Productivity puzzle? Financialization, inequality, investment

16 November 2016

By Özlem Onaran, Professor of Economics and Director of Greenwich Political Economy Research Centre, University of Greenwich

Productivity in Britain is lower than other developed countries, and the Great Recession has made this dismal performance even worse. This is not at all a puzzle given the investment and growth pattern in Britain. Among developed countries, Britain also has one of the lowest private investment rates as a ratio to GDP. At the core of this development lies the missing link between profits and investment. Rising inequality and financialization have been the main reasons behind this missing link and hence the major brakes on investment, growth, and productivity.

Productivity is defined as output per employee and has two components: one is simply related to demand, as actual output is demand driven. The second component is about potential productivity, which is determined by technological progress, which is in turn affected by both investment and wage costs.

Private investment responds to demand and public infrastructure and not just to profitability. Britain’s reliance on low wages not only leads to lower demand and affects investment through the demand channel, but also makes firms reluctant to invest due to a tendency to exploit low labour costs.

Despite increasing profits, private investment has been weak in Britain since the 1980s, as firms directed their profits to financial speculation. According to our recent research at the Greenwich Political Economy Research Centre on the investment behaviour of non-financial corporations in Britain, not only high dividend payments but also increasing financial revenues of firms due to their surging financial activities crowd out private investment in physical machinery and equipment (Tori and Onaran, 2015). Perversely, financial activities do not provide more funds for productive activity, in particular in the case of large companies as firms direct their profits to financial speculation.

Financialization and its effect on corporate strategies have also had detrimental effects on the bargaining power of labour and inequality (Guschanski and Onaran, 2016). On the one hand, the orientation towards shareholder value increased the dominance of shareholders’ demands over workers’ demands. On the other hand, increased domestic and global financial investment opportunities increased the fall-back options of non-financial firms both in terms of geographic location as well as financial assets, putting pressure on irreversible, domestic real investment in physical machinery and capital.

Financialization and increased fall back options of capital – in particular increased mobility of multinational corporations in search of low taxes on their profits – has also intensified tax competition between different jurisdictions. This process had profound effects on the composition of public spending and taxation (Onaran and Boesch, 2014). On the one hand, it increases the burden of taxation on labour income, while decreasing the tax burden on capital; and on the other hand, it shifts public spending away from social protection spending that benefits labour, towards spending that benefits capital, such as infrastructure. This process, in turn, has further contributed to the decline in the bargaining power of labour as well as public infrastructure and productivity.

These developments went along with further institutional and structural changes that led to a significant fall in trade union density and collective bargaining coverage. As a result, in the last three and a half decades, inequality has increased substantially and the share of national income that goes to wages has fallen dramatically. The share of wages in UK GDP fell from its peak of 76.2% in 1975 to 67.7% in 2007, and after the Great Recession further to 65.8% in 2015.

Wage stagnation has fuelled increasing profits as a share of GDP, but this has led to bleak prospects in terms of demand, and this in turn discourages investment despite high profitability. While this is a puzzle from a neoclassical point of view, it is not unexpected for Post-Keynesian/Kaleckian economics, which highlight the dual role of wages as both a cost item and source of demand. Our findings show that a lower share of wages in national income leads to a lower GDP in Britain as well as most large countries (Onaran and Obst, 2016; Onaran and Galanis, 2014).

Hence the demand regime is “wage-led”. On the one hand, a pro-capital redistribution of income leads to lower domestic consumption demand. On the other hand, the stimulus to private investment due to higher profits remains weak (or even absent) and at the same time private investment responds very negatively to the fall in demand. Our results show that despite increasing profit share in GDP, private investment decreased in Britain due to the substantially negative impact of the fall in the wage share on demand. Firms directing their profits to financial speculation in the absence of a healthy growth in demand is as much a result of this process as it is a contributor to the lack of demand.

The much celebrated impact of wage stagnation on external demand, i.e. higher net exports, is rather weak in Britain, and the impact is diminished substantially when all countries implement the same international competiveness policies based on labour market flexibility and a race to the bottom on wages (Onaran and Galanis, 2014; Onaran and Obst, 2015). This leaves Britain with the net negative impact of rising inequality on domestic demand. This explains why Britain’s export performance is so weak despite falling labour costs: international competitiveness is more about productivity than labour costs, particularly in a world in which a race to the bottom in labour costs has been normalised.

In the aftermath of the Great Recession, the lack of a full recovery in wage income continues to be a drag on household confidence and demand, which in turn discourages business investment in the absence of a healthy growth in domestic demand. In the past, the UK relied on household debt to maintain consumption levels in the absence of growth in wages. After the crisis, recovery is still based on the same shaky grounds as it is driven by a massive increase in private household debt and will remain fragile to any increase in interest rates in the future. The rise in inequality and stagnation in wages has been one of the fundamental flaws in the neoliberal economic model, which has been at the root of the Great Recession, and we are far from correcting this imbalance.

Overall, the mixture of financialization and rising inequality has created an increasingly more fragile mode of production with volatile and stagnant demand and investment. In the absence of strong investment performance and stagnant demand, it is no wonder that Britain is in a phase of low productivity and low potential growth.

The empirical evidence regarding the vicious circle of financialization – rising inequality, sluggish accumulation and productivity – hints at the need for alternative progressive labour market policies targeting the top, middle, and bottom of the wage distribution to reverse inequality embedded in a broader macroeconomic and industrial policy, financial regulation and corporate governance framework (Onaran, 2015). Only then will investment and productivity follow.