The attached is by Ravi Batra, professor of economics at SMU http://www.ravibatra.com/about.htm
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Ravi Batra, "The Crash of the Millennium," New York: Random House/Harmony Books, 1999, pp. 66-69 WAGES AND PRODUCTIVITY Supply and demand for goods are linked to the workforce through wages and productivity. What happens in the national labor market is the key to a country's economic health. Supply and demand for workers determine wages and employment. Skilled and motivated workers are the backbone of high efficiency, but what is perhaps crucial is that company wages reflect labor productivity. When new technology raises hourly output, then fairness demands that workers are properly compensated for their hard work and skills. This is not only a question of ethics but of labor peace and social prosperity as well. Wages are the main source of demand, productivity the main source of supply, and if the two are not in sync with each other, then national supply and demand cannot be in balance for long, and eventually the economy runs into major trouble. For a while the balance between the two forces can be maintained by raising artificial demand through excessive business investment, or through the expansion of consumer debt, money supply, corporate debt, government budget deficits, and even exports, but these are mere palliatives that may mask the problem for some time. Artificial spending is the stuff of which economic disasters are made. Frequently it culminates in recessions, but occasionally it has even spawned depressions and inflation—-even hyperinflation. Whenever and wherever a country has suffered a major depression, you will find a persistent and substantial wage-productivity gap. The bigger the size of artificial demand, the greater the eventual trouble. A SIMPLE ILLUSTRATION When the labor market is distorted in the sense that real wages lag behind productivity, the entire economy behaves irrationally. Let us take a simple example in a very simple economy. Suppose there are one hundred workers in a society, and each produces $5 worth of output. Worker productivity is then $5, and if everybody is employed, total output or supply will be $500. U.S. experience of the 1950s and the 1960s reveals that a high-growth economy with practically no unemployment and inflation requires that about 80 percent of output go to labor and the remaining 20 percent to the owners of income- producing property or capital, which is also an important resource contributing to productivity. (Capital owners usually earn incomes through their labor as well, so the 20 percent share is not their only source of earnings). Under this rule, wages will be 80 percent of output, or $400, and profits the rest, or $100. Keeping the argument as simple as possible, let us suppose that initially all wages are consumed and all profits are invested into new technology and the replacement of worn-out capital so that consumption spending is $400, investment spending is $100, and the aggregate spending is $500. In this case, the economy functions smoothly, for both national supply and demand for goods equal $500. Now assume that owing to new technology, worker productivity doubles to $10, so the value of output generated by one hundred workers rises to $1,000. If wages and consumption also double to $800 and the profits and investment to $200, again national supply and demand for products will remain in balance, this time each equal to $1,000. However, suppose wages rise only to $600, while profits up to $400. Consumption now equals $600, and it is clear that investment spending must now be $400 lest national demand be short of supply, resulting in overproduction. Would businesses be willing to put all their profits into new investment, when consumer spending grows slowly? The answer is most likely not. If you are investing $200 when your sales are $800, you are not likely to increase your investment for business expansion when your sales go down to $600. If companies realize that the current demand for their goods is inadequate, they will trim their investment even below $200. The purpose of capital spending, after all, is mainly to meet consumer demand; you would expand your business only in proportion to your sales. If sales fail to materialize, investment will decline. With consumer demand less than $800, the companies will invest even less than $200, in which case total spending will fall way short of supply, businesses will be stuck with unsold goods, and layoffs will have to follow. Thus the simple example makes it clear that when wages lag behind productivity, distorting the labor market, the product markets will also be out of kilter. It is of course possible that, for a while, the companies may not be aware of the shortfall in consumer demand; their high profits may convince them to expand their capital expenditures all the way up to $400 and to buy more machines. In this case, demand and supply will each equal $1,000, and the economy will reveal no signs of the potential imbalance possible from the slowdown in consumer spending. The growth process, however, will continue. With investment skyrocketing to $400, the use of new technology and worker productivity will climb even faster. Suppose in the next round output per employee jumps to $20, so total supply, with full employment of labor, soars to $2,000; if wages and consumer demand rise only to $1,200, then investment must climb to $800 to maintain the balance between supply and demand. It is clear that with wages lagging behind productivity, the growth process will become explosive, requiring ever-increasing doses of business investment to maintain high employment and the living standard. This process is purely artificial in the sense that businesses will be selling a large portion of their goods to each other rather than to consumers to sustain their prosperity. It's like a Ponzi scheme in which you have to create sellers to buy your products and sell them to other sellers. Such schemes always collapse. When firms raise their capital spending and buy more machines from other companies, in reality they sell goods to each other, because consumers certainly have no use for plant and equipment. Sooner or later, a point will come when the companies are unable to sell all their output, and a recession or a depression will result. If the growth process continues for a long time, then the potential overproduction becomes so large that a depression becomes inevitable. It is noteworthy that the power of this logic in no way depends on the simplicity of our assumptions. In the real world, some workers do save, and not all profits may be invested. Furthermore, there is a large government sector today in most economies, which additionally have to reckon with the ills of inflation. Labor income also may not initially amount to 80 percent of output; these assumptions are not crucial to the argument. What is critical is that real wages grow slower than the rate of productivity resulting from new technology and business investment. What could be done to rectify the problem? Since the fundamental source of the imbalance in both the labor and product markets is that wages trail productivity, the solution is clear. Either a law should be passed that all output be divided proportionately between labor and capital, or some institutions should be created such that wages grow in sync with hourly output. This, of course, has not been done anywhere in the world, even though the wage-productivity gap, hereafter called the wage gap, has been soaring all over the globe for the last three decades. Then how has the balance been maintained between demand and supply for products? The two forces of the market must always be in balance; otherwise, the global economic systems will explode in a storm of instability, which has not happened in the United States at least since 1990 and in Asia from 1990 to 1997. Some may even dismiss the global recession of 1990 and suggest that the world escaped a major slump between 1983 and 1997. The wage gap inevitably results in demand gap, which equals the difference between national spending and the economy's maximum potential output. Stated another way, how has the world, especially the United States, succeeded in eliminating or reducing the demand gap in the wake of a large wage gap persisting for decades? Almost all nations have followed the same recipe to maintain the market balance. Although a variety of artificial means is available to raise demand to the level of supply, most countries have resorted to high consumer and government debt. Investment spending, as shown above, can also be augmented to plug the demand shortfall, but this measure may generate more problems than it solves. For business investment initially increases national spending, but later stimulates productivity. As we've seen, to plug the demand gap, the country will have to allocate ever- increasing sums for capital formation, and the problem will only grow over time. There is one nation that has tried this method--Japan. In most regions, now including Japan, government deficits and debts have skyrocketed. Is it a coincidence that this phenomenon coexisted with the soaring wage gap? Clearly not. In fact, the logic of the argument is that this was inevitable: governments around the globe were forced to do this to maintain superficially healthy economies. Unable and unwilling to eliminate the wage gap, this is all they could do in the name of sound economic policy.
