Calls for the ECB to raise interest rates to curb inflation have failed to take into account the negative impact of “structural reforms” in labor markets on innovation.
In the major member states of the Organization for Economic Co-operation and Development, productivity growth has slowed considerably since around 2004-2005 (Chart 1). This is mainly due to two factors.
First, the contribution of information and communication technologies to aggregate productivity growth in the main OECD countries fell sharply from 2004, after ten years of ICT boom in the United States. Second, “supply-side” labor market reforms prove to be detrimental to innovation, especially when the innovation relies on a highly cumulative knowledge base. There are many arguments about this but, above all, structural reforms aimed at facilitating layoffs and increasing staff turnover are detrimental to the accumulation of (tacit) knowledge from experience.
Figure 1: growth (%) of gross domestic product per hour worked, 1975-2019 (five-year moving averages)
Slower productivity growth means slower growth of the pie that can be split between capital, labor and government, making it more difficult to resolve distribution disputes or, for example, fund the European Green Deal . The intensification of distributive struggles can in turn increase inflation.
Such struggles may be exacerbated by a side effect of low productivity growth – labour-intensive economic growth. An economy can only grow with After working hours or more productive Business hours. With productivity growth failing, reliance on higher labor input is the only alternative to fuel economic growth. But, sooner or later, labour-intensive growth will tighten labor markets.
From the point of view of supply-side economics, there is then a risk that unemployment will become much too low – and that where there is little (more) to distribute because of the productivity crisis. The coincidence of small growth in the handout with stronger unions in tighter labor markets can increase inflationary pressure. This will prompt bid proponents to call for a new “Volcker shock” – in 1979, amid high inflation, then-US Federal Reserve Chairman Paul Volcker raised the rate of interest at 20% and precipitated the recession – increasing unemployment and therefore disciplining workers.
Germany versus United States
The relationship between low productivity growth and labour-intensive economic growth can be illustrated by comparing Germany and the United States, respectively “coordinated” and “liberalized” market economies in the diagram of varieties of capitalism of Hall and Soskice. Figure 1 shows that between 1975 and 1995, productivity growth in the United States was lower and therefore more labor intensive (Chart 2) than in the European Union and Japan.
This can be explained by the fact that the United States has taken the initiative to implement supply-side labor market reforms. These were followed by weaker innovation performance in its old economy, creating the “Rust Belt”. On the other hand, until 2005, there was still a highly productivity-oriented and therefore relatively labor-intensive activity.exstrong growth in Germany (Chart 3).
All values in Figures 2 and 3 are normalized to 1960 = 100. On this benchmark, productivity in Germany increases to 450 in 2020, while in the United States it only reaches 300 over the same period. Working hours provide the mirror image: between 1960 and 2020, American growth required a doubling of working hours (100 to 200), while in Germany theytear down (100 to 77).
Yet the “booming jobs machine in the United States” was to serve as a major selling point for supply-side economics. Its proponents have repeatedly referred to a “sclerotic” Europe creating too few jobs, allegedly because of “rigid” labor markets and “too powerful” unions. In fact, economic growth in Germany was smarter: Germans produced more with less work, while Americans had to sacrifice a lot of free time to bring about growth.
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Figure 2: Labor-intensive, low-productivity growth in the United States, 1960-2020 (1960=100)
Figure 3: Productivity-led and labour-intensive growth in Germany, 1960-2020 (1960=100)
This is how Germany avoided high unemployment, despite the decline in total working hours from 1960 onwards, while the labor supply of women and migrant workers increased dramatically. The average number of hours worked per employee per year was equal in the United States and Germany in 1975: 1,813. Twenty years later, however, while the American figure remained almost unchanged (1,817 hours), the German count had fallen to 1,531. In 2020, the gap had widened further: 1,751 hours in the United States versus 1,324 in Germany.
Unacceptable unemployment rate
One of the most important victories for the right in recent decades has been that centre-left parties have spent more time discussing reforming labor markets and moderating wage demands than realization of a policy centered on productivity (and manpower).exdynamic), complemented by adequate reductions in normal working hours.
While Germany has seen only modest productivity growth since the 2002-2005 labor market reforms under a Social Democrat-led government, two things can be expected. First, there is less (additional) to distribute each year, so someone – capital, labor and/or government – must sacrifice the demands for additional income. The most likely outcome is stagnant wages and greater demand for austerity.
Second, however, labor’s bargaining position is improving due to more labor-intensive growth and lower unemployment. The more authoritarian unions will then most likely face a supply-side campaign that the European Central Bank must raise interest rates, to “do something” about an unacceptably low unemployment rate, supposedly at the source of inflationary wage claims. Yesterday the bank announced a 0.5% increase, with more action promised as early as September.
Obviously, this time a new Volcker shock to discipline workers will not need a 20% interest rate. A few extra percentage points are probably enough in today’s overheated markets to cause a crash in the value of properties, stocks, and bonds, not to mention cryptocurrencies and other junk. Historical experience shows that crashes in financial markets – and certainly in multiple markets simultaneously – can cause longer lasting recessions.
For more than 150 years, economists have made the default assumption that innovation is “exogenous”. It’s a comfortable assumption: if, whether they’re neoclassical or Keynesian, they know so little about innovation, then it probably doesn’t matter that much.
Yet, due to their ignorance of innovation, supply-side actors have no idea that (diffusion of) innovation suffers from their structural reforms – and that this ultimately leads to higher productivity growth. weak and tight labor market, in which wage demands can easily outpace (weak) productivity growth. In this situation, they know no better than to strangle the business cycle with interest rate hikes, hoping that high unemployment will eventually drive down wages and thus make inflation manageable.
Yet falling wages are again reducing productivity growth, further reducing the distributional margin, creating further inflationary pressures and even tighter government budgets, with calls for further austerity measures. In the end, the Volcker shock becomes an enduring and painful exercise.
Fortunately, there are alternatives. First, structural reforms on the supply side of labor markets that are detrimental to innovation, especially innovation based on cumulative knowledge, should be reversed. Second, tighter labor markets should be able to do their job: if demand exceeds supply, prices (in this case, wages) must rise. This is how markets are supposed to work.
Greater pressure on wage costs will favor a shift towards a more productivity-oriented (and less labor intensive) growth model, as in Germany before 2005, via a faster diffusion of advanced process technologies increasing productivity growth. Greater productivity gains, in turn, will increase the pie that can be distributed, which can ease inflationary pressures as well as austerity demands.
Alfred Kleinknecht is Professor Emeritus of Economics at TU Delft and Visiting Professor at the School of Economics, Kwansei Gakuin University, Nishinomiya, Japan.