Is flexibility a bad thing? - The Share Centre Blog

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Michael Baxter

Is flexibility a bad thing?

Written by: Michael Baxter on February 15th 2013

Category: Thought for the day

Okay, investors might argue that flexibility is pretty essential. But I am talking about wages. Data out last week showed that in the US, labour’s share of GDP rose in Q4. That may be bad for equities, or so some economists suggest. I am not sure. What all investors need is a stronger economy, and maybe right now that means higher wages and less flexibility.

Different times call for different measures. One of the biggest mistakes we make is to take the lessons of history too seriously. History does not repeat itself. Mark Twain once said: “but it does rhyme.” I am not saying there aren’t lessons from history, but just because something was right in, say, the 1980s it doesn’t mean it is right now.

Take the flexibility of the labour market. During the early 1980s the UK needed more of it. But right now I am not so sure.

Or take the minimum wage. From one point of view you could argue the very concept of the minimum wage is bad for an economy. The so called Austrian economists say that in an economy where the labour market is truly flexible, there would be zero benefits for those out of work, there would be no minimum wage, and there would be no unemployment. Wages should be determined by demand and supply of labour. In a market free from government intervention, wages will fall so that unemployment moves to nigh on zero.

Well, that may be right, but having full employment is not the same thing as having a healthy economy. As I have said many times, growth is a fragile thing. For most of humanity’s history it has not existed. GDP per capita has only been rising in any significant way since 1820. It seems to me that, for us to have growth, the economy needs something better than a completely free market for determining wages, at least it does at the moment.

One of the things an economy needs is for demand to rise. Demand can only rise in a sustainable way if wages are rising. The alternative is debt, and we all know the trouble that relying on debt got us into.

As an example take a theory called the paradox of flexibility. This term was invented by economists Paul Krugman and Gauti Eggertsson and it says that under certain circumstances a more flexible labour market leads to higher unemployment. And what are those circumstances? The theory assumes there is an output gap, meaning output is less than potential, thus there is spare capacity and interest rates are zero. It wasn’t like that in the 1980s, but it is like that now.

In his State of the Union Address, Barack Obama called for raising the US minimum wage. Right now, such a policy may be exactly what the US needs.

In the UK there has been much talk of a living wage. Maybe the UK minimum wage should rise so that it equals the living wage.

But won’t that lead to unemployment, I hear you say. The answer to that is yes… unless.

There has been lots of debate over using QE to fund massive stimulus programmes, be that new rail links, nuclear power stations, investment into renewables or supporting budding entrepreneurs. The snag is that right now UK unemployment is not that bad. Okay, at 7.7 per cent it is higher than we would like, but given the state of the economy, that number is remarkably low. So, for creating jobs,  there may be limited benefits from stimulus packages.

Having unemployment of 7.7 per cent five years or so into the longest economic downturn on record could be said to be proof of a flexible labour market. But a flexible labour market has meant lower wages, and has enabled employers to take on staff, even if the resulting increase in productivity is modest. As a result, productivity of UK labour lags way behind most of our economic rivals. According to data released by the ONS on February 13: “Output per hour in the UK was 16 percentage points below the average for the rest of the major industrialised economies in 2011, the widest productivity gap since 1993. On an output per worker basis, UK productivity was 21 percentage points lower than the rest of the G7 in 2011.”

So maybe what the UK needs is a much higher minimum wage, combined with massive QE funded stimulus programmes. That should get the UK economy kicking over.

But let me finish with some good news. According to data out last week, labour’s share of US income rose 4.9 per cent in Q4. See it in terms of a pie. Some of that pie is taken up by profits, some by wages. In recent years the share of the pie going to profits has been soaring. Some see the rise in corporate profits as justifying rises in equity prices. But when profits rise at the expense of wages, thus choking demand, I see rising equity prices as a bubble.

The news on rising wages to profits in Q4 is a good sign. Capital Economics has argued that we may see this sign continue in 2013. It says this may be negative development for equities. Well, in the short term that view might be right, but in the long run I think this is a very positive development, both for the economy and equities.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Tags: Austrian economists unemployment, flexibility of the labour market, labour productivity, living wage, Minimum wage, paradox of flexibility, wages profits GDP

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