We need growth fueled by rising wages, not more debt

It’s been a lost decade for British workers. Real wages in Britain have been falling for several years now. Adjusted for inflation, wages are back to where they were in 2003.

Part of this decline is due to the post-financial crisis recession, from which the economy has not yet fully recovered. But in part this is due to longer term trends: Since the early 1980s the share of income accruing to labour has been steadily declining.

In a new book, called Wage-led Growth: An Equitable Strategy for Economic Recovery, we are analysing the causes and the effects of these trends in income distribution. We argue that this has set economies onto a dangerous path of unstable growth. If wages lag behind productivity growth and inflation, this leads to rising inequality because profit incomes are more concentrated than wages. And for most households, wages are the most important source of income.

So how can people keep up their spending if their wages are not growing in line with productivity growth? The answer is they cannot – unless they start borrowing. Household debt has increased dramatically in the UK in the decade before the crisis, from 71 per cent of annual income in 1997 to 108 per cent in 2007. It should be clear that such a growth model is intrinsically unstable as it requires debt to grow faster than income.

Britain is not the only country that has embarked on a debt-led growth model. The USA, Ireland and Spain are other examples. This growth model essentially relied on a growing property price bubble, because mortgage lending with houses as collateral is at the base of credit growth. In these countries the crisis has been very painful, with people losing their jobs and, in many cases, their homes. In all of them the banks had to be rescued by governments. The reason for the crisis and the slow recovery from it is to be found in private debt, not government debt.

There is another group of countries that has responded very differently to slow wage growth. Germany and Japan (and to some extent China) have relied on export surpluses. They have accepted that domestic demand can’t grow if wages lag behind and have turned to external demand instead. This growth model relies on some other countries importing more than they are exporting and the debt-led economies did play this role.

At first, the export-led growth model may appear more stable, it relies on exports, not on household debt. Indeed, the export oriented countries mostly had a stronger recovery than the debt-led ones. However, the export-led model also relies on growing debt, but in more indirect way: its trade partners have to run current account deficits, which means that they are accumulating external debt. Simply put, the German model did not rely on its own household accumulating debt, but its main trade partners, France, Italy and Spain accumulating external debt. Their banks had to borrow abroad in order to finance lending to households. Again, this is an unstable growth model that relies on ever growing borrowing.

We return to the basic point that households can’t spend on consumption unless their wages are growing in line with economic growth. This is essence of wage-led growth. But there is more to it. In the book we present statistical evidence that higher wages shares can lead to higher aggregated demand and that they can also be good for productivity growth as wage growth speeds up technological progress. A 10 per cent wage increase typically leads to between three and four per cent higher productivity.

There are many factors that case low wage growth: firms can threaten to go abroad if workers don’t accept low wages, industrial firms now routinely engage in large scale financial transaction, technology has changed and so has legislation regarding trade unions. Among the labour market institutions, the organisational strength of trade unions emerges as a key factor, but capital mobility and trade globalisation are of equal importance.

So what can be done to move towards a wage-led growth model? We need strong trade unions and a welfare state, otherwise workers will not dare to ask for higher pay. But at the same time we need a strict regulation of financial activities. Only then can we go beyond debt-led growth.

Engelbert Stockhammer is professor at Kingston University.