Wages, Productivity and Inequality

I have mentioned previously in several posts the impressive success of the “Brazil Model” over the last decade. Under PT leadership, the country took advantage of a global commodity boom to build a middle class, increasing wages to reduce inequality. This fortified the country’s domestic consumption market, which in turn became a new growth engine for the national economy.

However, there is a very important downside to this development. Over the last decade, wage increases rapidly outpaced productivity gains, meaning that labor costs rose despite the fact that businesses were not increasing their output per worker. Wage growth is the key to reducing inequality, but without productivity gains such growth is unsustainable. Now that the commodity boom is over and Brazil’s economy is coming back down to Earth, the reality has become readily apparent. Growing wages in Brazil without massive investment in education, infrastructure and capital goods (such as machinery) have eroded the country’s competitiveness, and there is legitimate fear that recent gains in reducing inequality may be reversed in subsequent years.

Brazil’s situation stands in stark contrast to the U.S. and Germany, two manufacturing powerhouses that have seen wages stagnate over the last decade as productivity skyrocketed. Innovation, mechanization and globalization enabled businesses to reduce labor costs and increase their output per worker, while the purchasing power of the middle classes eroded and inequality crept upward. The result was therefore the opposite of what happened in Brazil: growing inequality helped businesses to maintain competitiveness in the global economy, and these countries now have some of the most dynamic manufacturing sectors in the world. But this led to other serious structural imbalances. In the U.S., the middle class turned increasingly to credit, which ended catastrophically in the collapse of the mortgage market in 2008. In Germany, growing export competitiveness combined with limited domestic demand led to unbalanced trade relations with Southern Europe, culminating in the ongoing Eurozone crisis.

The interplay between wages, productivity and inequality is therefore a fundamental challenge facing the world economy, and Brazil and the U.S. represent two opposite approaches that both have major shortcomings. In theory, wage increases should increase in tandem with productivity growth, but in practice this can be hard to achieve. In a society like Brazil with historically entrenched class divisions, reducing inequality is a top priority for policymakers and citizens alike and it is hard to argue from a moral perspective that the country should abandon this approach in order to maintain the international competitiveness of its businesses. Furthermore, the difficulty of unlocking productivity gains from within the middle-income trap means that Brazil would have few opportunities to build its middle class. In the U.S., unions have been the traditional guarantors of wage increases, but globalization has undermined their negotiating power as companies can simply choose to relocate to keep labor costs low. Policymakers have struggled to find an adequate alternative to guarantee that productivity gains “trickle down” to the rest of society.

What then, is the most appropriate approach to take on this issue? Are there moments when business competitiveness should be prioritized over inequality to create more wealth and innovation? And are there other moments where combating inequality should be the more central focus, especially in developing countries? It is difficult to come up with straightforward answers to this question, especially as the nature of the world economy rapidly changes due to globalization, digitization and automation. The growing role of additive manufacturing and internet services is causing such a paradigm shift that many now argue we are on the verge of a third industrial revolution that could completely transform society and upend our traditional models of economic development based on mass manufacturing systems. I have written before about how technological changes will force us to radically rethink our understanding of wages and productivity in the future. Looking at the difficulties currently faced by Brazil, the U.S., and Germany, a revolution in the nature of work may be the best chance these countries have of escaping their current paradoxes.