Want to Fix Income Inequality? Relink Wages to Productivity

Income and wealth inequality is the inevitable outcome of capitalism. Policymakers who seek to ease inequality need to apply proven remedies without diminishing the normal market elements of innovation, investment and productivity growth.

Economists Daron Acemoglu and James Robinson have concluded that the economic default setting throughout history has been for a small number of extractive elites to garner most of the gains from growth. They become the owners of capital.

Thomas Piketty of the Paris School of Economics recently enriched this conclusion, drawing on hundreds of years of statistics to conclude that owners of capital usually garner returns that are a multiple of GDP (and thus productivity) growth.

This brews inequality for two reasons. First, capital is quite narrowly owned. Second, owners of capital — whether medieval landlords, antebellum slave owners, Asian warlords, Prussian Junkers, U.S. billionaires or others — are adept at creating sympathetic, exclusive political environments.

Reverting to the historical norm

Since the 1970s, the U.S. economy has firmly reverted to this historic default setting of rising inequality. Real wages have stagnated.

Economist Emmanuel Saez of the University of California, Berkeley, notes that even during the 2009-12 recovery income grew 31% for the one-percenters, while barely moving (0.4%) for everyone else. And U.S. Labor Department data show that labor’s share of U.S. national income fell about 11% between 1999 and 2011-13.

Things were different during the near miraculous 18th- and 19th-century wave of innovation and entrepreneurship during the industrial revolution, where rising productivity was accompanied by rising real wages.

Rise of stakeholder capitalism

Back then, it was the ensuing tight labor markets (as well as labor activism) that enabled employees to reap a notable portion of the productivity gains during the long industrial revolution.

But the 20th century has taught the world a more nuanced lesson. Rising productivity is a necessary but not a sufficient condition for real wage growth. The law of supply and demand for labor was not rescinded by the industrial revolution. Markets set wages.

During much of the 20th century, real wages in the rich democracies rose only because public policies disrupted those labor markets, including the political calculus that produced widespread unionization.

In the United States, that impetus importantly coincided with the communitarian philosophy of stakeholder capitalism in executive suites. In his first public speech as CEO of GE in 1972, Reginald Jones said while he appreciated the fact that it was his job to make GE successful for its shareholders, he also had a responsibility to its employees, customers, communities and the nation.

By the 1980s, the collaboration preached by Reg Jones was passé. It was replaced in corporate board rooms by Randian self-absorption — including at GE itself, under the leadership of former CEO Jack Welch. Harmful short-termism, or so-called quarterly or shareholder capitalism, triumphed.

The northern European economies managed to avoid short-termism, however, thanks to the codetermination system of corporate governance. That’s why U.S. investment, productivity, and labor skill levels have fallen below northern European levels. (This is detailed in my book, What Went Wrong.)

The only group of U.S. firms that mimic the superior long-term perspective afforded northern European firms by codetermination are privately-held ones.

The rates of investment of privately-held U.S. companies are double that of their publicly-held counterparts. Indeed, there is compelling analytical evidence that firms that rely on codetermination provide shareholders a market bonus compared to competitors that rely on U.S.-style corporate governance.

Nurturing the wealth-creators

Codetermination is responsible for vigorous wealth creation over the last two or three decades in northern Europe. There, real wages have jumped past U.S. and UK levels and are now $10 to $20 per hour higher in terms of purchasing power.

Fundamental to this success have been wage policies crafted to nurture, rather than disrupt, the seminal wealth-creators of investment, innovation and productivity growth.

Gains to the owners of capital are important to incentivize innovation, to monetize intellectual property and to reward entrepreneurship. But a number of rich democracies have routinely prospered in recent decades, when the gains from growth have been broadly enjoyed rather than concentrated in the owners of capital, as it has in the United States.

For example, the incomes of the top decile of Australians rose 60% from 1990-2010, while income of lower-paid workers rose 40%.

To counteract the U.S. and UK disease, the nationwide wage-settling mechanisms in Australia and northern Europe ensure that about half of the annual (productivity) gains from growth flow to employees, with the balance flowing upward.

Their experience in recent decades confirms that giving a sizable portion of the annual gains from growth to employees, explicitly liked to productivity growth, imposes no investment penalty. Nor does it portend wage drift inflation.

Seeking solutions

Economists have rightly become concerned with inequality. The solutions they are debating include redistributive government fiscal policies and taxes on wealth.

But none offer the seasoned performance of the Australian wage-setting technique combined with codetermination. It has proven successful in widely distributing income gains while nurturing innovation, investment and entrepreneurship.

The lesson for the United States is that public policies should aim to re-establish the age-old link between wages and productivity that provided the fulcrum of the industrial revolution. The pathway to easing income inequality is well-lit.

The challenge is for lawmakers to overcome the tendency of U.S.-style cash-and-carry democracy to derail reforms targeting how the gains from growth are distributed.