Economic growth with falling real wages

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The UK recovery paints an unusual situation. We have both positive economic growth and falling real wages. How can we have economic growth with falling real wages?

Real wages are not the only source of economic growth. We can see growth from other components of AD –

I (Investment), G (Government spending) plus net exports (X-M)

Also, it is possible for consumer spending to rise despite falling real wages (at least in the short term). For example, if spending is financed by borrowing or declining savings ratio. Consumer spending could also be financed through re mortgaging houses (equity withdrawal) against the backdrop of rising house prices.

Economic growth in the UK

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Since 2013 Q1, we have seen a decent rate of economic recovery. In the past 12 months – between Q2 2013 and Q2 2014, GDP in volume terms increased by 3.2%

Real wages

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Real wages have been falling since the start of the great recession in mid 2008. In a recessing falling real wages are to be expected, but since the recovery, we might have expected real wages to match the growth in real GDP.

Why are real wages falling despite economic growth?

1. Flexible labour markets creating low paid employment. In this recovery, unemployment has fallen more rapidly than previous recessions. Evidence suggests the economy has been successful in creating new employment (often temporary / part-time/ self-employment). These new jobs are not particularly well paid. The recovery is good for job-seekers, but less good for those already in work. The relatively elastic supply of labour willing to take low paid jobs is keeping any wage growth low.

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Economic impact of welfare freezes

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Readers Question: What is the economic impact of proposed welfare benefit freezes proposed by Chancellor, Mr Osborne?

Mr Osborne has proposed a welfare freeze, worth £3 billion of savings over two years. This benefit freeze includes Jobseeker’s Allowance, Income Support, Child Tax Credit and Working Tax Credit, Child Benefit and Employment Support Allowance (paid to those judged capable of work). It does not include pensions, disability benefits and maternity pay.

The Treasury said that about 10 million households would be affected, roughly half of which are working.

The freeze will raise around £1.6bn in 2016/17, rising to around £3.2bn a year in 2017/18.

An argument for freezing welfare benefits is that it will help reduce the budget deficit and also – since 2007, average earnings (+17%) have been rising at a slower rate than working-age benefits (+22%.)

Economic effects

Aggregate Demand (AD) / economic growth. Welfare freezes will (ceteris paribus) reduce consumer spending, and lead to lower aggregate demand. It is an example of deflationary fiscal policy. It will be quite significant because people receiving welfare benefits have a high marginal propensity to consume because, on low incomes, they don’t have the luxury of saving – therefore, lower welfare benefits will directly lead to less spending in the economy.  Welfare freezes will also contribute to a decline in consumer confidence because it will be a visible reminder of economic hardship. Combined with other spending cuts of up to £24bn, there is still scope for these planned spending cuts to derail the economic recovery and cause lower growth or even a future recession.

However, the strength of the recent recovery suggests the UK may be in a better position to absorb austerity than a few years ago. Also, the chancellor can rely on the Bank of England to maintain a very loose monetary policy, which will help to offset the impact of this deflationary fiscal policy.

However, we still don’t know the position of the economy in a couple of years. there is evidence that the recovery still is unbalanced with low productivity growth and low real wage growth making the economy still vulnerable. Continued recession in Europe could  also act as a drag on the UK economy; it is possible that these commitments to spending cuts could hold back economic growth, that even monetary policy can’t overcome.

Deficit reduction. The spending cuts will contribute £3bn to saved spending, helping to reduce the budget deficit. However, it is still a small % of the current budget deficit (£93bn). Also, the reduction in deficit may be less than planned because it will cause a fall in tax revenues (e.g. less VAT receipts from lower spending) and also lower economic growth from the austerity measures.

Some economists argue that deficit reduction is essential and there is no alternative but to cut spending. They hope that cutting the deficit will reassure markets and business about the long-term strength of the economy. Other economists argue that recent evidence suggests people don’t gain confidence from austerity – but actually the opposite. (see: Confidence fairy)

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Budget deficit targets

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Politicians are often keen on making targets to eliminate budget deficits by a certain year. There is a strong political motivation to be seen as strong and committed to reducing government debt. Politicians who are vague about the debt are often heavily criticised and it is seen as poor politics. An advantage of budget deficit targets is that it ensure politicians have a stronger commitment to make politically difficult choices – raising taxes or cutting spending.

However, from an economic perspective targets for reducing budget deficits are not always as helpful as they may seem.

Benefits of budget deficit targets

There can be many sound economic reasons for reducing government borrowing. Just because a government can borrow, doesn’t mean it is desirable to.

  • It can prevent politicians choosing politically popular policies, such as tax cuts and spending increases. A deficit target can help prevent politicians putting off making difficult choices.
  • Without deficit reduction targets, some economists fear that there is an incentive to keep increasing the size of government spending, which crowds out more efficient private sector spending.
  • It can reassure markets that the government have a ‘responsible attitude to debt’ and are less likely to rely on printing money to finance the deficit and rely on inflation to inflate away the debt – which can reduce the real value of government bonds.
  • In some cases reducing the budget deficit can help lower bond yields because – with lower debt available on the market there is downward pressure on bond yields.
  • Some argue that budget deficit reduction gives consumers more to spend and firms to invest because the private sector have more confidence when the government is reducing its debt and is acting in a ‘responsible manner’. Others criticise this as being wishful thinking (see: Confidence fairy)

Problems of a budget deficit target

  • To stick to a strict budget deficit target may require tax increases / spending cuts at a time which is not appropriate for the economy. e.g. the UK economy is recovering, but if we increase income tax rates to improve tax receipts it may lead to lower growth and be counter-productive. See: Austerity can be self-defeating
  • Experience of Eurozone economies trying to meet budget deficit targets has been a deep recession.
  • Achieving an overall budget deficit means government have to finance investment spending out of tax revenue. But, arguably there is a better case for allowing government to borrow to finance investment.
  • A zero budget deficit is of doubtful value compared to other macro-economic objectives such as full employment, sustainable economic growth and low inflation.

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Economic system to improve income distribution

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Readers Question 1) Can an economy that factors in the need for government funded public services and to offer people a living wage, and other more distributive economic strategies such as taxing the rich more, etc. Can it work in purely economic terms?

Essentially the question is

  • Can we have economic growth and greater income redistribution to ensure everyone benefits from the proceeds of growth?

Redistribution

Economic growth (rising real GDP) makes it easier for the government to spend money on public services and welfare payments. With economic growth, tax revenues rise, as the government will collect more VAT and income tax. This can help reduce absolute poverty. If you compare UK society – 50 or 100 years ago, there have been great strides made in reducing the worst forms of poverty.

However, to reduce relative poverty and inequality may require different policies, such as a more progressive tax system and more generous means tested benefits.

Welfare payments can help economic growth

Unemployment benefit enables people to survive economic turbulence. It helps support them in finding a new job suited to their qualifications. Removing benefits would reduce income and could cause serious social problems as people feel totally excluded from society.

Government funded public services like education and health care play a major role in improving a nations productive capacity and helping long-term economic growth.

A living wage / minimum wage can help prevent monopsonistic exploitation. By increasing workers wages also creates more demand in society for goods.

Factors other than government policy

Also, fairness in society doesn’t just depend on government policy. It depends on the attitudes of firms, workers and society. If people in society value an element of redistribution it is more likely to happen. For example, do firms make workers shareholders in the company or is society dominated by powerful monopolists who want to maximise profits?

In the Nineteenth Century, the Dickensian idea of firms was that they were happy to pay as low wages as they could. The proceeds of economic growth did little to ‘trickle down’ to the poorest workers.

Post Second World War, economic growth was more consistent with reduced inequality; this was partly due to government welfare policies – e.g. unemployment benefit, but also firms were perhaps more likely to see it in their ‘enlightened self-interest’ to pay workers well and look after their welfare. Success in society became a little less judged by monetary gain, but also how you treated other people.

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Scotland post referendum

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An independent Scotland would have made an interesting economics case study. How would Sterlingisation  or a Currency Union have affected the Scottish economy? Now we may never find out. There were undoubted risks involved, though I’m not sure how much the issue affected the outcome. The Eurozone is also an interesting economics case study, but …

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Currency substitution – Dollarisation / Sterlingisation

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Currency substitution occurs when a country uses another currency without any official backing and without a Central Bank – instead of using its own currency.

For example, Panama uses the US Dollar as its currency. Even though it has no formal currency union with the UK. Jersey uses Sterling unofficially too.

The advantage is that a country like Panama gets to use a currency which has a stable value and international respect. The disadvantage is that it has little control over monetary policy and doesn’t have a Central Bank to act as lender of last resort to print money during periods of liquidity. Also, you lose the ability to devalue the exchange rate (which some may argue has advantages too)

Sterlingisation for Scotland

If Scotland vote for independence, Sterlingisation is seen as the best outcome for an independent Scotland. (Possibly as a precursor to a second stage where Scotland creates its own Central Bank and print its own ‘Scottish Pound’)

Sterlingisation would mean Scotland continues to use the Pound, but without a Central Bank as lender of last resort. It also means monetary policy would be set by the Bank of England.

Does it matter if Scotland doesn’t have a lender of last resort?

Given the problems of the Eurozone in recent years, there is an unfortunate precedent of countries being severely damaged by a lack of a Central Bank willing to act as a lender of last resort. However, there are two possible factors which could help Scotland.

  1. Firstly, some argue that having no Central Bank encourages banks to act more responsibly and avoid taking on excess risks. The Adam Smith Institute have produced a paper which is optimistic about the potential of ‘Adaptive Sterlingisation’ arguing that the period of free banking in Scotland in the eighteenth century was largely successful – with banks secured by shareholders. – How sterlingization and free banking could help Scotland flourish at Adam Smith – Institute.
  2. Would the Bank of England want to allow banks in the British Isles to fail? If Scotland gained independence, the Bank of England would have no compulsion to act as lender of last resort, but the UK banking systems is closely integrated; a collapse in confidence north of the border would have implications south of the border too. Would the Bank of England want to allow a failure of our near neighbour – when the financial and economic fortunes of the two countries are so closely tied together?

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Difficulty in switching from fossil fuels and oil

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Question and answers on the difficulty of switching from non-renewable energy sources, such as fossil fuels. (from – finding alternatives to fossil fuels)

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photo Dean

Readers Question: Why is it that on a global scale, alternative fuels are somewhat being ignored?

 

Firstly, fossil fuels are still cheaper. However, the gap is narrowing. For example, see how solar panels are coming down in costs.

solar-power
Cheaper solar power

There can be a reluctance to switch from one mode of production to another. Even if an alternative became cheaper, it requires significant investment to switch from one mode of power to another. For example, the UK kept steam trains running into the mid 1960s. Diesel was more efficient and cheaper many years previously, but it required a lot of investment in infrastructure to buy new diesel trains. Often it’s easier to keep going with old technology out of habit and merely because it is what has been used in the past. In some parts of the world, steam power is still used.

But, on the other hand, if we look back in history, we can see that a dominant technology can quite quickly lose its position. America quite quickly switched from steam trains to the petrol powered car. Once a tipping point is reached the momentum can swing to the new technology.

Also, a factor is that oil and petrol companies are very profitable and it is in their interests to keep oil based industries strong. If they can delay a switch to alternative fuels they might try. How much ability they have to delay an energy switch is open to question. But, there are powerful lobbyists to support the US coal and oil industries.

Readers Question: If it is not being ignored, Why is research and development is somewhat slow?

Alternatives to fossil fuels are generally not profitable in the short term. Therefore, private enterprise has limited incentives to research alternatives. This is an example of market failure, because the market ignores:

  1. The long term importance of developing alternatives to fossil fuels, which will one day run out.
  2. The external benefits of developing alternatives to fossil fuels, e.g. improvement in environment and reduced pollution.

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