MICHAEL KEATING. Slow Wage Growth and Its Implications for the Government’s Economic and Fiscal Forecasts

On Monday the Government will release the mid-year update of its economic and fiscal outlook. The Government hopes that the announcement of a return to budget surplus in 2019 will underpin its claims as an economic manager in the run-up to the May election. Clearly, however, that projected surplus will depend upon the assumptions employed, and it is contended here, and in advance, that we should be very suspicious of the most critical element in the government forecasts – the wage forecast.  

In a previous post, Economic Strategy for the 21st Century, I argued that ‘The fundamental reason for the economic stagnation of the last decade [in the OECD and Australia] has been inadequate demand growth, mainly because of increasing inequality and low wage growth’.

Thus, the critical factor in determining Australia’s future economic growth is wages and the distribution of those wages. As the Governor of the Reserve Bank put it last year, when commenting on Australia’s relatively poor growth record in recent years: The crisis is in real wage growth.

The Governor’s recognition of the importance of wage growth is most pleasing. But what we really need to know is what has been the cause of this low wage growth? Such an explanation would then provide a much better basis for forecasting the future and designing policies to improve future wage growth.

The official authorities in their analysis have mostly tried to argue that wages will pick up as employment rises and unemployment falls. In other words, they see the slow wage growth as purely a short-term business cycle phenomenon. In their view, there has been no change in the long-term relationship between unemployment and wage growth. At most the RBA has raised the possibility that the level of unemployment compatible with stable wage growth (the NAIRU) may have fallen a little, and consequently a return to past rates of increase in wages will require a return to a lower rate of unemployment than in the past. According to these same authorities, however, we have nearly achieved the target lower rates of unemployment, but so far this calendar year wages are increasing at an annual rate of 2¼ per cent; well below the Budget forecast of 2¾ per cent in the current financial year and by 3¼ per cent in 2019-20.

By contrast the weight of opinion overseas is that in many advanced economies – including Australia – the rate of wage increase has been decoupled from economic growth. Furthermore, the gap between the rate of wage growth and productivity growth is larger for low skilled workers, meaning that the distribution of earnings is also becoming more unequal. For example, the OECD (2018:29) found that: ‘On average, hourly wage growth in OECD countries was still 0.4 percentage points lower in the last quarter of 2017 than it was in late 2008, while unemployment was at a similar level’.

Furthermore, aggregate demand in most economies is usually wage-led because the positive effect of a higher wage share, and/or a more equitable distribution of earnings, on consumption typically dominates the negative effects on investment and net exports. Indeed, investment may also be higher if investment is more responsive to an increase in the rate of capacity utilisation than to the negative impact of a lower profit share. In short, therefore, low wage growth is now generally recognised as representing a critical part of the explanation for the economic stagnation experienced in the OECD since the Great Recession which started around a decade ago.

The reasons for this decoupling of wage growth from economic growth have mainly to do with the nature and impact of technological change on the labour market. We don’t need to explore these causes further here[i], but the important point to note is that this means that the stagnation of wages has become a structural problem and not a cyclical problem. Thus, it will not correct itself as economic activity recovers. Instead this slow wage growth is acting as a restraint on aggregate demand and thus on economic growth. In addition, over time this slower rate of increase in aggregated demand will result in lower investment, which in turn will lower the rate of introduction of new technology, while skills will also atrophy. Thus, eventually the rate of potential output growth will also slow and a new equilibrium will be established between the new slower rate of aggregate demand and potential output growth.

In this context I am reminded of Keynes’ remark that: ‘when the facts change, I change my mind’. I therefore find it more than passing curious that the Australian authorities, and more generally most Australian economists, seem largely unaware of, let alone interested in this problem of wage stagnation and its causes. An immediate consequence of the authorities’ ignorance is, however, that the Government’s economic and fiscal forecasts to be issued on Monday, rest on particularly shallow foundations.

I will discuss these government forecasts in more detail in a further article to be posted following the release of the Government’s Mid-Year Economic and Fiscal Outlook update.

References

Bell. S. & Keating, M., 2018, Fair Share: Competing Claims and Australia’s Economic Future, Melbourne University Press.

OECD Economic Outlook, Issue 2, 2018, Paris

OECD Employment Outlook, 2018, Paris

Michael Keating is a former Head of the Departments of Employment & Industrial Relations, Finance, and Prime Minister & Cabinet. He is currently a Visiting Fellow at the ANU.

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