#101: The pay paradox

WHY GOOD BUSINESS CAN BE BAD ECONOMICS

Though we’re past the #100 mark, there’s a string of topics crying out to be discussed. Future articles might look at what the market economy really is – and what it isn’t – and perhaps take in the “gig” or “sharing” economy as well. I’m also thinking about doing something rather outside normal parameters, looking at where businesses should (and shouldn’t) seek to invest.

Here, though, we look at a critical paradox. It’s critical, because it goes a long way towards explaining why countries like Germany prosper whilst countries like Britain don’t.

Economics is full of paradoxes. Perhaps the most famous is the “paradox of thrift”. If you save or I save, that’s prudent and commendable. But if we all save, and do too much of it, that’s bad, because demand will slump, to the detriment of the economy. Actually, what this really means is that we want a “Goldilocks” amount of saving. If there’s too much of it, we’re stifling demand – but if there’s too little, we’re not investing enough.

Here’s another paradox, less widely recognized (indeed, seemingly hardly recognized at all), but actually much more important. Let’s call it “the paradox of pay”. This is important, and certainly merits discussion, because it’s a major factor depressing performance in a number of Western economies.

The pay paradox

Here’s how it works. If you’re running a business, keeping down pay can be a good thing. As a business, wages are likely to be one of your biggest costs, indeed very probably the biggest of the lot. So, if you keep your wage bill as low as you possibly can, your profits will increase.

That sounds good.

If all employers do this, however, business, and the economy, are the losers. Small pay packets mean weak consumer spending, and the consumer typically accounts for 60-70% of the GDP of a Western developed economy. If you undermine wages, then, you undermine sales.

No so good.

Henry Ford famously understood this. That’s why he paid his workers more than the bare minimum. If he didn’t, reasoned Mr Ford, how would they ever be able to buy his cars?

There’s a revealing story about this, in a different car plant in a different era. A manager proudly unveils the first production robot, and says to a trades union leader: “try to persuade that to join your union!”

To which, of course, the union man replies: “try persuading it to buy a car!”

The truism, of course, is that workers and consumers are the same people.

Micro and macro

Actually, the “paradox of pay” really amounts to the difference between microeconomics (the economics of the firm) and macroeconomics (the study of the whole economy). Low pay can be good microeconomics, but is always bad macroeconomics.

It can make sense for a company to minimise its wage bill. But it is idiotic for a country to do the same.

There are, however, simpletons who think that an economy should be run like a business. So, if it’s good for businesses to minimise wages, it must be good for a country to do the same. The theory – a pretty half-baked one – is that, if we can keep down the wages of people making (say) cars in our country, we keep those cars cheap, thereby increasing our ability to sell them on the world market.

Actually, this theory is worse than half-baked. Observation reveals that low wages don’t make for national competitiveness or prosperity. If they did, Ghana would be richer than Germany, and Swaziland more prosperous than Switzerland.

In reality, there are perfectly good reasons why a high-wage economy like Germany is more prosperous than a low-wage country like Ghana. For a start, demand is stronger. The German worker has more money in his or her pocket than his Ghanaian counterpart, increasing his ability to buy goods and services produced by other German firms. Moreover, the higher the average level of pay, the higher both quality and productivity are likely to be.

From this, an obvious truism follows. A company like Mercedes or BMW can never turn out cars cheaper than a plant in a, say, Vietnam. If Germany’s car-makers (or any other German sector) tried to compete on price, they’d fail.

So, being sensible people, they don’t. They compete, instead, on quality. This is the obvious (indeed, the only rational) course of action for a developed economy. Competing on quality makes sense.

Trying to compete on price is, frankly, pretty crazy.

The price of a fallacy

Some countries – the obvious examples being America and Britain – don’t seem to grasp what, to a German, seems perfectly obvious. Instead, they assume that getting wages down must be a good thing. Pursuing this policy involves maximising the supposed “openness” of your economy, and backing “globalization” to the hilt. By all means ship out skilled jobs from Derby to Delhi, if profits increase. Go ahead and outsource work from Cleveland to Calcutta for a short-term boost to the bottom line. “What’s good for American (or British) business”, the slogan runs, “is good for America (or Britain!)”

It’s a persuasive slogan.

It’s also, in economic terms, drivel.

The point, you see, is that running a country isn’t the same as running a business. Businesses can benefit from low wages. A country can’t.

This said, a lot of businesses are too smart to succumb to the low-wage mantra.  Many enlightened firms recognize that getting good staff – skilled, innovative, productive, dedicated and committed employees – can’t be done on the cheap. The pay-off in terms of quality and productivity can far outweigh the cost of paying good wages to attract and retain the best.

A fool’s paradise

If a country follows the low-wage route, a string of adverse consequences quickly follows. It’s a chain-reaction process.

For starters, outsourcing skilled jobs undermines consumption. One seductively-easy way of countering this is to fill the consumption gap with credit. Countries that follow the low-wage mantra tend to succumb pretty soon to a policy of making credit both cheap and easy to obtain. This involves both low interest rates and “deregulation” of the lending industry. This in turn results in soaring indebtedness and escalating risk.

It also depresses tax revenues, and undermines productivity, whilst skewing the economy away from activities at the high end of the value-added spectrum. You end up with very little manufacturing, but plenty of pedicurists and pizza-deliverers.

What results is an economy with low skills, feeble productivity, and too much debt (does that remind you of anywhere?). You find yourself in a position where each incremental unit of GDP comes at a high cost in additional borrowing (say, getting on for £6 of new debt for each £1 of growth). Tax revenue weakens, resulting in big fiscal deficits and escalating debt.

You can try to offset the deficit by cutting public spending, of course, but even a passing familiarity with Keynes should convince you that voluntary “austerity”, by depressing demand, is likely to be counter-productive. Some of the weaker Eurozone countries have had austerity imposed on them by their inability to devalue. Other countries have embraced austerity voluntarily, out of sheer folly or desperation.

As well as depressing the economy, too much austerity is likely to depress voters, the end result being that you’re out on your ear. Frankly, if you’ve been following the fool’s mantra of a low wage strategy, that’s nothing more than you deserve.

At some point, meanwhile, someone notices that people are struggling to cope with servicing their bloated debts, so you cut rates even further, now to levels that are a long way below inflation. Doing this might be unavoidable, but it’s still akin to handing a bottle of gin to an alcoholic.

One consequence is that, whilst asset prices balloon, returns collapse. This opens up huge chasms in pension and other provision, which can be impossible to bridge even with a high savings ratio, let alone with a savings ratio that has crumbled under the onslaught of impoverishment.

At this point, with foreigners wondering whether to go on bailing you out with capital infusions, and the locals beginning to wonder whether inflated house prices don’t amount to realizable riches after all, hopefully some nice people turn up with a waistcoat that laces up at the back.

Wisdom and folly

So there you have it. Paying low wages might, at the micro level, help you to make cheaper washing-machines (though whether it’ll help you to make high quality ones that people actually want to buy might be a different question).

At the macro level, though, low wages have a string of adverse effects. They undermine quality and productivity. They’re likely to push debt up sharply, inflate asset prices and depress returns. They’ll certainly undermine demand, stifle growth and undercut tax revenues, and they’re highly likely to degrade the value-adding profile of the economy.

The Germans, amongst others, clearly understand this. The British authorities, equally clearly, don’t. It will be interesting to find out whether Mr Trump and M. Macron understand it, too.

#100: Defining times

BUILDING THE NEXT CRISIS

Reaching the 100^th article in the series seems a good time to provide an overall “wrap” of the economic situation, as seen through the prism of Surplus Energy Economics. The conclusions may not be particularly cheering, but they should at least have the merit of clarity.

We can now be pretty sure of at least three things.

First, the long rise in world prosperity is over. Real economic output does continue to increase, but only very gradually, and is now being matched by the rate at which the population is expanding.

Second, prosperity will carry on rebalancing towards the emerging economies. Citizens of China and India, for instance, continue to enjoy increasing prosperity, though not at rates as high as reported levels of growth in per capita GDP. By contrast, and with very few exceptions, prosperity in the Western developed economies has passed its peak, and is now declining, albeit at rates which vary markedly between countries.

Third, the financial crash of 2008 is unfinished business. Essentially, the burden of debt forced central banks into policies of ultra-cheap money, and these have had precisely the effect that could (and should) have been anticipated – indebtedness continues to rise, provision for the future has been sabotaged, and bubbles are emerging across a broad range of asset classes. As well as adding huge amounts of debt, we are pillaging futurity, because of policies which cripple returns on pension and other provision.

We cannot yet know when the sequel to the global financial crisis (GFC) will occur. It is in the nature of the system that seemingly-unsustainable conditions can last for a lot longer than seems logically possible. Equally, however, a crash can occur with very little prior warning, and in ways that may not be predictable.

We may, though, be inching towards greater visibility about how and where the catalyst is likely to emerge. It’s becoming increasingly apparent that the United Kingdom is much the most vulnerable domino in the series. If you’re looking for a single lead indicator for the next crunch, the value of Sterling may be the one to watch.

Overview – the two economies

If you understand the surplus energy approach, you’ll appreciate that we need to think in terms of two economies. The first is the real economy of goods and services, and is an energy system, not a monetary one. The cost at which energy can be accessed determines the level of prosperity that we can achieve.

In tandem with this is the financial economy of money and credit. Obviously, money has no intrinsic worth. It commands value only as a “claim” on the output of the real economy. Creating money doesn’t add prosperity – it merely dilutes existing claims on that prosperity. Expanding the sum of credit simply creates claims on a future economy that will not be able to honour them. This establishes an inevitability of claims destruction – in other words, a crash.

The following chart illustrates the energy situation. What the chart shows is the ECoE – the energy cost of energy – for petroleum, renewables and the overall energy mix. If 20 units of energy are accessed, but one unit is consumed in the access process, then the ECoE is 1/20, or 5%. What this means for prosperity will be addressed shortly.

ECoEs move in ultra-long-term trends, almost wholly unrelated to the market price of energy at any given time.

Prices are subject to both short- and long-term cyclicality.

Cost, on the other hand, is driven by a combination of depletion and technology. Depletion pushes cost upwards, because we exploit the highest-quality, lowest-cost sources of energy first, only moving on to costlier sources once the cheaper ones have been exhausted.

Technology operates to reduce costs, but it does so within the envelope set by depletion. New techniques can improve how we operate within the laws of physics, but cannot overcome those laws. Thus, hydraulic fracturing enables us to extract oil from shales far more cheaply than we could have extracted those same resources in the past. Technology does not turn a marginal resource like shale oil into the equivalent of a giant, simple field in the sands of Arabia. That is simply not possible.

Overall ECoEs seem to have been rising since the mid-1960s. Back in 1965, the average ECoE was probably only about 1%, meaning that we consumed a single unit of energy in accessing 100 units. Those days of abundance are long gone. For oil alone, ECoE is estimated to have risen from 2% in 1980 to 8.8% by 2010, and could hit 15% by 2020. Oil is a premium fuel, and is therefore worth using even when it is costlier than some other sources.

The cost of renewables has fallen sharply, making the best renewables cost-competitive with fossil fuels. But renewables still account for only 3% of world energy consumption. This proportion is set to go on rising markedly, but there are locations and applications which will remain extremely challenging. Similarly, technological progress will continue, but it would be a mistake to extrapolate forward a rate of progress that has been achieved from a very low base.

The nature of energy cost

As the preceding chart illustrates, the overall ECoE cost of energy is rising pretty exponentially. But, because the world economy is a closed system – after all, we’re not trading with Mars – this cost doesn’t leave the system. So it isn’t directly analogous to the “cost” of running a home or a business.

Rather, it is an economic rent, which means that it restricts choice. Prosperity is the residual between economic output and the required level of investment in energy supply. (This is “required”, of course, because without energy there wouldn’t be an economy). If, out of each $100 of output, we had to spend $2 on energy, we would be left with $98 to use as we wish. If the energy cost rose to $10, we’d still have our $100, but could exercise choice over only $90 of it.

In the same way, someone can become poorer if the cost of essentials (such as food, water and energy) rises more rapidly than his or her income. This is why prosperity is not the same thing as per capita GDP. This analogy is a good one, because the cost of energy plays a big role in the supply of essentials. The energy content in the food or water that we must have is higher than in things that we don’t need, but simply want. From this, it follows that the cost of essentials is a major transmission mechanism between ECoE and prosperity as we experience it.

The financial economy

From this, you might think that we can measure prosperity simply by deducting ECoE from GDP. Alas, it isn’t quite that simple, because the financial economy (recorded by GDP) isn’t the same as the real economy of goods and services.

The existence of the financial system enables us to time-phase activities in a way that wouldn’t be possible in a hand-to-mouth economy based on barter. We don’t just live in the present, but inherit from the past, and must provide for the future.

This time element is a great virtue of finance but, in the wrong hands, it is equally capable of becoming a serious vice.

It has now been in the wrong hands for a dangerously long time.

Beyond immediate consumption, an economy perpetually undertakes futurity activities. These include investment (which should increase future productivity) and the related concept of saving, which we need to do, not just to tide us over hard times, but also to prepare us for old age. On the other hand, we can borrow (or otherwise incur future obligations) if it seems beneficial for us to do so.

To work effectively, all of these ‘futurity’ activities need both long-term thinking and a properly functioning market.

Unfortunately, the powers that be have, over two decades and more, evolved a system in which neither of these predicates applies.

First, planning for the future has been weakened by an ideology of short-termism.

Second, a functioning market in futurity has been undermined – indeed, virtually destroyed – by monetary policies geared solely to the management of existing debt. Obviously, manipulated interest rates block the signals that the market is supposed to transmit. This leads us into making faulty decisions.

“Triple D” – plundering the future

It’s important to note that debt isn’t the only (or even the most important) component of our relationship with futurity. Taking the United Kingdom as an example (albeit rather an extreme one), the factor that poses the greater economic threat could be unfunded forward pension (and other) commitments well in excess of £2.5 trillion, rather than aggregate debt of £4.9 trillion.

Debt can be inflated away, if you don’t mind the costs of inflation – and if your creditors don’t take umbrage over being bilked through “soft default”. But you can’t inflate away futurity deficits like pensions in the same way, because they are effectively index-linked.

As well as encouraging borrowing by making it cheap, slashing interest rates – in Britain, from 5.75% ten years ago to just 0.25% now – has destroyed the ability of pension funds (for example) to make the sort of returns required to match current contributions to future needs.

The whole theory of pension provision is that, having invested X amount now, returns on this investment give us a lot more than X in the future. If, during his or her working life, someone had to put aside exactly the amount that they would need in retirement, the process simply wouldn’t work. The demands made on us in our working years would just not be affordable.

Artificially low rates, therefore, destroy the equilibrium between the present and the future. (They also block the essential process of “creative destruction”, miss-price risk, and manufacture bubbles).

Moreover, artificially low rates mean that our provision for the future deteriorates at exactly the same time as our future obligations to repay debts increase. If you add to this a third ingredient – an inability to organise the provision of care for an ageing population – the result is a potentially lethal cocktail.

We can call this toxic mix “triple D” – debt, deficits and demographics.

The great self-delusion

Obviously, mortgaging the future (by plundering our futurity reserve) boosts the present at the expense of the future. This means that recorded GDP figures are inflated by this process.

This is analogous to the way in which banks behaved in the years preceding 2008. By selling toxic instruments to themselves via off-balance-sheet SPVs (special purpose vehicles), banks created “profits” (and hence bonuses) at the expense of their own balance sheets.

Entire economies are now replicating this practice.

To work out what is really happening to the economy behind the smokescreen of plundered futurity, we need to calculate the extent to which recorded GDP has been flattered by the cannibalization of the collective balance sheet. What we are looking for is the proportion of GDP that would remain if the credit taps were turned off. That’s the underlying, “organic” or sustainable level of output.

The SEEDS system has an algorithm for measuring this. Its results are very probably conservative, because they conclude that, over the last decade, only about 19% ($18 trillion) of global borrowing ($98 trillion) has been used to inflate consumption at the expense of futurity.

Even so, this is enough to suggest that world GDP (in PPP dollars) was only $88 trillion last year, 25% below the reported $117 trillion. It also means, of course, that aggregate debt as a percentage of underlying GDP is probably nearer 300% than the reported 220%. In any case, measurement of debt isn’t by any means the same thing as measuring futurity.

Prosperity and the coming denouement

Having adjusted GDP for the plundering of futurity, we can deduct the economic rent of ECoE to measure prosperity. “Prosperity” is defined for the individual as ‘income, after essentials, that the person can choose how to use’. For the economy as a whole, prosperity is sustainable (borrowing-adjusted) GDP, less the economic rent of ECoE.

Globally, and in inflation-adjusted dollars, prosperity per capita was almost 4% higher in 2016 than it had been in 2006, but this rate of improvement has been decelerating towards zero. Aggregate world prosperity is still growing, but now only at a trend rate of around 1% annually, which is roughly the same rate at which the global population is expanding. So individual prosperity, on a worldwide basis, has stopped growing.

The next chart illustrates this, setting out – in per capita terms – three measures of economic output. The first, in blue, is the financial economy as recorded by GDP. The black line adjusts this for the estimated impact of “plundering futurity”, with the accompanying trend in debt shown by the yellow columns. Finally, the economic rent of ECoE is deducted to arrive at prosperity, shown in red.

 

These, of course, are aggregate measures, covering wide disparities of experience. At the positive end of the spectrum, citizens of China and India became, respectively, 58% and 48% more prosperous between 2006 and 2016. Prosperity in these countries is continuing to grow, albeit at rates a lot lower than in the not-too-distant past.

At the other extreme, individual prosperity in the United Kingdom declined by 13% between 2006 and 2016. British prosperity can now be seen to have peaked as long ago as 2000, since when the total decline has been 17%. Over the last decade, prosperity has also fallen by 9% in Italy and Spain, by 8% in the Netherlands, and by 7% in both the United States and France.

Some of these national circumstances repay investigation. Spanish prosperity fell sharply because the country was more exposed than most to the ravages of debt-fuelled expansion in the years before 2008, but has now returned to stability. The Italian economy has suffered from decades of declining competitiveness, something which – before Italy joined the Euro – was customarily cushioned by gradual devaluation of the lire. Membership of the single currency effectively forced Italy into painful internal devaluation (a.k.a. “austerity”) instead.

The outlook for France will hinge on the as-yet unclear direction of policy under President Macron. The risk here is that M. Macron will opt for the wage-depressing policies that pass for “reform” in the neoliberal lexicon. In other words, he might follow Britain in trying to create a low-wage economy. Doing this necessarily undermines demand, impairs productivity and increases household dependency on credit.

The continuing decline in American prosperity means that Mr Trump simply cannot deliver on his commitment to improve the lot of the average household. Mr Trump is an outsider, but this does not guarantee that he will not pursue the same policies that have failed in the past.

The most significant (and worsening) decline in prosperity, however, is that of the United Kingdom. For at least two decades, the British economy has been managed with remarkable incompetence. The UK just about dodged a bullet in 2008, but may not manage to do the same next time – and that next bullet could now be pretty close. Exactly why Britain is quite so vulnerable will have to be left to another article, but there are plenty of reasons to question the sustainability of the British economy.

Conclusion

As we have seen, the world has ceased becoming more prosperous, because increasing ECoEs (experienced in the rising cost of essentials) have dragged down growth in the real economy to a rate matched by population expansion. Within this, countries like China and India continue to become more prosperous whilst, in much of the West, people will keep getting poorer.

We’ve been trying to buck this trend by plundering futurity, spending borrowed money whilst running policies which cripple returns on pension and other provision for the future. This has been an exercise in futility, and must in due course lead to a sharp correction in the form of claims destruction.

Nowhere is this more evident than in Britain, so anyone seeking a single lead-indicator for the next crash could do a lot worse than watch the value of Sterling.