Paul Krugman on verge of an illumination

Today Paul Krugman wrote a piece (and a blog post) about China’s high level of investment in the face of low domestic consumption. It is obvious to me that he is making headway in understanding the importance of low labor share of income.

Remember low labor share means high capital share. Capital income is dedicated to increasing the means of production, whereas labor income is primarily dedicated to purchasing the finished production. Paul Krugman refers to this directly…

“What immediately jumps out at you when you compare China with almost any other economy, aside from its rapid growth, is the lopsided balance between consumption and investment. All successful economies devote part of their current income to investment rather than consumption, so as to expand their future ability to consume. China, however, seems to invest only to expand its future ability to invest even more.”

“Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic “rebalancing” — the jargon phrase of the moment. Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place.” (emphasis added)

For me, he is describing the growth model of effective demand, where an economy in its early stages puts more income into capital investment and then over time must shift income to labor to purchase the production of the earlier investment. The result is an increasing standard of living. Yet, he is also describing the problem with the US economy where labor share of income has backtracked to a lower level below previous normal levels. We too have created a lop-sided balance between consumption and investment in the form of labor and capital incomes.

One can talk all day about monetary and fiscal policy, but at some point you have to talk about labor income to validate the rise in capital income and even the propensity to invest when demand is low. Labor’s share of total output that it receives in the form of income has fallen 5% in the US since before the crisis. In China, labor’s share is much lower, partly due to large exports in relation to their domestic market and partly due to an abundance of labor as Paul Krugman points out in his post. He sees China as “running out of peasants”. Thus wages will have to rise.

What will happen to wages in the US if wages in China change? Many see wages in the US tied to wages in China. Thus if wages rise in China, they would rise here. An associated view was tweeted by Noah Smith on June 17th, 2013…

“If China’s economy crashes or even slows substantially, I predict a sudden rise in labor’s share of income in rich countries.”

It is true. We have seen that labor’s share of income has fallen in advanced countries, whether or not this is due to labor competition with China or a business philosophy to maximize profits. The result is that domestic consumption is weaker. Yet there is an implication that capital needs the extra income to develop infrastructure and more means of production for the future. OK… then at some point labor will have to receive a larger share of income in order to consume the increased production just like in China. Will the United States return to a “standard of living” when labor share of income was 5% to 10% higher?

Paul Krugman is on the verge of connecting the problem of low consumption in China with the problem of low labor share in advanced countries. He is on the verge of an illumination about the dynamics between labor and capital incomes. I have seen him progressing towards this lately.

The realization of the importance of labor’s share of income would signal a wonderful evolution in the thought of Paul Krugman. Back in the late 90’s he undermined the living wage efforts by saying they were not about living standards  and economics, but about morality.

“In short, what the living wage is really about is not living standards, or even economics, but morality. Its advocates are basically opposed to the idea that wages are a market price–determined by supply and demand, the same as the price of apples or coal.”
Paul Krugman is now on the verge of seeing higher relative wages as critical to the “on-going” balance between production, consumption and a healthy sustainable economy. The lop-sided and wide-spread imbalance between labor and capital is creating present and future problems for the global economy.
Cross-posted at Effective Demand