Friday, October 06, 2006

To Wage War

According to Paul Krugman in today’s New York Times (by way of Mark Thoma and of jurassicpark at Welcome to Pottersville, and thanks to Google Blog Search, since I’m not a Times subscriber right now):
The Dow is doing well largely because American employers are waging a successful war against wages. Economic growth since early 2000, when the Dow reached its previous peak, hasn’t been exceptional. But after-tax corporate profits have more than doubled, because workers’ productivity is up, but their wages aren’t — and because companies have dealt with rising health insurance premiums by denying insurance to ever more workers.

If you want to see how the war against wages is being fought, and what it’s doing to working Americans and their families, consider the latest news from Wal-Mart....
I have an immediate problem with this explanation for the rising stock market (which is not to say that I have a better explanation). If wages (and total compensation) are being kept down in the face of rising productivity, why isn’t competition keeping prices down as well? It seems to me that, to make his explanation complete, Prof. Krugman needs a story about reduced competition in product markets. Otherwise, there is no reason to expect that the markup of prices over wages should rise as wage bills decline. If wages are the only story, then at best the stock market is being short-sighted in not seeing the eventual effects of competition.

Prof. Krugman’s example, Wal-Mart, is an excellent case in point. Historically, Wal-Mart has reaped the benefit of reduced costs not by raising its margins but by cutting its prices and thereby increasing its market share. Wal-Mart’s profits have gone up, but its competitors’ profits have gone down. (More precisely, some of the competitors’ profits have gone up, but more slowly than they would have in the absence of Wal-Mart’s cost-cutting, whereas other competitors have stopped earning profits altogether and, in many cases, gone out of business.) Historically, Wal-Mart’s cost cutting has not obviously resulted in increased profits for the retailing business in general. Things may have changed now – Wal-Mart may now have such a large market share that it plans to grow by raising margins rather than cutting prices – but in that case, the story is not really a story about costs but a story about monopoly power.

As I said parenthetically above, I don’t have a good explanation for the rising stock market. My best guess as to why profits are so high has been that economic rents in certain industries (oil and software, for example) are puffing up aggregate profits. But this wouldn’t explain why the stock market is still going up. Of course, one doesn’t really need an explanation because we can always attribute stock price movements to changes in the required equity risk premium.

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17 Comments:

Blogger Gabriel Mihalache said...

The hypothesis, as such, is interesting. Worth researching, I think. But the wording is far too politicised. It's gratuitous.

Fri Oct 06, 02:11:00 PM EDT  
Blogger spencerengland said...

This stock market cycle has been very, very unusual in that it has been almost completely driven by rising earnings as the PE has fallen almost continously since its
1999 peak of 29 to 16.5 now -- based on trailing operating earnings.

For example, from 1949 to 2000
only 21.5% of the gain in the S&P
500 was due to increases in eps
while the remaining 78.5% of the gain was due to rising PEs. Moreover, this is based on the operating eps rather then reported eps in 2000.

Sat Oct 07, 09:32:00 AM EDT  
Anonymous Bruce Wilder said...

gabriel is correct that the rhetoric is polemical. However, Krugman is just reporting the facts, when he points out that almost all the "gains" in this business cycle have gone to business and very little approximating nothing has gone to labor. Moreover, this is the culmination of a trend going back to the mid-1970's.

Average productivity is rising faster than marginal productivity (i.e. wages), which is another way of saying that capital is getting a bigger share of the pie.

The vagaries of the stock market are mysterious to me, but it doesn't seem much of a stretch to relate an increasing share of national income going to Capital in the form of corporate profits to a rising stock market.

Whether Krugman "needs" a specific argument about product market competition depends on how you regard the pervasiveness of rents.

Unions, traditionally, have done well in industries, where firms have enjoyed large rents. Large rents imply that there is something remunerative over which to negotiate with management.

To ask, "If wages . . . are being kept down in the face of rising productivity, why isn't competition keeping prices down as well?" seems to reveal a certain wilful blindness to the implied power relations. It is sort of odd to think that because an actor is powerful in arena A (wage negotiations) the same actor must necessarily be weak in arena B (product market price competition).

If wages are being negotiated at all, instead of being simply an outcome of an indifferent labor market, it implies a product market rent is being earned.

Wal-Mart would indeed seem an excellent example. Wal-Mart, possessing a markedly superior distribution system, is able to earn a substantial economic rents as a consequence. That is, Wal-Mart can obtain factor resources at market prices, and due to higher technical operational efficiency than in retail generally or the economy generally, obtain a higher than normal factor productivity from those resources, hence an economic rent. Schumpeter would be proud, I'm sure.

Wal-Mart is clearly a very powerful player, in possession of substantial rents, rents which it increases or preserves, if it can prevent labor or other suppliers from capturing them.

If there is a competitive mystery, it is why Wal-Mart can drive down wages, and still get competent employees.

Why are there not better uses for labor?

Ordinarily, with labor productivity rising, we would expect wages to get bid up. Why can Wal-Mart, in this labor market, with labor productivity rising, bid wages down?

Power certainly matters, especially, when Labor confronts a large and powerful employer, protecting large rents. Krugman points at that.

But, why, with corporate profits high, and nominal unemployment low, and productivity rising, are wages not being bid up?

Sat Oct 07, 11:17:00 PM EDT  
Anonymous Anonymous said...

Investment in the real estate market has returned to the stock and bond markets it left in 2000.
So we have this modest rally, so far, with no fundamentals driving it and there is understandable nervousness.
Who is going to buy the products and services behind those stocks when the consumer has spent his MEW? Retail down 2 months in a row could mean people are saving early for the Xmas season, or it could mean something else.

Sun Oct 08, 12:44:00 AM EDT  
Blogger knzn said...

It is sort of odd to think that because an actor is powerful in arena A (wage negotiations) the same actor must necessarily be weak in arena B (product market price competition).

That’s not what I’m saying. I’m saying that making an actor more powerful in arena A doesn’t automatically make the same actor more powerful in arena B. If WalMart can get away with paying lower wages, then so can its competitors. WalMart’s advantage in distribution was there to begin with, before its got its wage bill down; the advantage hasn’t increased, so why should WalMart’s margin increase?

Sun Oct 08, 09:18:00 AM EDT  
Anonymous happyjuggler0 said...

Long post warning

I have two theories, one new and one old, that probably have holes in them, but here goes:

Old theory:

During WWII, which came on the heels of the "Great" Depression, most of the world's factories were literally destroyed, leaving the US, Canada, Sweden and Switzerland with having the lion's share of operating factories, as well as intact physical infrastructure.

This in effect radically increased the value of such existing factories. Companies put a premium on increasing output as opposed to innovation (which didn't disappear, but did decrease in relative importance). As a result they bought labor peace (i.e. no strikes or work-to-rule slowdowns) by paying their line workers more and more. They could do this because they were basically minting money with their newly scarce factories.

The part of the world with large amounts of human capital eventually rebuilt its physical capital, and thus ended the anomalous WWII premium that US (and Canada, Switzerland and Sweden) factories enjoyed. However their unions kept increasing demands and the companies kept paying them, not realizing that the anomalous paradigm shift had ended.

This came to a head in the early 70's, and the rest is statistics that seem to depict increasing inequality. In reality they depict a reversion to the pre-depression income distribution mean, although I will grant that the increase at the top is likely also due to increasing returns from those high skill sets due to "high tech" gains.

That is a theory that fits with observed income distribution changes amongst the workforce from WWII to present.

The new theory (possibly) explains an increase in businesses share of productivity gains.

New theory:

Imagine a company that achieves a huge productivity gain from restructuring operations thanks to the new CEO. The monetary gains from this improvement go to the company, not to the workers. Only when the productivity of comparable workers thoughout the economy rises does this sector see raises comensurate with their productivity as companies bid for them.

If (US) companies are gaining productivity increases by offshoring relatively low skill tasks, and the workers they lay off who were getting market wages then get new jobs at almost the same pay as before, then there is no increase in productivity economy-wide (US) of that worker type, but the companies do gain in the productivity, then the companies pocket the lion's share of their productivity increase, with the newly hired offshore workers getting raises though.

So long as new offshoring produces "new" low skill US workers via layoffs, then the US economy's generic new job creation for low skill workers won't result in the net increase in low skill worker demand that it otherwise would have. Depending on the numbers of offshored jobs vs newly created domestic low skill jobs, this could result in lower wages, stagnant wages, or higher wages in real terms. But regardless, those wages will be lower than otherwise would have been the case.

Sooner or later there will effectively be economy-wide (US) diminishing returns from the offshoring of relatively low skill workers. One factor may be that eventually workers in countries like India will gain larger shares of their productivity as their underemployed numbers dry up. This will reduce the relative attractiveness of such workers. Meanwhile the domestic (US) market continues to generate new demand for such workers. Then we ought to see (in theory) a reversion to the mean of productivity's share amongst workers relative to business.

I have no time frame for this to happen. It may take decades to start, or it may start to happen relatively soon as US companies that have offshoring potential dry up as they have already offshored that which is reasonable to offshore.

Trying to get companies like the allegedly evil WalMart (or any other business) to pay a higher percentage of its productivity gains to its workers is a fool's errand, and is actually counterproductive. It tends to discourage new such low skill employers from forming up, partly out of fear of societal shame, and partly out of fear of governmental regulations of a punitive nature. No company, whether it is low skill WalMart or a high skill high-tech company pays its workers more than they think they have to.

Ultimately the only thing "we" can do to organically change this outcome is to societally and politically encourage, not discourage, the creation of new hiring of low skill/low wage workers.

Additionally, as always, we ought to do our best to avoid regulations that make US-based employment artificially expensive. As well as the tried and true chestnut to "improve education". How to do the latter is of course the rub.

Sun Oct 08, 02:35:00 PM EDT  
Anonymous Bruce Wilder said...

KNZN: "If WalMart can get away with paying lower wages, then so can its competitors. WalMart’s advantage in distribution was there to begin with, before its got its wage bill down; the advantage hasn’t increased, so why should WalMart’s margin increase?"

Where's Hal Varian when you need him? I need some geometry here, I think.

Wal-Mart's cost advantage means that Wal-Mart's costs don't determine prices; prices are determined by the costs of the marginal, higher-cost producers.

And, the claim that anything Wal-Mart can do, its competitors can do, doesn't hold water, either. If that were true, Wal-Mart would not have its distribution cost advantage, now would it?

Moreover, the labor market is a pool. If Wal-Mart sheds full-time workers and draws off part-time workers, to lower its labor costs, does that create more part-time workers for other companies to use?

One company's strategy is another company's opportunity, but it would be wrong to assume that company A can simply imitate company B. That's why a resource policy, like using part-time workers, is a "strategy" -- it constrains what competitors can do.

I don't know the answer, but the central mystery to me is how it is that Wal-Mart can essentially bid down its labor costs, when unemployment is low and labor productivity is rising.

Krugman's pointing at the Republican assault on the prerogatives of organized Labor is an incomplete story, but not for the reason that KNZN cites. It is not because Krugman fails to recall Dr. Pangloss's admonition that we live in the best of all possible worlds, or to believe that Wal-Mart will be guided by an Invisible Hand to give up all that it has squeezed out of its employees in lower prices everyday.

Sun Oct 08, 03:34:00 PM EDT  
Blogger knzn said...

Bruce, I grant you that WalMart’s strategy gives it a first mover advantage and that others cannot simply copy it precisely, but there are two points I need to make here: (1) Krugman is just using WalMart as an example of what he regards as an economy-wide trend. If it is economy-wide, that means everyone is doing it in one way or another, and they will all have the opportunity – and, since they care about market share, the incentive – to cut prices. WalMart may not be the marginal producer whose costs determine prices, but the marginal producer is also involved in a successful war on wages. Eventually, that producer will cut prices, too. (Unless you’re interpreting Krugman to say that only inframarginal firms are winning the war on wages, which seems unlikely to me.) (2) Historically, WalMart’s actual strategy has been pro-active price reduction, attempting to undercut as many competitors as it can, by as far as it can. To the extent that it continues that strategy, we should expect its cost cuts to flow directly into prices.

Sun Oct 08, 08:02:00 PM EDT  
Blogger spencerengland said...

The point I have wondered about WMT stems from the point that WMT has over 50% labor turn over every year.

Normally, we associate higher wages and higher productivity with on the job training and workers becoming more proficient through experience.

This is very much in line with standard economic theory.

But obviously WMT is not following this model as its labor force seem to remain at or near the entry level of relatively untrained and/or unexperienced workers.

But since WMT is seeing very large productivity gains with a very different model it suggest we need to take another look at our theories of training and experience being a significant driver of productivity growth.

Mon Oct 09, 12:19:00 PM EDT  
Anonymous Bruce Wilder said...

KNZN: "Unless you’re interpreting Krugman to say that only inframarginal firms are winning the war on wages, which seems unlikely to me."

I'm not sure what Krugman's argument would be, but I will offer a hypothesis I cannot reject.

Organized labor necessarily concentrates on firms enjoying large rents, which firms may, indeed, be termed inframarginal. Labor law used to advantage unions in dealing with firms enjoying large rents. The precedent or example of unionized wages, benefits and labor practices serves to buoy the entire the labor market, and is adopted by government as a standard of fairness. That's the New Deal model, which Krugman regards wistfully.

When Krugman points to Wal-Mart, I think he may be saying that this is an example of how the New Deal model has been reversed to reduce labor's share of the national income. Here's a very large, prominent employer, enjoying large rents, but in contrast to the unionized employers of the New Deal, which were raising wages and benefits and labor standards, even in the face of the Depression, here is Wal-Mart doing just the reverse, in the face of nominal prosperity and growth.

There are some difficulties associated with relating a macro division of income between labor and capital to the rules, which govern the negotiations between employers and employees.

But, assuming that all employers are equally well-positioned to reduce labor costs is misleading. Krugman is focused on Wal-Mart, I think, because he believes that Wal-Mart is well-positioned -- better positioned than many competing firms earning smaller or no rents -- to raise wages.

Rents are central here, because it is only in the presence of substantial rents that there is anything to negotiate. It is the division of rents that is being negotiated between large employers and organized labor.

Mon Oct 09, 03:25:00 PM EDT  
Anonymous Anonymous said...

"
If there is a competitive mystery, it is why Wal-Mart can drive down wages, and still get competent employees.

Why are there not better uses for labor?

Ordinarily, with labor productivity rising, we would expect wages to get bid up. Why can Wal-Mart, in this labor market, with labor productivity rising, bid wages down?"

It's a mystery?
What happens when 75,000 people in one area lose their jobs all at once? The housing prices in that area will hit the floor due to competition to sell (people all wanting to leave at the same time to look for a new job somewhere else?)

Walmart has that kind of wage clout BECAUSE they're hiring and not laying off workers.

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