The Wage Repression Lie For Dummies

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In October 2011, Washington's governor Christine Gregoire (a Democrat) declared an emergency in the state's apple markets. Growers were expecting a massive haul of the crop but were unable to find enough labor to get it off the trees. With the first wisps of frost on the horizon, it would have been criminal to leave so much product to waste and spoil. And, ironically, that is exactly where the beleaguered applers turned.

Through her emergency declaration, the apple owners were able to procure criminal labor (or, more accurately, criminals as labor). Male "offenders" from the Olympic Corrections Center in Clallam County were put to work gathering in that massive harvest, earning all of $8.67 per hour. That, of course, was not the true cost rendered to the apple growers since the state had to pick up the tab (or at least part of it) for transportation and security. That amounts to a government subsidy of growers and perhaps even an expectation for future subsidies.

Gregoire was quoted in McClatchy DC as saying, "I don't believe we have ever done this in history...But it's either that or the apples rot."

Contrary to that assessment, the markets at the time were declaring that rotting apples were exactly what was needed. If there was genuine demand for all that ripening inventory of unharvested apples, it would have been reflected in the price paid by wholesalers and ultimately consumers. That would have afforded the apple growers the profit opportunity to increase the price paid to marginal labor.

In 2011, the most quoted and advertised price for labor was $22 per bin. They were even advertising wages as high as $120 to $150 per day. And yet the labor "shortage" persisted. If there truly was a market demand for all those apples, the prices would have converged to the point that both labor and business would have been satisfied.

Governor Gregoire and some of her apple growing constituents even went so far as to go to central planning central, traveling all the way to the other Washington (DC) to petition Congress for less restrictions on foreign workers. It should come as no surprise, then, that another emergency was loudly proclaimed by the apple growers for October 2012. Another bumper harvest "forced" the orchard owners to up their labor offers to as much as $28 per bin. And still they complained of shortages.

These record apple crops are the product of productivity and innovation. Orchards are populated with more hearty varieties, grown by more sophisticated methods. The state's record crop was in 2010 was believed to be 110 million boxes, generating an estimated $7 billion and employing some 60,000 workers (figures according to the Department of Agriculture). The crop for 2011 was only slightly lower at 109 million boxes.

Despite the record harvests and assumed labor shortage, Washington applers have increased their capacity year after year. If they had perhaps paid market wages for their labor, or if the true cost of labor had been reflected in their profit estimates, they might have been less sanguine on the need for additional capacity. Instead, they have been successful at finding government substitutions to maintain profit levels without a corresponding increase in market price for their product. If market prices were sufficient, they would not be complaining about any labor shortages.

The problem in Washington state is not shortages, it is oversupply. It is particularly poignant in 2012 as apple harvests have been decimated in other states. New York and Michigan were hard hit by weather last year, so if there was ever a year when constrained supply for a given demand might have moved prices considerably higher, it was then.

In fact, that is the very market mechanism by which economic efficiency is transmitted locally in the production of any good or service. Excess supply depresses prices to the point that labor "shortages" appear only where businesses wish to increase volumes at below-market labor. At some wage level above $28 per bin, perhaps well above, there would be plentiful and available labor. But that would make marginal apple picking occur at a loss. The correct interpretation from a detached, unbiased perspective is that market prices are saying the oversupply should be destroyed because it cannot profitably be moved from tree to grocery.

In the opposite case, the imbalance of supply versus demand induces a rise in prices that signals growers to pay higher wages to capture said profit opportunity. The price of products and the potential for profit opportunity is the ultimate economic arbiter of not only profit, but overall wage levels. Just because you grow it does not mean someone will buy it at the price you want to sell it. Absent price action, in today's economic and political context, that means you appeal to the big brother of subsidy (or some other artificial manner of interference).

The more businesses appeal to central planning, the more rigidity enters the overall system. The laborers that are shunning that $28 per bin wage are doing the economy a favor. If they can get higher paying work elsewhere, they are demonstrating and living economic efficiency by moving to firms and industries that are experiencing the most profitable opportunities (in the aggregate). Again, profits and wages, in a market economy, are inextricably linked.

A current counterpoint to that argument is the current state of business in America. Corporate profits are at "record" levels, yet wages remain depressed and stagnate, where the labor market is generally regarded as unsatisfying (at best). There is no longer an evident and direct linkage between profits and wages, so absent that invisible hand of market efficiency there must be an appeal to another immutable force of correction - the minimum wage.

There is certainly no denying the profit angle here, particularly on corporate businesses. Part and parcel to profits is cash flow and cash levels, and here again results belie that assumed relation to wage increases. According to the Federal Reserve's Flow of Funds Report (Z1), cash levels (including all equivalents) at nonfinancial corporate businesses were about $1.4 trillion, on average, in Q3 2012. That compared to $1.19 trillion, on average, in 2007. Despite the traversing of the Great Recession, that means a 17.7% increase. Median household income over the same period has fallen some 4%. We should not expect an exact or precisely proportional response between corporate income, cash flow and household income, but at least they should be moving in the same direction.

Part of the problem has certainly been smaller and midsized businesses that have not been a full part of the past four year's "recovery". Cash balances at nonfinancial noncorporate businesses have gone from $949 billion, on average, in 2007 to $929.5 billion, on average, in Q3 2012.

The size disparity is clearly a problem that is being played out in dampening the robustness of the recovery, but the growth in corporate business alone should have been more noticeable in the labor markets. Cash, like unpicked apples, is a wasted and unproductive asset if sitting idle. If there was a market "price" that cleared the cash "imbalance" (assuming cash hoards are real) it would entice corporate managers to deploy money resources appropriate to idiosyncratic estimations of future profits. In terms of labor, that means if the expected future profits were high enough, these corporate managers would use cash to hire workers or raise wage levels in whatever endeavor furthered those profit motives.

Clearly something is constraining that impulse. For one, obviously, there is that not insignificant complication of future estimations of profits. Perhaps businesses are not seeing sufficient signals that indicate profitable opportunities. The moribund pace of economic expansion, trending "unexpectedly" downward as it has, is likely holding back the "animal spirits" of entrepreneurs and existing businesses. Thus the Federal Reserve and Federal government have been impelled to step into the economic fray to force businesses into "risky" ventures.

Part of the Fed's ZIRP effort is to make all that cash expensive in the context of both inflation and profit expectations. If zero or near zero interest rates provide no return on holding cash, profit-seeking businesses will surely mobilize said cash, at least in theory. However, there is a parallel complication to that theory. As much as businesses are penalized by holding cash, they are afforded the opportunity to invest financially.

Going back to the Flow of Funds Report, nonfinancial corporate businesses were indebted to the tune of $7.11 trillion, on average, in 2007. By Q3 2012, that same business segment increased the level of borrowed funds to $8.37 trillion (+17.6%). Notice that the increase in cash levels is very close to exactly matching the increase in debt levels. The ratio of cash to debt in 2007 was .1676, while the ratio of cash to debt in Q3 2012 was .1674.

This is not a coincidence, as the same phenomena is duplicated by nonfinancial noncorporate business. The ratio of cash to debt was .251 in 2007, slightly moving to .246 more recently. Business cash levels are far more often tied to liquidity perceptions than not. The impulse to borrow funds marginally decreases the effective cost of holding an otherwise idle asset, an effect not unlike liquidity preferences within the financial system.

The incentive side of ZIRP to encourage borrowing for the sake of economic activity (without regard to ultimate disposition or efficiency) means that the largest businesses have been able to freely expand their leverage levels, and to do so "profitably" since all that debt comes with a relatively low price (interest rate). Having assumed that debt, however, those businesses have also assumed rollover risk since that debt will eventually come due. Thus the careful and deliberate linkage of debt levels to cash levels.

While the increase in debt explains a lot of the increase in cash "hoarding", the lack of wage growth and robustness in employment is related to the incentives toward financial investment over real investment. In the twelve months ending with Q3 2012, S&P 500 companies repurchased about $375 billion worth of shares. That figure was actually down significantly from the previous year where more than $425 billion was used for share repurchases. Not coincidentally, the decline in aggregate repurchase activity is coincident to the rather dramatic decline in corporate earnings growth in 2012.

While neither of these levels is above what was seen in 2007, they still represent a departure from the linkage of profits and wages. The lackluster wage trend can be extended backward to before the Great Recession, and it coincides with the rapid and distinct rise in the usage of corporate funds for financial rather than productive investment.

There is, however, a distinction that should be made here, one that cannot be understated. There is no single method of determining what amounts to maximizing profits, often owing to the distinction between real investment and financial investment. Firms that undertake one, the other or both are seeking the same profitability function. What I suggest is dramatically different, and where the close relationship between profits and wages has been severed, is in the accounting of profitability or the preferred measure.

Not all profits are created equal. In modern finance, there is a subtle but significant difference between net income and earnings per share. Ostensibly the two should also be inextricably linked, but the distorted investor preferences conditioned to liquidity and asset inflation has given rise to the growing imbalance toward financial investment. Net income can only be produced by operations (with some accounting "refinements" allowed), while earnings per share includes both net income and the number of shares. Thus, as I wrote a few weeks back, firms have different incentives to invest cash financially and enhance earnings per share.

If the perceived "value" of earnings per share exceeds the perceived "value" of straight net income, the firm will be pre-disposed toward financial investment. Since most corporate managers are paid via financial instruments that themselves derive "value" from earnings per share, the emphasis remains on financial investment. As investors "reward" earnings per share over net income through their own preferences (as in times of asset inflation driven by liquidity), the marginal tendency toward the financial is hardened.

Money that flows through higher stock prices is inherently and unquestionably less productive than wages, in economic terms. There is a heavy element of stratification in this method of circulation since stocks are not uniformly distributed. Thus corporate money that increasingly flows into financial investment will naturally tend toward upper income stockholders. The operative economic and monetary theory of this "wealth" effect is to encourage these concentrated stockholders to then increase the theoretical notion of "aggregate demand".

There is little wonder as to why such a convoluted and stratified system would fail to produce desired results. Not only does marginal monetary flow favor higher incomes in this manner, it also produces no national wealth as consumption is preferred over production. In other words, any system designed in this manner will consume itself over time.

This is not a market system, nor is it in any relation to a capitalist system. A capitalist system produces those wealthy stockholders, but their paper wealth was predicated on actually producing productive wealth. If productive wealth is the only measure of economic and monetary success, producing wealthy people actually requires productive investment leading to successfully increasing the living standards of all participants. Goods and services are produced more efficiently and cost effective, wages are proportionally assigned according to profit potential and wealth generation leads to the rising tide of economic health.

Given all the financial interference, this new modern system has delinked (quite intentionally) profits from wages. The emphasis on financial over productive is the limiting factor here. Increasing minimum wages will not change that fact, it will only increase the cost of production and reduce future profit expectations in the segments that are most affected (while favoring perhaps less profitable industries and segments that are not as affected). The economy generates no additional value or wealth from federal interference in market mechanisms.

Just as the prison labor subsidized erstwhile unprofitable apple capacity, increasing the minimum wage simply keeps economic efficiency from taking place. Thus the minimum wage hike accomplishes the exact same for minimum wage laborers. They have reduced incentives to increase their own "value". Economic productivity suffers, and no additional productivity or true wealth results.

We can all agree that perhaps the biggest economic shortfall right now, the source of so much dysfunction, is and has been wage and labor income. But the solution is not to increase the level of interference in the business estimation of future profitability, it should be to identify and remove the impediments to shared success between profits and wages. Markets offer such a remedy, but are unable to enact re-allocation because they have been superseded and coerced by government interference, none more so than monetary regimes predicated on the wealth effect and the primacy of aggregate demand.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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