Cultural economics of China and the effective demand growth model
I had a friend who worked as a teacher in China. She made about $600 per month there 10 years ago. She said there was one question that the Chinese would ask her, even Chinese that she met for the first time. People would ask her name, where she was from, what her job was… and then they would ask her … How much money she made.
As an American, that is a very uncomfortable question, but the Chinese were very straightforward and unabashed with the question. They felt it was a normal acceptable question to ask. The problem was that she made 3 times what her Chinese co-workers were making. As they found out what she was making, animosity grew. They were socially respectful enough at work but she could feel a tension about wages.
Think of the massive number of workers in China who think at least once a day about higher wages and more time off. Yet their loyalty to their companies is institutionalized. Many companies control where their workers live, the rents they pay, the hours they work and so on. I have heard it said from Chinese businessmen that workers perform better with strong authoritarian control.
There is a great desire for the Chinese to make more money in their work. Even the future success of China’s re-balancing depends upon higher wages. But how much would wages have to rise in order for the re-balancing to succeed?
I bring in the growth model of the effective demand research…
This model shows the optimal path of labor and capital utilization as the real GDP in an economy grows or declines as the case may be. The green line shows effective labor share equal to capacity utilization. The green line is the optimal path. The blue line shows the optimal capacity utilization for any given level of real GDP. Here is the equation of the blue line…
cu* = optimal capacity utilization… Y = real GDP… els = effective labor share… a = business cycle amplitude constant in terms of a base year’s dollars.
The optimal level of labor share is found where the blue line and the green line cross.
The red line is the effective demand limit based on a natural unemployment of 7%. The red line has the equation…
cu = els/(1-u)
cu = capacity utilization… els = effective labor share… u = natural rate of unemployment
The orange line is actual data from the US, 1967 to 2012. You can see how the economy stays below the red line as real GDP changes through the business cycles.
When real GDP is low (dark blue line), labor share is optimally low to allow for investment, as is the case in China. But China’s real GDP is growing at over 7%. So the line is shifting up. As the line shifts up, real GDP increases, and labor share must increase in order to maintain optimum utilization of labor and capital.
Now the question… what happens if labor share does not grow as real GDP increases?
This graphs shows an effective labor share of 58%, yet real GDP has grown far beyond that as seen by the blue line shifting upward. The yellow dot shows where the economy must remain, since the yellow dot cannot go above the red line. Capacity utilization is thus constrained to around 64% by effective demand. The only way to increase capacity utilization is to increase labor share.
The difference between the blue line of optimal utilization of capital and the yellow dot is the dead-weight loss to society. Now as real GDP increases in China without a corresponding increase in labor share, the dead-weight loss will grow and grow and grow. Eventually the dead-weight loss can be so great that growth is inhibited, in spite of ever-accelerating growth in investment spending.
The dead-weight loss is based on low labor costs in the face of rising output. The result is more profit to those who own capital. There are incentives to increase profits through investment, and not production for domestic demand. To continue on this path of high investment is not optimal in order for an economy to mature.
I am explaining the situation is China through the eyes of the effective demand research.
My back of the envelope calculation says that as China’s real GDP grows at 8% per year, their labor share would have to rise on average at 2.3% per year. For example, if effective labor share is 60% this year, next year it should be 61.4%. That is a big increase, but then so is an increase of 7% for real GDP.
There are many cases through history where a country is growing and then they reach a barrier and the growth stops. In many cases, the barrier comes from a labor share that never rose enough. Such is the case with many export-led economies. China is in a race with the above curve so as not to face a huge dead-weight loss from insufficient effective demand. If labor share does not rise enough in China, there will be repercussions felt around the world.
My view is that China will simply not be able to raise labor share enough due to their cultural values. They have strong institutions to keep workers under a strict control. They also have a reputation for being stingy with their money. We see their dismal offer of $100,000 for the Philippines after that terrible storm. That is like the cost of 5 cars. It is what is called a “character-defining moment”.
As Michael Pettis explains, they must have enough social capital in order to absorb all that 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 absorbed. He puts forth an argument with the implication that expansionary monetary policy designed to bolster investment will ultimately be ineffective when social capital is weak.
“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.”
My view is that China is so determined to be an economic rival of the US, that they will keep increasing investment until their economy is as productive as the US. They will base this growth on the comparative advantage of low wages and low labor share. As a culture, it will be extremely difficult to switch from a mind-set of increasing productive capacity, to one of increasing purchasing power of the workers.
Lambert, Edward. When labor share does not rise in the growth model. Effective demand blog, 4/6/2013.
Lambert, Edward. Building the growth model of effective demand. Effective demand blog, 4/6/2013.
Pettis, Michael. Rebalancing and long term growth. Michael Pettis’ Chinese financial markets blog. 9/3/2013
Can increased labor share be substituted by progressive taxation?
The current labor share dichotomy may be caused by preferential tax treatment of non-earned income. If capital gains were taxed as regular income, top management would stop “paying” themselves in share-based payment, and would instead pay themselves with actual wages. Would that actually increase labor share of income, or not?
There are some regions that are currently considering “basic-income” legislation where functionally everyone will be paid a certain amount every year by the government, and the remainder of their income would come from employers directly. Seems crazy, but social costs related to administering various sorts of programs might actually be reduced significantly (no need to means-test, automated distribution through EFT rather than some other more laborious method involving offices with desks, windows, and paperwork, etc). What sort of impact would a basic income have on labor share?
Hi J. Goodwin,
With progressive taxation like you mention, if money is paid as wages and salary, labor share would rise. You are forcing a transfer of money from capital to labor. Profits will be reduced. Dividends would be reduced. Stock prices should decline.
Keep the mind the difference between labor income and capital income. Currently effective labor income in the US is around $11.5 trillion. Capital income is then $4.2 trillion. If you lower capital income by 5%, labor income only rises by 1.8%. Labor share would rise from 73.2% to 74.6%.
Now you have to be careful when you raise labor share. If you do it now when real GDP is close to the effective demand limit, you can trigger a contraction. Many contractions started with a rise in labor share before a fall in labor or capital utilization.
Your theory would be successful when real GDP is not close to the effective demand limit. Like within the first year or two after a recession.
And as for basic income, it is not considered an increase in labor income when it is a transfer from the government. Basic income is more a redistribution of labor income, as I understand it explained in Switzerland.
Is that how you understand it?
I don’t think “basic income” is the way to go. With the revamped welfare law we ended up with government picking up what the employer should be paying. I can see “basic income” being used as a way for companies not to pay proper wages based on production/productivity. This has become especially worse with the successful lobbying for lower taxes on the highwage earnes and capital along with policies leading to mega companies essentially becoming stateless.
The results within an economy, the effect on an economy of money paid to wages out of money created via the input of labor I believe is not reproduced by money given to the population via government via taxation.
Does your model show labor share to be a constraint on US growth at present?
There is something very true about your words. It is best to earn your money through work. The basic income could weaken the movement for better wages. Is that what you are saying?
Yes, low labor share is constraining productivity increases.
I have doubt that there is significant movement for better wages. There’s certainly no quid-pro-quo for reductions in food stamps or anything like that versus wage increases.
You have articles out yesterday all over the place about Wal-Mart asking for canned goods for their employees who can’t feed their families on Wal-Mart wages. It is a crazy world when a company realizes they have employees who can’t live on what they pay them, and their response is to have a canned goods drive.
That is crazy about Walmart. There is an issue of “Food Security” in developing and poor countries. Many talk about food that is donated to the poor as not a reliable source of secure food, because at some point it may stop.
Same thing in this case with Walmart, having a canned goods drive does not develop Food Security.