Guest post by Edward Lambert as taken from his Blog Effective Demand
Yes, the economy is a concern. There are problems to sort out. The problems run deep. What is the solution?
The solution to the problems of the economy will be found through “Social Efficiency” and raising the social standards that have been declining through the years. I will present 3 examples of lowered social efficiency, grade inflation in schools, the minimum wage and finally low interest rates. My purpose is to show that nominal interest rates need to rise, but that real wages must rise in unison too.
Grade Inflation at Yale University
Let’s go to Yale University and see an example. Yale is currently working on a solution to its grade inflation. Grade inflation is when more students get A’s than before.
“…a full 62 percent — nearly two-thirds — of grades awarded in Yale College, the university’s undergraduate school, are A or A-. (That wasn’t case four decades ago, when just 1 out of 10 grades awarded fell in the A range.)”
“What do they call the person who graduates first in their medical class? Doctor
What do they call the person who graduates last in their medical class? Doctor
Rather than worrying about grades, I’m more concerned that students are sacrificing real learning for a better GPA.”
The problem is that standards, and more importantly, Social Standards of quality have been lowered. The issue of grade inflation at Yale is just one isolated example of declining Social Standards around the world. Just this week we see cheating in the schools of China is rampant, even as parents try to bribe teachers so their children get better grades.
Low Social Standards with Low Minimum Wage
Let’s now search for declining social standards in the economy. One example is the minimum wage, which has been declining in relative worth for decades. Many economists feel that a lower minimum wage makes it easier for businesses to compete and survive. However, the problem is that a lower minimum wage is a lower social standard, and as a result, many businesses that are not socially efficient are able to survive, just like an incompetent doctor who graduated because of grade inflation at his school.
When it comes to understanding the social efficiency of the minimum wage, I go to Bruce Kaufman, and in particular his paper entitled, Institutional Economics and the Minimum Wage: Broadening the Theoretical and Policy Debate. He writes about the social cost of labor, which is more than the private costs of each laborer combined. Social costs include education, health care and even more time for parents to spend with their families.
Think of the doctor who graduated last in his class, but still became a doctor. The school covered its own private costs by graduating the student and increasing its market share of alumni who can donate money in the future. The student covered his private cost by graduating. However, there will be a social cost to society by having a sub-par doctor. The school has a responsibility to cover that social cost by not graduating poor students. But since standards are lower, social costs rise.
I will present 2 points that Bruce Kaufman makes.
First, wages need to cover the social costs of labor. If wages do not cover the social costs, the quality of people’s lives suffers, while business profits more. The market failure is corrected by raising the minimum wage.
“…the minimum wage reduces or eliminates the externality-like gap between the private and social cost of labor and thus improves economic efficiency. The effect is analogous to placing a tax on a paper mill that dumps pollutants into a river. The higher cost causes the firm to reduce production and cut employment, but economic welfare is improved—not hurt—because the tax corrects a market failure (a missing property right) that allows the firm to use a valuable social resource (the river) without paying the cost. A minimum wage is also, in effect, a tax on firms, but these firms—like the paper mill—are using a resource to make profit without paying the full social cost.”
Second, Bruce Kaufman distinguishes between “high road” and “low road” firms. The basic difference is that high road firms invest in communities for the long-term. They are committed to meeting social costs in order to have a socially responsible business in that community. Society should appreciate these types of business.
On the other hand, low road firms seek to cut costs in order to raise profits. These firms pay their workers as little as possible with little concern for the social costs of their business upon society. We know these types of firms are growing in numbers, because more working people are receiving food stamps.
“Minimum wage laws may enhance efficiency in another way as well, by protecting not only workers but also “high road” employers who make long-term investments in human capital, physical capital, and R&D. Research shows that productivity is higher at firms using a high performance work system (HPWS) with self-managed work teams, job security provisions, extensive training, employee involvement methods, and formal dispute resolution programs (Appelbaum, Berg, Kalleberg, Bailey 2000). These kinds of organizational investments are crucial for long-run growth but may be seriously impeded by the instability and hyper short-term competition found in competitive markets. A minimum wage law can protect and encourage new forms of work organization, such as HPWS, by putting a floor under competition so “low road” firms are not able to undercut and drive out high road firms.”
The point Kaufman is making is that a higher minimum wage protects the high road firms that are socially more efficient. Lowering the minimum wage is like lowering the standards of social quality. The result is that we find more businesses surviving that are not socially desirable, because they do not pay the proper social costs.
Low Social Standards with Low Interest Rates
Now we come to interest rates. We all know interest rates are low because the Federal Reserve keeps the Fed rate at the zero lower bound. It is assumed that the economy is depressed. Thus low interest rates make money cheaper so as to entice businesses to invest and create jobs. Nonetheless, low interest rates lower social efficiency, just like grade inflation at the schools and a lower minimum wage.
With low interest rates, low road firms find it easier to survive. Low interest rates encourage businesses with lower standards for social efficiency. Thus social costs continue to rise.
Bruce Bartlett today makes a case that low interest rates lower the cost of capital. He mentions two results… 1. capital is substituted for labor in production and 2. labor’s share of income declines. His main point is that if you raise the cost of capital, labor will be more valuable and the declining labor share will reverse its downward trend. I agree. But for the reasons of social efficiency.
Bruce Bartlett says we need to raise the cost of capital. However, we must also raise the cost of labor, so that labor has more money to demand products. Thus, it is doubly true that we need to raise the cost of capital by raising interest rates or at least scaling back loose monetary policy. Why? If we were to raise the cost of labor (which must be done), while keeping capital cheap, labor is put at a further disadvantage. In essence, we will have to raise the cost of both… labor and capital. The result will be a balanced foundation for socially efficient economic growth.
We have seen in the past week that investors around the world reacted strongly to the idea that the cheap money from quantitative easing by the Fed may start to decline. Investors behaved just the like the students at Yale who recognize that grade inflation exists, but do not want to change the grading system. People depend upon socially inefficient standards for their own self-interest, while society suffers for it.
Raising interest would lead to a temporary hit of effective demand, but as wages improve and social efficiency improves, effective demand will begin to rebound in a socially better way. The Chinese are raising interest rates to clean out inefficient investing, which is accumulating and will hurt them in the future. The same logic applies to the West, where increasing “social” inefficiency of the economy is suppressing demand on a permanent basis due to accumulating social costs. Raising interest rates and wages will temporarily hurt demand but open the door to a long-term healthier demand. I think this is understood in China.
Michael Pettis, who has been warning of inefficient investing in China, talks about the ability of social capital to absorb capital investment. Social capital refers to the institutions of business and society, as well as the purchasing power of society. When social capital is well-developed, capital investment is supported. He puts forth an argument with the implication that expansionary monetary policy designed to bolster investment will be ineffective when social capital is weak.
“…if social capital is too low or, to put it another way, if capital stock exceeds the ability of an economy to absorb it efficiently, then the best way to achieve growth may be to focus not on increasing inputs, which may end up being wasted and so may actually reduce wealth, but in improving the ability of the economy to absorb the existing inputs.”
In many ways social capital in the United States is weak. Labor income has fallen. Communities are more fragmented. The scope of small business start-ups are more limited. Corporations leave less room for grassroots business. As Michael Pettis says, it is important to have institutions that transfer resources to businesses that increase social capital.
“I would argue, however, that economies are much better at absorbing and exploiting capital if they operate under an institutional framework that creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights), encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses…”
Bruce Kaufman made this same point above in terms of how a higher minimum wage supports high road firms that are socially efficient.
Michael Pettis gives a basic argument implying that if monetary policy is ineffective, it would be better to improve social capital first, which includes supporting small business innovation, increasing wages and raising household income. He sums up his arguments…
“What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently.”
Low Labor Share Constrains Demand for Production
In the United States, labor income needs to rise in order for capital growth (investment) to be absorbed efficiently. In effect, expansionary monetary policy is made ineffective when there is weak social capital.
Ultimately, low real wages and low labor share of income mean less demand for finished products. Thus production is limited. Even if capital is cheap, there is less effective demand to warrant investment in capital. With cheap labor, business has limited its own production, even while raising profit margins. Cheap labor is limiting economic growth through less effective demand. The answer is to raise labor income.
The standards of social efficiency have fallen in the economy.
Real wages are stagnant, while businesses record record profits. Businesses defend a low minimum wage in the name of economic efficiency, so that firms can compete better. However, a low minimum wage creates an environment where socially undesirable firms can compete with socially desirable firms, who would be willing to pay the social costs of their production. The result is that high road firms lower their standards to compete causing social costs to grow and accumulate. Eventually economic growth is suffocated by the accumulated social costs.
Low interest rates are defended because they allow any and all firms to survive, even the socially undesirable ones, in the name of “economic recovery”. I say that the true economic recovery is the recovery of higher standards of social efficiency. Until these higher standards are brought back, social costs will grow and accumulate putting a weight on economic growth. Low interest rates increase the accumulation of social costs.
There are socially unproductive standards rampant in society and the economy. And just like at most universities, where the grading curve goes lower and lower and lower, the economy too is lowering its standards. The result is a sub-par economy.
We need to start raising the curve, so that the chaff is separated from the wheat… so that socially inefficient wages are separated from the socially efficient ones… so that the low road firms are separated from the high road firms… so that flighty investors are separated from the investors who want to commit to the long-term growth of a community.
We need to raise the social quality of the economy once again. The solution is to raise real wages and to unwind expansionary monetary policy… steadily and carefully.
Bartlett, Bruce. Labor’s Declining Share is an International Problem. Economix blog, The New York Times, 6/25/2013, Web link
Kaufman, Bruce. Institutional Economics and the Minimum Wage: Broadening the Theoretical and Policy debate, Cornell University, ILR school, ILRReview volume 63, article 4, number 3, 2010. Web link
Moore, Malcom. Riot after Chinese teachers try to stop pupils cheating, The Telegraph, 6/20/2013, Web link
Pettis, Michael. How much investment is optimal?, Michael Pettis’ China Financial Markets, 6/10/2013, Web link
Trotter, J.K. Yale Averts Grading Curve Apcalypse, The Atlantic Wire, 6/25/2013, Web link