left to itself, for various reasons, the markets cannot enable efficient matching, especially in developing economies. Therefore, what role can governments play in facilitating such matching?

I had blogged earlier about the possibility of governments facilitating this by establishing and adding value to a dynamic meta-labor supply database. This would serve as a database for individual employers or placement agencies to locate job seekers who meet their requirements, thereby benefiting both sides.

I am strongly inclined towards the view that public policy has an important role to play in facilitating this matching process. The debate should be about how to achieve it without creating any major labor market incentive distortions.

Globalization and American economy

The impact of globalization has been one of the most controversial topics of debate in macroeconomic policy making for nearly two decades now. However, for most part, the debate has been partisan and driven by ideological considerations (free-marketers Vs protectionists). In this acrimony, important issues about how the dynamics of globalization affects economic output, employment, trade and inequality have not got the deserved attention, atleast among policy makers.

In this context, Michael Spence and Sandile Hlatshwayo have an excellent working paper on the impact of globalization on employment, economic value-added, and value-added per employee across various sectors of the US economy. The deeply empirical paper has several interesting findings.

They divided the economy into two buckets - tradeables and non-tradeables - and examined what happened in them during the high-noon of globalization, the 1990-2008 period. Tradeable sectors' output is traded across national borders and include manufacturing, agriculture, mining, technical services, financial services etc. Non-tradeables include government services, health care, retailing, transportation, construction, restaurants, legal services etc.

Their main findings, based on examination of historical time series data from US BLS and BEA, drawing on aggregate and particular industry level data for employment and value-added, include

"Value added grew across the economy, but almost all of the incremental employment increase of 27.3 million jobs was on the non-tradable side. On the non-tradable side, government and health care are the largest employers and provided the largest increments (an additional 10.4 million jobs) over the past two decades... without fast job creation in the non-tradable sector, the United States would already have faced a major employment challenge."

And about the underlying forces driving these trends and future prospects, they write,

"The trends in value added per employee are consistent with the adverse movements in the distribution of US income over the past twenty years, particularly the subdued income growth in the middle of the income range. The tradable side of the economy is shifting up the value-added chain with lower and middle components of these chains moving abroad, especially to the rapidly growing emerging markets. The latter themselves are moving rapidly up the value-added chains, and higher paying jobs may therefore leave the United States, following the migration pattern of lower-paying ones."

And about the implications of this trend, they point to long-term structural challenges with respect to the quantity and quality of employment opportunities for Americans, especially with respect to income distribution

"... almost all incremental employment has occurred in the non-tradable sector, which has experienced much slower growth in value added per employee. Because that number is highly correlated with income, it goes a long way to explain the stagnation of wages across large segments of the workforce."

More critically, they point to the impact of this trend on the US labor market, which assumes greater significance in view of the prevailing unemployment gloom,

"The expanding labor force was absorbed in the non-tradable sector (roughly 26.7 out of a total of 27.3 million net new jobs), government and health care leading the growth (10.4 million incremental jobs between them). In our view, it is unlikely that this pattern will continue. Chances are good that the pace of employment generation on the nontradable side will slow. Fiscal conditions, the costs of the health-care sector, a resetting of real estate values, and the elimination of excess consumption all point to the potential for a longer-term structural employment problem. Expanding employment in the tradable sector almost certainly has to be part of the solution. Otherwise, the United States will have a longer-term employment problem."

In other words, the authors make the point that while globalization has made goods and services less expensive for Americans (and kept a lid on inflation), it has also diminished employment opportunities for Americans at the lower and middle parts of the value chain, besides leaving open the danger that the higher-paying jobs at the top end of the value chain too may follow lower paying jobs in leaving American shores.

They also claim that the two contrasting trends across the tradeable and non-tradeable sectors - the former growing in terms of income (higher wages and profits) but not jobs and the latter growing in terms of jobs but not income (stagnant wages and benefits) - is a recipe for increasing inequality and social and political polarization.

Their prescription for the American economy is simple - boost the tradeable sector. Without dramatic increases in the size and scope of the tradable sector, the US economy will face an extended period of slow job growth and rising inequality. Arguing against protectionism, they advocate policies that incentivize businesses to invest in the physical and human capital necessary to make American workers more productive, rather than simply outsourcing work overseas.

See also this from Michael Spence and this from Uwe Reinhardt.

The "wageless and jobless recovery" in the US?

The labor market problems facing the US economy shows no signs of easing even as an ideological battle over the policy alternatives is on. By every imaginable yardstick, the labor market is at its weakest in decades and for all talk of recovery, unemployment rate remains stuck near its recession-time peak.



All labour market figures make very depressing reading. Almost 14 million people, or 9.1% of the labor force, were unemployed in May, with 45% of those unemployed for 27 weeks or more. Another 8.5 million part-time workers wanted but could not find full-time jobs; an additional 2.2 million dropped out of the labor force because they could not find work. The percentage of the population working has fallen to 58% from 63% over the past five years, reducing the number of Americans with jobs by 10 million.

Laura Tyson writes about the other costs of long term unemployment,

"The economic and human costs associated with the jobs crisis are staggering. An extended period of unemployment means lower earnings: workers who return after long-term unemployment earn 20 percent less over the next 15 to 20 years than a worker who was continuously employed. The longer workers are unemployed the more likely they are to lose their skills and drop out of the labor force. And the longer workers are unemployed, the more likely they are to lose their homes, their health and their marriages – and the more likely their children will grow up in poverty - with adverse implications for their health, education, and future incomes."

Now economists from Northwestern University have found that the woes are not confined to persistent unemployment but also includes wage changes. They "found that the current economic recovery in the United States has been unusually skewed in favor of corporate profits and against increased wages for workers". They show that since the recovery began in June 2009 following a deep 18-month recession, "corporate profits captured 88 percent of the growth in real national income while aggregate wages and salaries accounted for only slightly more than 1 percent" of that growth.

They also found that between the second quarter of 2009 and the fourth quarter of 2010, national income rose by $528 billion, with $464 billion of that growth going to pretax corporate profits, while just $7 billion went to aggregate wages and salaries, after accounting for inflation. In other words, the share of income growth going to employee compensation was far lower than in the four other economic recoveries that have occurred over the last three decades.



In fact, each of the indices of corporate profits showed strong growth over the past seven quarters - the index for the Dow Jones industrial average was nearly 46% higher at the end of the 2011 I quarter, and the S&P 500 index was 44% higher in that same quarter. In contrast, the three indices of hourly and weekly real wages of US workers showed little to no positive growth between the second quarter of 2009 and the first quarter of 2011. While each of the three corporate profit and stock value indices were far above their values in the base period, each of our three hourly and weekly wage indices were basically flat.

The BLS data reveals that average real hourly earnings for all employees actually declined by 1.1 percent from June 2009 to May 2011 and real wages and salaries declined by $27 bn over the seven quarters, the first ever such decline in any post-War II recovery. Further, worker productivity has grown just under 6 percent since the recovery began, helping to keep employment down while lifting corporate profits.

There is nothing surprising about this trend. In financial market meltdown induced balance sheet recession, consumers postpone spending and businesses defer investments to pay off their massive accumulated debts. When the magnitude of balance sheet damage is considerable, the recovery takes time, especially without substantial direct support from government. A downward spiral becomes inevitable - since consumer spending goes down, businesses start lay-offs and postpone investments; high unemployment and the excuse of recession also gives them the perfect excuse to squeeze more out of each employee without paying more. Corporate profits rise even as wages stagnate. And dismal economic expectations add to the woes by discouraging businesses from investing. The recovery path becomes a steep and arduous climb up.

Update 1 (4/7/2011)

The debate in the US about the economic policy options is between Conservatives who call for austerity measures to rein in the burgeoning public debt and Liberals who advocate more fiscal austerity to provide the stimulus that can lift the economy from its deep aggregatee demand slump.

Mr John Taylor traces the economy’s ailments to the abandonment of predictable, rules-based fiscal and monetary policies. The bail-outs and stimulus of George Bush junior and Mr Obama, and the Fed’s emergency lending and QE, he argues, sowed paralysing uncertainty. He believes that deep spending cuts would reverse this effect and thus generate private spending and growth.

In contrast, Christina Romer argues that near-term fiscal stimulus, by boosting employment and income, lessens the pressure on households to pay down debt whereas premature austerity could worsen the cycle of weaker growth and deleveraging.

Household debt in US remains well above its normal levels despite all the deleveraging of the past three years. As Carmen and Vince Reinhart have shown, countries that experienced macroeconomic and banking crises could repair their debt overhang only after a prolonged period of deleveraging. While Conservatives say that fiscal stimulus will only substitute private debt for government debt, Liberals argue that such stimulus spending expedites the process of balance sheet repairs.



Since recession ended in June 2009, GDP growth has averaged 2.8%, roughly its long-term trend. After so deep a slump, the pace is usually much faster. The gap between actual and potential GDP has been stuck at around 5% since late 2009.



For the record, the Obama administration has so far injected about $1.2 trillion in fiscal stimulus, the Fed has cut interest rates to nearly zero and then, in two rounds of QE, bought $2.3 trillion of government and mortgage-backed bonds.

Update 1 (19/7/2011)

David Leonhardt has a nice article on the huge consumer spending slump that the US is facing. He writes that,

"The auto industry is on pace to sell 28 percent fewer new vehicles this year than it did 10 years ago — and 10 years ago was 2001, when the country was in recession. Sales of ovens and stoves are on pace to be at their lowest level since 1992. Home sales over the past year have fallen back to their lowest point since the crisis began...

The Federal Reserve Bank of New York recently published a jarring report on what it calls discretionary service spending, a category that excludes housing, food and health care and includes restaurant meals, entertainment, education and even insurance. Going back decades, such spending had never fallen more than 3 percent per capita in a recession. In this slump, it is down almost 7 percent, and still has not really begun to recover...

If you’re looking for one overarching explanation for the still-terrible job market, it is this great consumer bust. Business executives are only rational to hold back on hiring if they do not know when their customers will fully return. Consumers, for their part, are coping with a sharp loss of wealth and an uncertain future (and many have discovered that they don’t need to buy a new car or stove every few years)."

He feels that the US economy is moving away from the debt-financed consumption dominated model that underpinned its growth since the eighties. See the graphic here.

The downward spiral with public policy?

Consider the following news stories

1. The MGNREGA moves from being an unemployment insurance program to becoming a market wage jobs entitlement program. The pressure to raise wages every year is increasingly driven by populist considerations,

"The wage rates for workers under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) have been increased. According to the rates revised by the Ministry of Rural Development with effect from January 1, 2011, the wages will go up by 17-30 per cent."

2. In fact, if ever a government wanted to design a policy that boosts aggregate wages across all sectors, there could not have been anything better than MGNREGA. Businessline has these latest Labour Bureau figures,

"Andhra Pradesh, for instance, has seen farm wage rates – the average taken for ploughing, sowing, weeding, transplanting and harvesting operations – going up 40.3 per cent in 2009 and 27.8 per cent in 2010. It is no different in other States, where, in the last year alone, the price of agricultural labour surged 15 to 20 per cent in Haryana, Bihar, West Bengal and Assam, 32 per cent in Punjab, and 43 per cent in Orissa."

(Given the concerns about the low wage rates in China and its impact on structural imbalances there, it may be worthwhile for the Chinese government to embrace its version of an employment guarantee scheme!)

3. To square the circle, the wage boost coupled with the upward movement of fertilizer prices (thanks to this), means higher cost of agriculture production, which naturally generates pressure for higher Minimum Support Price (MSP). This was therefore inevitable,

"The Centre is set to announce significant hikes, ranging from 15 to 17 per cent, in the minimum support prices (MSP) of most crops to be planted during the ensuing kharif season. The higher MSPs, while expected to further fuel inflationary pressures, are meant to compensate farmers for the surge in cultivation costs experienced by them in the last couple of years".

4. And high MSP also leads the way to record procurement, with all its attendant storage problems and carrying costs. Going by current trends, wheat procurement during the ongoing 2011-12 rabi marketing season (April-June) is set to cross 27 mt (of a total wheat crop of 84.27 mt), well beyond the target of 26 mt and the previous record high of 25.38 mt in 2009-10,

"At the start of the current marketing season on April 1, wheat stocks in the Central pool were placed at 15.36 mt against the minimum buffer and strategic reserve requirement of seven mt for that date. By July 1, the stocks are likely to be in the region of 40 mt or twice the corresponding required level of 20.1 mt."

So we appear to have this vicious spiral - higher farm wages leads to higher agriculture input costs begets higher MSP begets higher food prices.... Not to speak of the impact of higher farm wages on non-farm wages and the larger economy itself. See this, this, and this.

It is really unfortunate that our vast academic community has made virtually no serious attempt to assess the economic and social impact of the most important poverty eradication strategy of the times. It is impossible to tease out the magnitude effects of the aforementioned chain of events, without rigorous field surveys, pain-staking data collection over a period of time and from different areas, and comprehensive analysis of this data. In the absence of such research, we are forced to rely on official aggregate data to draw broad, un-quantified, and often vague inferences.

Tailpiece

And as if all the aggregate wage boost was not enough, here is more sage expert advise to increase the productivity of NREGA spending,

"Why cannot we have a system, where rural labourers are paid Rs 250 for working eight hours on farmers' fields? Out of the Rs 250, Rs 125 can be underwritten by NREGA, with the balance coming from farmers. We are, then, able to dovetail welfare schemes with productive activity and raise the latter component to 70-80 per cent."

Where and when will all this end?

Update 1 (14/6/2011)

Reuters report points to labor shortages across the country and the role of NREGS in causing it. It also points to the steep increase in farm wages and its impact on food prices.

Global unemployment challenge

The biggest immediate problem facing the developed economies is arguably the persistence of high unemployment rates. As the graphic below reveals, among the major economies, apart from Germany, unemployment rate remains well above the level before the onset of the Great Recession in September 2008.



Its innovative short-work scheme that encouraged companies to keep workers on reduced hours rather than let them go and the strength of its exports sector played a major role in limiting the impact of the Great Recession on the German labor market. Labour market reforms initiated in the last decade too helped Germany retain its competitiveness during the Great Recession.

In the circumstances, contractionary fiscal and monetary policies, driven by fears of burgeoning deficits and inflationary pressures, are only likely to further shrink these economies. This danger is all the more so since aggregate demand is very weak and the private sector is in no position to lead the recovery.

Anemic economy will only exacerbate the debt crisis and increase the debt-to-GDP ratios. As to inflation, given the considerable idling resources in all these economies, it looks like a phantom menace. The immediate challenge should be to get these economies back on some stable recovery path, so that jobs are restored and created, by continuing the expansionary policies for some more time. Or else, we could be staring at a lost decade for developed economies.

Euro and Germany

Floyd Norris examines the widespread belief that the the big winner from the introduction of Euro has been Germany. He points to an ECB study which finds that since its introduction in 1999, Germany has gained competitiveness, not only against other major industrial nations but against all other members of the euro zone.



The study also finds that over the same period, Germany’s balance of payments has gone from a small deficit to a strong surplus, but in the euro zone as a whole the balance of payments position has deteriorated slightly. Norris writes,

"With the exception of Germany, each of the countries shown has lost competitiveness because unit labor costs have risen more rapidly in those countries. Absent the euro, many of the countries probably would have devalued their national currencies, but that is not possible as long as they remain in the euro zone."

I have already blogged about how decline in competitiveness has played an important contributor to the problems of countries like Portugal and Greece.