Tuesday, May 15, 2012

Why Higher Wages Make Economic Sense

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Last May 1, the usual arguments of the business sector were unleashed with its central theme: No, business cannot afford wage hike. Beset with high cost and poor business climate, business simply cannot survive added cost of labor. How do we attract investments if we increase wages? Look at China and Vietnam. Didn’t they have a cheap labor policy? Aren’t they getting much more investments than us due to lower minimum wages?

As if the anti-wage-hike position isn’t entrenched enough, an army of economists follows with a recital of the dogma of “labor flexibility”. They say, wage level should be equal to the so-called “marginal productivity of labor” – which is economese for whatever the employer wants to pay them. Labor is supposedly not exempt from the law of supply and demand. Raising minimum wage will only increase unemployment, as it supposedly disallows all voluntary labor wage contracts that pay below the minimum wage. It will also introduce inefficiency in the labor markets, now faced with a "deadweight loss" due to the intervention of the government who will always fail to set prices right.

But why, if they are right, aren’t we attracting investments still? What explains Philippine firms’ low level of competitiveness? Why does unemployment remain high? The response has always been, never mind the workers, that it is not enough. Lower wages a bit more, then we’ll get the investments that would have gone to China. Lax regulations a bit more, and we’ll have more productive factories and viable businesses. Dismantle a little bit more unions, and businesses will be more efficient and will eventually increase their wages in the long-run.

This essay says enough.  It is high time that the government replace the failed “cheap labor policy” with a policy that increases wage income. In a time when self-rated poverty is worsening, prices of petroleum products remain high if not rising, and wages are not enough to even sustain a decent life for a family of five, no other proposal would be more just and fair than a proposal that increases the share labor gets from the economic pie.

The roadmap towards prosperity through increasing labor income is simple: Increasing wages will induce demand and increase labor productivity. Ensuring that workers are paid well, free to spend on non-basic commodities, and save for their future will facilitate the creation of a strong domestic market and large savings base which domestic banks can capitalize. Higher wages will increase capital-intensiveness of firms, increasing their productivity in the process. Rising corporate income will mean larger revenues for the government, which will pummel it back as welfare and unemployment support.

Let us elaborate.

Pro-Labor Policy and the Road to Prosperity

Great economic booms are usually associated with the industrial peace created by huge concessions to the working class. This, because a nation needs to position a strong, well-paid domestic market as the crucial driver of productivity gains. For instance, the United States (US) after the Great Depression sought to increase workers wages in order to establish a Fordist regime. It is called Fordist following Henry Ford’s decision to increase by leaps and bounds his workers salaries so that they can afford to buy their own cars, from him. Eventually, everyone else followed, and New Deal concessions with the working class plus increasing purchasing power created for the US a robust domestic market that later became the most powerful consuming block in the world. It is every bit as economist Michael Kalecki said: “Workers spend what they get. Capitalists get what they spend.”

Literary Digest interview with Henry FordLiterary Digest interview with Henry Ford (Photo credit: Wikipedia)
Let us take Japan. After WWII, the Diet of Japan passed a very liberal labor law – the Trade Union Act of 1949 which allowed workers to organize, strike, and bargain collectively. Because of intensive labor struggles, Japanese workers experienced rising incomes, creating a huge worker-middle class that served as the avant-garde home demand for Japanese manufacturing industries. In fact, it is the Japanese markets' tightly-constrained demand for kei-haku-tan-sho (light-thin-short-small) products that compelled Japanese firms to innovate, and create never-before-seen products that invaded the global market. Home demand conditions are important, and thus the necessary domestic market through a high wage regime.

This might sound like a chicken-and-egg proposal, for how would capitalists be able to afford higher wages? Aren’t we putting the cart before the horse? In fact, there wouldn’t be a few who would cite China – the master of low wage policy who managed to suck in investments due to cheap labor. They would say that a laissez-faire market and liberal labor policy would be enough to eventually raise the living standards and wages of workers; they may point out that in fact, China’s wages are already on the rise, with Shanghai’s decision to increase 13% per annum its minimum wage until 2015. Never mind the fact that the cost of living in China is pushed down by the social welfare system built by the communist party, which, while challenged, still survives until now: low wage would supposedly translate to higher investments, then higher jobs, then higher worker income.

The contrapositive of this is summed up by President Benigno Aquino’s rhetoric when he disapproved workers’ call for P125 wage hike – saying that businesses cannot afford as much as P194.9 billion additional cost. Setting aside the wrong computation (he used 40 million figure for the workforce which is wrong given that almost a fourth of that number are unpaid family workers, and a huge segment was in the informal sector which doesn’t receive minimum pay anyway), he fails to note that business would also be facing as much as P194.9 billion additional demand. Sure, some of it might go to savings or to taxes – but savings provide capital for business anyway, and increased revenues would go a long way by providing for much needed infrastructure spending.

Practically, in our age now, it is far better to rely on your own domestic market rather than the global market, especially if you are on the process of incubating your industries – as ADB, in a rather crude reversal of its decades old dogma (without apologies for prescribing the failed dogma in the first place), suggested Philippines to do. This is only possible if you develop your domestic market to begin with by ensuring that your buyers are not reduced to slaves – that they can buy for leisure and save for better life, that they have enough wages to do just that.

Higher Wages and Workers’ Productivity

There are arguments that higher wages without corresponding increase in productivity would result to a disaster. One cannot simply do the other way around, they say. Increasing wages beyond its current levels may force firms to face loses and even close – as it is assumed that it is already the maximum of what employers would have offered anyway.  This argument ignores the fact that in the US for instance, workers have tripled their productivity in over 30 years while the richest 1% tripled their share of income – with the top 10% absorbing all productivity gains since 1980. Same thing is happening all over the world. Labor is getting more efficient as it gains more skills, yet firms absorb all the windfall. It seems that increasing productivity follows from increasing workers’ upkeep.

In 1892, economist Jacob Schoenhof showed that in the last quarter century (from 1892), England, France, Germany and the United States experienced decreasing cost of production hand in hand with increased earnings of labors. He then presented, vis-a-vis “the iron law of wages”, the “true law of wages”: high wages translate to high productivity, low production cost and low prices. He recommended the following: abolish duty on raw materials, keep on high skill manufactures enough tax to raise revenue, establish technical and art schools to allow laborers to learn better to compete with more artistic foreign rivals, give each free choice to pursue individual interests [1].

Where will workers invest their higher wages? The obsolete neoclassical model would presume that they would substitute work for more leisure, i.e. they will all become “lazy” if you reach a certain point. But this is a static model, and an unsophisticated one at that. We know that a person, after achieving a certain point of wage, would invest in his or her own self-development (through education for its own sake, or for increasing its skills), and what would this effort redound to? Wouldn't it increase  productivity? [2]

Workers will invest in education, as long as there are incentives and institutions are in place. And increasing education of our workforce is necessary if we are to transition from labor-intensive production (which pays cheaply) to a capital-intensive one (which yields more value). Eventually, as long as there is a strong regulatory and welfare function of the state, this will redound not to increase in unemployment, but a decrease in labor-hours for all and more social services (due to increased revenue yields as productivity increases).

But a number would indeed, substitute labor to leisure as income rises. Is this necessarily bad? I don't think so. More than the fact that leisure is necessary for the reproduction of labor capacity (wouldn't a good spa now and then refresh your capacity to work?), more demand for leisure would end up creating new industries, generating more employment.

Higher Wages and Capital Productivity

There is another reason why society would benefit from higher wages. Remember that a capitalist decides whether to use labor or equipment in producing a particular commodity. Labor is cheaper in the short-run as it does not require any or huge upfront costs, while investing on capital equipment or technology is expensive in the short-run but cheaper in the long-run as processes become automated and firms save on labor. The decision whether to choose labor or capital depends on the price of the two. Increasing labor price would increase the probability of the firm choosing capital, while decreasing wages would increase demand for labor. Thus, higher wage will simply force employers to shift from labor-intensive to capital-intensive production. China, in fact, is already doing the transition.

Why is this good? Capital-intensive production results in a more efficient production and less waste, and frees up the labor force from processes that are too tedious, dangerous, or boring for human labor. On a firm level, why should an employer pay for three persons to do a task that a single machine can do more reliably and efficiently? On the employee level, why should a person undertake the dangerous task of labor-intensive construction for infrastructure (which, by the way, remains to be one of the most perilous industries for workers) if it can be done by machine, or at least, be done with the aid of a machine? Automation and mechanization minimizes exposure of people to dehumanizing and routine jobs, freeing their intelligence and skill for more advanced types of work.

Sounds familiar? In fact, restated another way, this reminds us of the main argument of advocates “against” wage hikes. They say that the transition to capital-intensive production would decrease the demand for labor – leading to higher unemployment or pressure to lower wages. How can then the shift to capital-intensive production be positive for labor?

There is an analogous case. Centuries ago, it was argued by many political-economists that industry is bad for agriculture because it will attract farmers to become laborers. Higher incomes, far better working conditions, and way higher consistency in income would starve agriculture of personnel. Who would then feed us? People asked this until they found out that industrialization increases agricultural productivity. True, there were fewer peasants, but they are working in a sector that has been made far more efficient by industry-supported mechanization. Such has been the evolution of agriculture that even as the United States has less than 5% of its economy on the agricultural sector, it is a net food exporter. The agricultural sector “suffered” in terms of starved supply of personnel, but society gained as a whole.

Would shifting to capital-intensive production starve the labor market of potential employers? Yes it may, but it will not necessarily be bad if the gains of the industry are felt by the entire society – more so the displaced workers. Instead of retrenchment, why not require industries to retrain its personnel as a force for industrial expansion or deepening? Instead of letting the retrenched and the jobless to wallow into the depths of poverty, why not translate increased revenues due to improving productivity to increased social welfare? Instead of looking at unemployment spending as a burden, why not see it as a necessary incentive for capital-intensiveness in industry? It is the same as Australia subsidizing its industry to prevent its people into shifting to more lucrative but less value added agricultural investment. In the end, it will lead to a more efficient economy, improving productivity, higher incomes, and better working standards for all. [3]

Where will we get the money? I have already hinted at this, but let me restate it: capital-intensive production offers more chance to accumulate profits for firms, translating to higher corporate base that the government can tap. Higher firm productivity can deepen the tax pool of the government if the government will have the political will to capture the windfall. This tax pool will finance social welfare and unemployment benefits. More than that, it can also finance education and human capital formation so that the unemployed can be put back to the labor force again – with better skills and higher productivity.

Russia's technology industry. Picture from telegraph.co.uk.

But how about the employed? Higher wages will largely redound to increased consumption or increased savings, which are both stimulus for increased investments: the former putting upward pressure on supply and the later providing the financing for improving production and expanding to create economies of scale. Moreover, capital-intensiveness raises the “marginal productivity” of labor. The less labor is utilized, the more valuable labor becomes, the higher the required pay for labor becomes. This is the paradox: if we increase wages via government, market is reconfigured such that those who are receiving high wages will continue to do so.

Why does a barber in the US earn ten times as much as the same barber doing the same job in the Philippines? Because their market can afford to pay more, since the wages of consumers are higher. And since higher wages will not just be an output of increased firm productivity (as the instinct is to hold costs down), it has to be extracted from the firms as government policy. Firms are simply not in an informed position to determine wages because they are not concerned with the aggregate demand. Ford was able to do that because of its size. On other cases, it can only be the government [4].

Are Higher Wages Inflationary?

Sure. Higher wages may lead to increase consumption, which would redound to higher investments, which may result to higher productivity. But won’t gains be erased by spiraling inflation? Won’t higher wages lead to firms demanding higher prices for their products? And won’t increased consumption signal higher demand which will bring further upward pressure on prices?

Let us approach the problem on the monetary level. Where will the money for increased wages come from? Of course, from the existing money supply. The demand for money in the aggregate does not increase or decrease - there will be the same number of goods around, and same amount of money supply. What happened merely is a redistribution of wealth from the capitalists to the workers.

If anything, inflation can only come from increased demand of commodities. Let’s assume that inflation will be caused due to aggregate demand increases because of increase in purchasing power of workers. The usual answer is that inflation will erode purchasing power increases –inflation primarily driven by producers increasing their prices in order to reduce demand and prevent exhaustion of its inventory. But what is more realistic – an entrepreneur increasing its price due to increased demand, or him increasing production to increase gross income? Wouldn't capitalists be induced to produce more rather than increase price? This is on top of the fact that there are associated “menu costs” involved - changing menu prices disrupt demand and even supply regularity.

This is also the reason why entrepreneurs will not be inclined to pass the added cost of labor to the price of their products. They would rather expand and increase production, and seek new markets. Expansion rather than tightening has always been the reaction of business to exogenous shocks. If they cannot do so, they will fail anyway. Once volume of sales dips, their net income might not suffice to cover for the interest of their loans to the banks (as we know, it is through banks that firms usually generate their seed capital).

Would their expansion be a success? I think yes, and this is because of increased purchasing power of workers. And we know that as business expands, the more it invests on product development, further decreasing prices and increasing quality. Again, a glorious cycle of increasing wealth [5].

Would there really be inflation to begin with? That has to be empirically established via testing and econometric analysis. Hess and Schweitzer (2000) as well as Jonsson and Palmqvist (2004) have econometrically proven that the link between inflation and wage increases is weak. But even without their studies, there are serious reasons to doubt that real inflation would be significant, or if it is, that its impact wouldn’t be manageable.

Anyway, much of our inflation is “cost-pushed” rather than “demand-pulled” i.e. it is not because of high demand, but because the cost of necessary inputs are high. Over-dependence on imported crude oil and imported foodstuff (from Vietnam) is the culprit for jacking up prices in 2008-2009. This will not be addressed by holding wages down. It can only be addressed by strategic planning to shift to self-sufficiency in renewable energy and food production.

And oh, we forgot to include that in the Philippines, there are other determinants of high production costs. We are for the longest time haunted by high power prices due to a flawed electric power industry and high transportation costs due to low infrastructure spending and failure to share the cost of financing equitably. Our firms, both in the industrial and agricultural sector, face insurmountable barriers to entry to due to presence of stiff foreign competition under the trade liberalization regime. Our MSMEs are burdened with high transactions costs due to red tape in business registration and redundant, inefficient taxations. Why blame labor cost alone?

Labor Protection and Development

We have already established our position for a higher wage on economic grounds. But even if we assume the claim of the anti-wage-hike militants – that economic growth can only occur by dismantling protection on labor – no one of us wants an economically robust country built at the foundation of blood due to wage slavery and labor abuse. We certainly do not want to see Filipino workers committing suicide because their powerhouse industries are giving them subhuman treatment, like the ones producing Blackberries and IPad now in China, or the despicable experience of British workers (as depicted by Oliver Twist) that compelled Marx to write his Communist Manifesto.

We don't want Filipino workers to receive below minimum wage salaries when even minimum wage salary, pegged at P426 per day, is bare 45% of the daily cost of living for a family of five. No morally sound Filipino would want that, even if eventually (as propounded) we will be prosperous because of economic growth. But even in that, there is no guarantee. What if the Filipino capitalists who earned their billions through wage repression suddenly decide to reside in another country (and Filipino aristocrats had a history of doing so), and sell their cheap goods elsewhere? What will happen to the vast majority of Filipinos who were their workers?

There is another way. Prosperity can be achieved, and is not mutually exclusive to that of ensuring welfare for your citizens. When China, as late as the late 1990s, came out to join WTO as a manufacturing giant, it wasn't considered a prosperous country - it was seen as a corrupt oligarchy, where a handful of extremely rich elite feeds from the cheap labor of the rest. Sure it is an economic powerhouse, but it wasn't prosperous. Only under Hu Jintao which focused on wealth redistribution and wage increases that the middle class emerged and China, truly, can be considered wealthy.

The question then becomes, does having accumulated huge capital a necessary condition for prosperity and good life for citizens? I don't think so. Maybe decades ago, it was still necessary, but now, with the level of technology-induced productivity, we no longer have to undergo a social fabric-wrenching experience in labor slavery in order to accumulate capital. We can simultaneously develop industrial capacity through direct government intervention while making sure that productivity increases are shared to workers in the form of wage increases.-30-


[1] See Economic and Industrial Delusions by Arthur B. Farquhar; Henry Farquhar. Review of "The Economy of High Wages" by J. Schoenhof by Lindley Miller Keasbey (page 547-548). Available here.

[2] An interesting technical note: this has already been described more abstractly by economist Robert Lucas, Jr. in his human capital accumulation model (1988) of explaining economic growth that does not make an appeal on the neoclassical sense of diminishing returns.

[3] In fact, in the long run, the correct response to automation is not to lay-off people, it would be to shorten working time, as less labor time is required for all individuals to produce the same number and same quality of goods. This is what happened to France, and on a little less scale, the rest of Europe. Instead of automation causing an unemployment crisis, it translated to a five hour work day and a “slow Europe” – as they did not need to work as fast to support their consumption.

[4] If one fears that productivity increases will not meet wage increases, we stop increases until real purchasing power of both firms and employees are no longer increasing. That is the scientific way of doing it. Playing prophet of “a priori” doom will not generate prosperity nor information on how our economy works.

[5] However, this is until such time that real inflation begins to settle in, and this is the period when we have to slow the economy down before unemployment kicks in. China made a brilliant example of this as they shifted to increased taxes after 2005 economic overheating. It only stopped this trend only because of the global economic crisis in 2008, when they again expanded monetary supply through stimulus.

Interesting Readings:

Buchanan, Daniel Houston (1934). The Development of Capitalistic Enterprise in India. Frank Cass & Co. London.

Jonsson, Magnus and Stefan Palmqvist (2004, April). Do Higher Wages Cause Inflation? Sveriges Riksbank Working Paper Series 159.

Hess, Gregory D. and Mark E. Schweitzer (2000 April). Does Wage Inflation Cause Price Inflation? FRB of Cleveland Policy Discussion Paper No. 1.

Schoenhof, Jacob (1892). The Economy of High Wages. An Inquiry into the Cause of High Wages and their Effect on Methods and Cost of Production. G.P. Putnam's Sons.

Some Sources:

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