People's Democracy

Do Lower Wages Increase Employment?

Jayati Ghosh

IT is common to argue nowadays that there is an inverse relationship between employment and real wages. That is, that high wages mean lower employment in the aggregate, and that the existence of unemployment really means that wages are too high. This notion has a very old history in economics. It formed a major part of the dominant economic discourse from the 1870s onwards. In fact, until the idea was blown apart by Keynes in the 1930s it was the basis of most macroeconomic thinking.

REVIVAL OF THE FALSE NOTION

Recently there has been quite a revival of this notion, which is based on the notion that trade unions and protective labour laws effectively make wage costs too high for employers. It is believed that if wages are allowed to fall, employment will increase to the point where everyone who wants a job can get one. This in turn sets a guideline for policy: allow labour markets to function “freely” without impediments and regulation, and full employment will inevitably be attained.

The Keynesian revolution of the 1930s had already questioned this analysis, pointing out that at economy can settle at a point that is not characterised by full employment. The insight was to show that unemployment can result when the economy is operating at a low level because of low aggregate demand in the system.  The total use of labour is then determined by the level of output, which is in turn determined by overall demand for goods and services.

Since this labour use is independent of the wage rate, reducing wages will not help. In fact, because of the difference between how an individual employer thinks and how the system as a whole works, reducing wages might even have the perverse effect of further reducing the people’s purchasing power and therefore their effective demand. This would result in even lower levels of aggregate output and therefore employment.

Despite this argument, across the world there has been a revival of the notion that there is a strong inverse relation between wages and levels of employment. Now it is argued that, independent of the level of output, employment would increase if only wages could be lowered. But because of trade unions and labour laws that make the process of hiring inflexible and put lots of constraints on employers, less people are able to find work.

This argument is now being applied to developing countries as well, such as India, where it is now not uncommon to hear the argument that labour legislation of various sorts, and high levels of wages in the organised sector, have combined to produce low levels of employment generation, especially in manufacturing.

This argument has served two purposes. First, it has attempted to provide an explanation of the abysmal performance of employment generation in the Indian economy over the 1990s, when employment was supposed to grow through the unleashing of private animal spirits because of liberalisation and deregulation. Second, it has been used to suggest that substantial reform of labour laws, in terms of easing restrictions on hiring and firing and doing away with minimum wage regulations, are required to increase levels of employment.

ARGUMENT IN THE INDIAN CONTEXT

For all these reasons, this argument needs to be considered seriously. Let us consider the context of the Indian manufacturing sector. While the slow (and falling) rate of employment generation is evident in all sectors, it is also marked in manufacturing. Even the data of the Annual Survey of Industries, which presents the most optimistic picture, shows annual employment growth in manufacturing industry to be well below 1 per cent per annum over the period since 1990.

It turns out that for aggregate manufacturing, there is no evidence at all for an inverse relationship between real wages and employment. Rather, two factors seem to have been the strongest factors in affecting levels of employment in manufacturing: the rate of growth of output, and the technological changes which lead to changes in the pattern of labour use. 

Most technological changes in Indian industry have operated to improve labour productivity and therefore have led to lower requirements of labour per unit of output. Over the past two decades there has been a more or less continuous and stable increase in labour productivity.  But these do not only reflect technological progress emerging from within the Indian economy.

It is important to remember that in the manufacturing sectors of developing countries like India, technological choices and changes do not reflect domestic resource availability so much as the patterns determined by such changes in the North. These changes, which come in the form of new products and changed processes, typically are more capital intensive, dictated by the requirements of Northern economies. Therefore, such advances generally imply improvements in labour productivity and lower use of workers per unit of output.

The converse of such increases in labour productivity, of course, is that employment tends to increase less than output increases. And this has been the basic pattern in Indian industry, which has operated quite independently of wage levels.

A look at specific sectors reveals a similar result, even though there are some differences across sectors. Statistical exercises which look at the relationship between employment, real output levels and real wages, find that there is typically no negative relationship between real wages and employment.

In most of the manufacturing sectors, in fact, real wages are positively associated with employment, sometimes quite significantly so! This may be because when industries are growing, they go in for more technological innovation, which increases labour productivity and therefore higher wages as well.

So, there is little systematic evidence of an inverse relationship between wage levels and employment in manufacturing industry across the range of manufacturing sub sectors as well as for the sector as a whole. This should come as no surprise, in labour surplus economies like that of India, which are also currently suffering from under-utilised capacity due to inadequate effective demand.

The solution to the unemployment problem in India, therefore, is not lower wages costs as some have been arguing. Rather, policy should be directed towards encouraging more growth and a mix of technological choices that encourage greater use of labour.