Global economic malaise driven by unemployment and low wages

A new report by the International Labor Organization, the Organization for Economic Cooperation and Development and the World Bank found that high unemployment and low wage growth are the two key problems facing the world economy today. The report identified these issues not as mere symptoms but rather as the causes of the slow recovery from the 2008 financial crisis.

The authors argue that the current stagnation in most G-20 economies is the result of three intertwined issues. First, despite some improvements, unemployment has not fallen rapidly enough since the economic crisis and will remain “substantial” until at least 2018. Second, the current recovery has been characterized by a proliferation of poor jobs and extremely insecure employment prospects. Third, wage growth has remained stagnant even since the recovery began.

This has created an economic environment in which demand for goods and services is low. Many workers are without jobs, and most of those who have work find it below their expectations and remain insecure. Combined with low wage growth, the deteriorating quality of jobs means workers are not encouraged to consume at rates that would keep the economy growing. Under such circumstances, firms do not see sufficient demand to justify investing in the production of new goods and services. So we end up in a vicious circle: a demand-constrained economic environment characterized by a decline in investment spending, high unemployment, poor quality jobs and low wage growth. The lack of investment exacerbates the slack labor markets that give rise to sluggish and demand-constrained recovery.

As the chart below shows, wage growth in the U.S. has been firmly tied to unemployment since the mid-1980s. When unemployment rises, wage growth slows; when unemployment falls, wage growth increases. That is why we end up with the mirror image pattern in the chart.

As the graph shows, in the past 30 years, high employment is one of the key drivers of wage growth. The supply of labor is constrained when unemployment is low, and employers have to offer higher wages to encourage people to work for them. By contrast, in economies with high unemployment, there is an enormous pool of idle labor, and employers do not need to offer higher wages to attract workers.

If the current economic stagnation is indeed caused by the lack of demand due to low wage growth and high unemployment, policymakers must start by addressing unemployment in order to boost economic growth. After the economy returns to full employment, then wages will begin to grow in lockstep.

Unfortunately, this is where the joint report breaks down and becomes vague. It discusses training programs to try to increase employment. But given the lack of demand for goods and services, which the report underlines, training unemployed workers alone will not lead to more people being employed. 

There is an old parable told by economists that is often used to illustrate this dilemma. Imagine that we bury nine bones in a backyard and send 10 dogs to find them. We will end up with nine dogs returning with bones and one with no bone. Now imagine that we train the dog with no bone to get better at finding bones. What would the result be? If the training went well, the dog with no bone will return with a bone, leaving another dog with no bone. The lesson is clear: With a limited number of bones, it does not matter how well we train the dogs; we will always end up with some that come back empty-handed.

The economics of this is even worse than the dog and bone example. If we train workers to be more productive while not increasing the number of jobs, they will produce even more goods in less time. Meanwhile, the demand for goods will remain the same, since we have not created new jobs. As a result, employers will see that they now need fewer employees to produce the same amount of goods. Engaging in extensive training of the labor force, as the joint report advises, might increase their productivity but will not address one of the key problems the report highlights: the gap between productivity and demand for goods and services. As such, by its own logic, the advice these researchers give would actually worsen the problems they are meant to solve.

So what would a real solution look like? It is quite simple: The government should create jobs. This would reduce the unemployment rate and push up wage growth. This in turn would increase investment and lead to higher growth. The report notes successful examples of public employment programs in India and South Africa but failed to recommend a similar approach as the optimal solution because the authors fear that governments are already reaching maximum spending capacity. This is misleading for two reasons.

First, when the public sector creates jobs, it leads to a rise in consumption and investment. This in turn increases economic growth, which leads to a tax multiplier effect, or increases in tax revenue for the government. We know from history that government budgets tend to be balanced in periods of high economic growth and low unemployment. Thus, to improve the government’s finances, we should focus on employment and economic growth. That means we have to first ensure that all productive resources are employed and worry about the finances later.

Second, governments with their own central banks can run high deficits for as long as they want. The central bank will always hold down interest rates by purchasing government debt in the secondary markets. The only real threat here is inflation, but this will occur only when the economy has reached full employment, at which point the government would pull back on spending because it will have reached its target. We have seen this before, during World War II, when the U.S. government ran enormous deficits of 20 to 25 percent to fully employ the labor force for wartime production. The same can be done in peacetime, with the government building and repairing roads and bridges rather than constructing bombs and tanks.

Overall, the report from the International Labor Organization, the Organization for Economic Cooperation and Development and the World Bank is a step in the right direction. Using extensive data, it cuts through the fog of confusion that many economists are throwing up to justify policy inaction on the current stagnation. Unfortunately, the authors tie their hands by adhering to groundless notion that governments cannot simply employ people to solve the unemployment problem.