Is capital really outpacing labour?


Many  economists these days debate the increasing gap between wages and productivity as a bi-product of increasing inequality that skews the output dividend towards capital.

Teresa Ghilarducci describes how trends in both productivity and labour remuneration decoupled in 1973.

In real terms though, earnings were growing much faster than productivity until 2009 when productivity gains were not met with higher earnings.

In nominal terms, compensation of employees has actually outpaced capital expenditures and other non-labour costs since the late nineties, and vastly outpaced payments to capital since 2012 as a tight job market inflated wages. 

As previously noted on this blog, prices exhibit a higher correlation with capital expenditure (investment and otherwise) than with labour expenditure (.99 and .96, respectively), a trend inverted (in yearly terms, as plotted below) in the beginning of this century to much dismay of the economics profession staple models and Marxist economists.

What then to say of Ms. Guilarducci’s chart? That it plots the rate of cumulative change but does not account for firms’ reluctance to invest in capital nor for its cost increasingly being passed to consumers. These observations could suggest increasing capital inefficiency, as noted before here.


More pro-cyclical investment

The German and French governments agreed in principle  to a pro-cyclical investment budget exclusively funded by and available to Eurozone Member-States.

The budget’s restricted objectives encompass investment, human capital, R&D and innovation to achieve convergence and competitiveness considering the Single currency constrains “monetary policy and exchange rate”. 

The instrument is an intergovernmental initiative in the scope of the EU Budget, reinforcing political decision-making in European integration.

The budget’s stabilisation function would be similar to that exercised by the EU Budget in that its long-term planning and stable resources compensate investment shortfalls during economic contractions.

The Eurozone budget’s resources may include funds earmarked for the Structural Reform Support Service (SRSS) meant to stimulate structural reforms. 

The rationale for the SRSS’ Reform Support Tool is markedly different than the Additionality criterion applied to EU Budget spending: it incentivises additional spending and could be envisioned to compensate additional costs with reforms.

In that, the SRSS’ Tool may compensate (reform) cycle expenditure whereas the Eurozone Budget wouldn’t necessarily do so, a proposition the more valid as EU Budget barely delivered counter-cyclicality during the recession years (shaded grey in the chart below).

Another aspect of the pro-cyclicality of the Budget is the final destination of expenditure contractualised to achieve its objectives. 2007, 2008 and 2014: these years were exceptional in that a Cohesion Member-State (Romania and Greece on the two latter years) was amongst the top ten recipients of EU funds.

Consider that most EU funding execution is contracted within the Single Market to those most able to implement – typically firms foreign to Cohesion Member-States who are the main funding recipients.

In that, the stimulus to aggregate demand delivered by the EU Budget is necessarily restricted and thus its counter-cyclical role is significantly limited. In fact, the Budget delivers (human, physical and intellectual capital) convergence and (product market) competitiveness. It is up to firms located where capital is introduced to find markets, whereas most of those firms finding markets through the EU Budget are already capital-intensive.

In a nutshell, the current Eurozone Budget design shall hardly deliver the counter-cyclicality sought by its French proponents.

Lower returns to education may lead to lower fertility

Galor and Weil’s model of fertility and technological frontier (widely replicated by other authors – YakitaGalorBasso and CuberesBecker et al and presenting conclusions also reported by NIH) concludes individuals choose between allocating their available effort to increasing the quantity of descendants or improving the quality of descendant’s human capital.

The model foresees that this choice shall inevitably lead to decreasing fertility as society improves its technological profile: individuals improve their income and from a certain moment onwards technology improvements leads to lower fertility and higher human capital.

Consider the following chart

  • Yellow – wage premia of bachelor over high school graduates
  • Red – fertility rate
  • Dashed green – participation rate of bachelor degree
  • Dashed purple – participation rate of high school degree
  • Light blue – participation rate
  • Dark blue – average real earnings

Whereas the lower wage premia may have led a fertility increase between 2003 and 2007, the persistent decline of both measures from 2008 onwards suggests a different status. This Modern (thus characterised by the authors) dual decline is also foreseen in the model – yet it would have required a decline in both earnings and education.

And yet the Master educated labour force (dark red, on the right) is increasing faster than broader labour force (purple).

Instead, lower wage premia combined with a skew towards higher qualifications implies less available income in the working population and increasing demand for education in the present generation.

That is, individuals’ demand for education increased costs by 120% in 16 years (not shown) impacting their budget and disposable income. The effect of proximity to the technological frontier through education is likely manifesting in the present generation’s fertility strategy rather than its fertility strategy adapting to consider the returns to education in the following generation.

Thus, lower returns to education may be reducing the present generation’s thrust to procreate.

Update the IMF also finds income affects fertility.

Effects of the frontier on income and fertility

News articles succeed in alarming audiences: fertility rates are broadly declining worldwide

While some laud the development as containing resource erosion and consumption leading climate change , others lament the new geograhical distribution of the only source of prosperity particularly in a world where nature is threatened, safe a gift from above – Paul Romer does not include physical capital in the endogenous growth model.

Intuitively, fertility follows a hump-shaped plot: low income aggregates procreate to guarantee survival, while fertility remains constrained in upper income aggregates by the level of education attained.

The pathway to reduced fertility in developing countries is widely explored and documented: labour is the only input resource to income growth in capital deprived societies hence children must be numerous, an objective challenged by high infant mortality rates. Hence, as economic science demonstrates, fertility rates decline as the source of income changes from decreasing to constant or increasing returns activities applying higher capital intensity. 

Education determines achievement when capital replaces labour or resource productivity as it delivers prospective and retroactive productivity gains in the form of innovation and operation of increasingly complex systems.

Likewise, educational attainment constrains the income of aggregates in developed countriesResearch finds female employment is positively correlated with fertility as higher incomes increase the possibility of procreating.

Hence, the structure of income in societies at or near the technology frontier impact fertility rates.

Does domestic value added speed up growth?

Yes as a consequence of development.

Even if spurious, the link between imported inputs and growth in income per capita is present in research and data

From Bernard of Chartres and Newton to Myrdal , to Acemoglu and Rodrik, scientists and economists agree knowledge is cumulatively more efficient.    

Considering firms and workers learn-by-doing, integrating foreign inputs in exports improves worker productivity. When firms start turning diminishing returns into constant returns – that is when firms invest in capital and technology such that an extra machine or extra worker or an extra patent produce more than those existing machines, workers and patents – economies begin catching-up towards the frontier of knowledge.

Consider a developing country today and the mobile communication industry (it could be Kenya). When it began installing cell towers, the country imported existing technology from other countries and introduced its own services on the network. 

As the country’s citizens needed financial services, and an entrepreneur found that using the mobile  network was appropriate to distribute such services, the country innovated and moved closer (if not established) the technological frontier on the cellphone industry.

Acemoglu and Aghion find that firms and countries start by investing in machinery and hiring workers while focusing less on the quality of their staff or capital. 

Countries that are closer to the technology frontier, as the example country/industry above, focus more on innovation than in production (Romer’s scientist-worker model) – meaning less investment but more quality in investment. 

Convergence to the world frontier necessarily implies less investment and increased welfare, a description that corresponds to developed economies.

Such economies at the frontier increase the domestic value-added in exports that are adopted by countries further away from the frontier. 

Paradoxically, growth in GDP per capita in developed economies is negatively correlated with domestic value added between 1995 and 2014, as liberalisation increased foreign value added in exports.

This is particularly visible in the inversion from positive to negative correlation between foreign value added of exports and GDP per capita observed in Estonia and China in the years before and after WTO accession.

Conversely, foreign value added was negatively correlated with GDP per capita in Lithuania before the country acceded to the WTO and turned positive in the years after.

How does income grow?

Amongst other factors, by collaborating with others.

As described in a post published a while ago, panel data shows wealthier countries are also those that produce domestically more of what is exported. This was a casual observation, without much economics behind it.

comprehensive study conducted by the ECB also concludes larger Member-States (presumably measured by GDP) are also those that add more value to exports. The study identifies such value added as “upstream” in production (p. 77).

The same study also concludes integrating more foreign inputs in exports improves labour’s skill composition (through learning-by-doing, for instance) and labour compensation (of both high and low-skill workers) while increasing firm competitiveness (as measured by the gap between productivity and wages) (p. 92).

The study also observes Member-States that integrate foreign inputs significantly benefit from technology pass-through that leads productivity gains, increasing firm competitiveness and prompting an increase in domestic value added to exports or foreign value chains.

My research finds a positive correlation between domestic value added and GDP per capita in the years between 1995 and 2014 for only 11 of 50 countries and regions in the OECD database.

Seven of the eleven countries are primary sector/extractive industry exporters, two are small island States – and China and Estonia.

Both China and Estonia are significant exporters of machinery and likely achieved unconditional convergence.

My research also finds a positive correlation, within a 95% confidence interval, between imported content of exports and GDP per capita in a sample of 623 observations of the same 50 countries and regios in the OECD database for the same years.

Yet the intensity of imported inputs to exports only explains about 14% of per capita income growth in these years – and to a very low significance. 

Hence causality is hardly proved and correlation is hardly significant. The causes of convergence lie elsewhere.

How are countries converging?

Most likely through imported innovation.

Simon Johnson asks the question rhetorically while explaining growth is the product of labour (quantity and quality), capital, technology – and the residual, or total factor productivity or the way these factors are organised.

Technology has a significant role as the most recent Nobel laureate on Econoics Paul Romer explains. Romer’s theory describes firms’ choice between investing in innovation and production, accepting the returns on innovation are seldom fully internalised by firms whilst being significantly higher than those of ordinary production.

As the opportunity-cost of production in this two-occupation model is significant, revenues in foreign firms located in fast-growing economies typically grow much faster than costs – at least until such costs increase so as to decrease the opportunity-cost of production.
At a macro level, capital, labour and technology are joined by government spending (K g on the equation below) and fixed costs (FC) such that institutions (that adequately allocate public capital investment) and supply shocks (foreign or domestic) matter to firm output. Notice the model is succint yet more encompassing than Johnson’s description.

Different factor intensities deliver growth at different paces. Fast-growing countries present specific characteristics explored in the coming posts focusing topics such as unconditional convergence, the role of government and foreign content of exports.

EU growth: what happened?

The economic structure seems significantly skewed towards exports – in the current context of tariffs and retrenchment, the EU’s growth model is jeopardised. 

Euro Area growth is waning

Long a preferred measure of economic activity and inflation drivers, a plot of Producer Price Indexes shows significantly different paces of economic activity whether considering investment or consumption goods.

The EU economy is less competitive in consumer goods than in investment goods. More worryingly, the gap between domestic and total capital investment prices in the Euro Area is far more significant as a result of the explored comparative advantage. 

The Balassa-Samuelson effect could justify the gap, as could the Podpiera effect. Arguably, the widening gap could hamper investment, depressing endogenous growth and exposing the economy to foreign demand shocks.

Considering how the significant gap between domestic and total producer prices of investment goods disproportionately affects domestic firms, it is arguable that the EU’s industrial fabric is skewed towards serving (mid-tech) foreign technological demand rather than domestic demand for more advanced intermediate consumption (in trend since 1995). In that, less diverse supply hampers competition and produces the visible price gap.

Sales of High Technology components from/to High Income (HI countries) countries fell between 1995 and 2008, while it increased from/to Developing and Emerging Economies (DEE). Exports of high-tech products from EU-28 fell considerably after 2000 while the current account surplus increased significantly. 

The gap between prices for investment goods practiced domestically and abroad is far wider than say, in Japan.

This is worrying and structural and it significantly impacts firms’ incentive to invest and innovate. It’s not a single cause nor a cyclical cause – but it is there.

More to follow.

Replying to Simon Wren Lewis

“But for a country that can create its own currency there is never any necessity to default.”

This sentence on Simon-Wren Lewis’ Why should someone who is anti-austerity care about debt  is inspiring – and intuitively demonstrates how tractability in macroeconomics may hamper realistic thinking. 

Printing currency is socialising public debt through inflation.
Beyond politically appalling, it is useless in a world where domestic content (read value-added) of price-sensitive exports is necessarily low.

This holds unless a country can ensure foreign demand for domestic currency denominated assets and export inflation regardless of issued assets. 

Assuming this happens with a handful of high output, net importing countries in the world we should ask ourselves what is the price elasticity of demand to higher labour costs (inevitable as currency depreciation and current account deficits erode real earnings – I’d look into the history of banking in France since the XIX century for a gist).

Finally, even if this would work in those economies where demand for domestic assets is inelastic (maybe two or three of that handful), we’d be condemning people to lower real income in the short-term (due to inflation) and economic decline in the medium-term as (imported) investment inputs would become more expensive (and, excluding FDI, so would foreign inputs to exports).

What Simon Wren-Lewis describes was done by so many a European Country in the past before the Euro – and a reason why the Euro was so lauded.

How to keep the EU economy growing next year

By stimulating capital investment. It implies adjusting capital depreciation rates and the deductibility of interest payments, both Union-level instruments. Such policies may deliver a more effective stimulus to investment than the ECB’s interest rate policy.
Amongst the EU’s most significant challenges in the coming years is arresting the sluggish/declining productivity growth of the past few years and return to income growth at (least at) the long-term pace of inflation target of 2%. 

As a job-intensive recovery depressed investment, despite the efforts of ECB and Commission, real disposable income grew at 55% slower from 2009 than in the nine years preceding that year.

labour market squeeze could threaten these gains in the years going forward. Productivity actually grew faster from 2009 than in the years preceding it, regardless of whether we measure it by employee or work intensity.

Table above: Labour Productivity indexed to 2010

The link between productivity and income could hint at higher capital intensity fostering productivity growth – or lower labour costs relative to the production horizon of capital and technology (in the neoclassical framework of Romer). 

Because investment measured by Gross Fixed Capital Formation as a percentage of GDP decreased 7% from 2000, productivity gains are most likely the product of a labour market rout (coupled with wage restrain) than of efficiency gains in how inputs are transformed. This hypothesis is coherent with slowing growth of real income per capita. 

Table above: Gross Fixed Capital Formation as a percentage of GDP

Imported inflation, the labour market squeeze or a demand shock could very easily erode the gains in productivity and income – if investment and innovation don’t resume.

The current series of posts questions the assumption that firms increase investment when interest rates are lower. Survey data and microeconomic research question this assumption too.

For instance, Acemoglu’s capital-augmenting technology function hints at lower incentives to capital investment from lower interest rates. 

Caballero defines a capital investment equation that considers labour-capital elasticity (or the incentive for firms to invest instead of hiring) based on capital cost (the so-called user cost) and capital intensity (or the amount of capital involved in production). Caballero argues that firms consider the current level of capital and the interest rate when deciding whether to invest, subject to other costs of investing such as availability of qualified persons to operate that investment. 

In practice, holding the value added of buying a new machine constant, a ten-fold decrease in the interest rate only increases investment by 25% controlling for adjustment costs. 

That is, higher adjustment costs affect capital investment. Typically governments let higher capital intensity increase adjustment costs as there’s only so much capital intensity a firm may accumulate before becoming costly to integrate yet more capital.

Governments may otherwise choose to affect capital levels through higher depreciation rates that increase the incentive to invest; or introduce incentives to investment that decrease the costs of capital such as increased depreciation rates.

These instruments may reveal essential when market interest rates increase from 2019 onwards, and may be activated at European Union-level through the CCTB, the Common Corporate Tax Base. The Union may adopt flexible calculations of the depreciation base of a leased asset (increasing or decreasing the incentive to investment, Article 32) and of the deductibility of interest (increasing or decreasing the disincentive to investment, Article 69, CCCTB) in the scope of these directives. Combined, both affect a firm’s decision to invest.

The work of Cummins and Hassett is undoubtedly valuable to understand the firm’s investment decision. Beyond finding a relationship between the user cost of capital and investment by focusing on tax reform years, the authors define the tax-adjusted user cost as increasing with lower interest rates (hence, the low interest rate environment hampers investment – as long argued in this blog – albeit lightly as the ECB agrees) and decreasing with lower depreciation rates.

In other words, lower interest rates should be combined with extended depreciation rates such that firms are enticed to accumulate capital. Otherwise, a policy-bound accelerated depreciation schedule accelerates firm investment decisions.

As such, in the years after 2019, the Union should focus on an accelerated, policy-bound accelerated schedule of depreciation to induce capital renewal followed by gradually increasing depreciation rates (to a steady state) that permanently decreases the capital user cost.

In practice, this implies the Union can consider the labour-intensive recovery when granting leeway to investment while preventing overinvestment.