The Global Labor Market

In a typical economy, wages are determined essentially by two broad forces that are constantly adjusting to market conditions. The first is the market value of the production that a typical employee creates by unit of time (aka “productivity”) and the second is the relative scarcity (supply of the type of labor and talents etc. relative to its demand) of the worker in terms of general availability as well as skills and knowledge used directly or indirectly in the process of creating value for the market.

To simplify somewhat, the more a job can be done “by almost anyone”, the lower the pay will be. The more “special and scarce” the talent, skills, or knowledge the worker has that are of direct use to the market or to the production process, the higher the wage will be. This is the “market value” of labor and it is very intuitive for anyone who stops to think about it for 5 minutes.

Fixing or manipulating wages with laws and regulations creates distortions that can be benign or damaging, depending on the extent and details of the wage and price “manipulations” of the State or unions, but direct and widespread State intervention in wage setting is generally a bad idea.

Note that there is absolutely NO value judgement here: it seems obvious to me that the daily work of a dedicated and competent nurse or primary school teacher is significantly more “life changing and important” than the impressive performances of a typical pro sports player earning several millions per year, but my opinion does not matter. Yours neither. If I was the almighty dictator of the world, maybe I would impose specific incomes to specific jobs based on my estimation of how “admirable and fundamental” that occupation gives to the world, but we don’t want that, trust me… and I don’t want you to be my all-knowing-and-wise dictator either. Sorry.

The market value of what people “bring to the table” in a decentralized and free world is simply determined by the demand for that person and the relative scarcity of that person, or more specifically the demand for and relative scarcity of what a person “supplies.” Period. This approach creates “aberrations” for many of us, but it also generates material prosperity never seen in History… However, there are cracks in the foundations.

A company that produces something requiring relatively few humans and relatively lots of physical capital (such as oil and natural resources) or human capital (such as specialized software design and programming or investment banking or high finance) will display higher “market value” per employee (aka “productivity”) and relatively low employment volume, on average, and this translates to higher wages in that sector/company, especially if the required workers are hard to find and highly demanded.

I don’t know the incomes of the top software designers, architects, and programmers at Google, Apple, or IBM, but I am willing to bet my life income that they are significantly underpaid relative to what is in their head and the value they bring to their firm in terms of their knowledge and skills.

Since the end of the Soviet Era in 1990 and the acceleration of the process of global economic integration boosted by amazing leaps in telecoms and technology, the world has become “one” in many regards. Complex and deep global supply chains have emerged, with multinationals producing in many countries either directly or via a web of “partners” to whom they subcontract actual production and assembly, while keeping a tight control over design and value-added knowledge about innovation and technology, market information, marketing, branding, and distribution channels. In this process, regional market dynamics have become “global”, including large parts of the labor market. This has far-reaching and long term consequences.

WHY WE ARE PROBABLY OVERPAID

I know this is insulting, but please bare with me for a minute. Technology has made the coordination of the production process on a global scale simpler and cheaper, which means that competent executives of multinationals can harness global labor supply and global resources more and better than before.

Cost cutting is easier, as the “matching and coordination” process is simplified by the rise of “production subcontractors” in emerging markets who can take orders and produce goods with an almost infinite supply of available low-cost workers. The volume of production decreases unit costs due to economies of scale in production and transportation. The process creates extreme efficiency in the purest sense of the term: the production of one unit “mobilizes” less “resources” than before, thus “liberating” resources for other uses.

In other words, people are less employed in rich countries, which makes them available to work in another sector, either an existing or upcoming one. Indeed, this has been happening for a “long” time on a human scale (but only for a few seconds in geological scale). In North America, 75% of all jobs were in agriculture about 200 years ago. Then there were massive productivity improvements over the next 2 centuries, which rendered all these people “useless”, and the economy gradually moved to different sectors: manufacturing, construction, heavy industrial goods, services, advanced technology, etc. This is the process of economic development in a nutshell: there is destruction in some “parts/sectors” of the economy which takes the form of a relative or absolute decline and prosperity in others, which takes the form of relative or absolute expansion.

The process generates aggregate net gains. Indeed, if we had held on to horse transportation and manual labor in the fields, we would not have all this “progress”. The process eliminates jobs in some areas and creates jobs in other areas, and the process of adjustment requires that the economy be “flexible and resilient” and that people be equipped to “renew and switch around.”

There are two myths that need to be explored before we go any further.

Myth 1: cheap labor of emerging markets automatically means that rich countries lose jobs to these markets due to the “unfair” cost advantage.

Myth 2: Firms are greedy because they try to cut on labor costs.

Let’s start with Myth 1, the myth that low wages in emerging markets represent impossible-to-beat competition for richer countries. What really matters in the end is that the total production cost per unit is competitive. This total cost includes ALL possible costs to the firm: wages, non-wage compensation, regulatory costs, all types of taxes, etc. To keep things simple, let’s focus on the simplest case: unit LABOR costs, that is the cost of labor per unit.

Suppose a US worker is paid 20$ per hour and produces 20 widgets per hour. This worker represents a unit labor cost of 1$: 20 units “cost” 1 hour to produce, and 1 hour “costs” 20$ of labor to the firm, so one unit costs 1$ of labor.

In the same way, suppose a Chinese worker is paid 1$ per hour and produces 1 widget per hour. This low-paid worker has the SAME unit labor cost as the “high-paid” US worker: 1$.

The high output per hour of the US worker allows him to be paid more than the Chinese worker while preserving the competitive edge of the firm. Productivity differentials “allow” wage differentials. This is true between countries, between sectors, and between individuals. When productivity differentials decrease between countries in certain sectors, there will eventually be “convergence” of labor incomes in those sectors, as demand for labor will go to the cheaper-priced place and cause global re-alignment of labor costs.

Although “productivity” was defined by “units produced per hour” in my simple example, the more correct definition of “productivity” is “market value created per hour” (or something like that). Note that even a police service or a public administration has “productivity”: if you can get the same or better public goods and services, infrastructure, education, etc. from the government without paying more taxes or with less taxes, the public sector just made “productivity gains” and the population is better off, because it gets more / better services without paying more, hence improving material standards of living. This includes the social safety net, public infrastructure, the army and police, education, the legal system, State bureaucracy, public health care, and a host of other government goods and services.

When average productivity increases, material standards of living increase as well for the entire economy. However, there are important details when you “disaggregate” things, that is when you delve into the details instead of looking at the entire economy.

The rapid and massive transfer of production knowhow, human capital, technology and capital from high-income countries to low-income countries created a rapid upgrade in emerging economies in their capacity to produce more volume of goods and more complex goods, at all levels and in many sectors. This means that the rich-country “productivity advantage” has been decreasing in many sectors (except advanced innovation and high-knowledge sectors, which are not labor intensive) and the wage differentials in many sectors no longer reflect productivity differentials. Indeed, unit labor costs are several orders of magnitude higher in rich countries than in lower income countries, which means wages “should” adjust downward in high-income countries and increase in low-income countries.

There are hundreds of millions of available workers in Asia, Latin America, and more and more even in Africa willing and able to do more and more of the tasks that rich-country workers do. The emergence of “labor competition” from emerging markets started in clothing and electronic assembly mostly in China, Mexico, and a few other places, but the phenomenon is spreading to many sectors and countries.

In theory, the increasing productivity in emerging markets would boost wages in those countries and boost global living standards, and that is indeed happening… on an unprecedented scale. This would then increase global consumption and production, thus increasing jobs and wages, which is also happening… 100 years ago, at least 70% of the world population was in severe poverty, still in 1990, the global poverty rate was about 40%… in 2017 it was slightly below 10%. This is good news for the world as a whole.

However, the net gains are not equally distributed within and between countries, and this is a growing issue within rich countries, as the “process of adjustment” can take 20 to 30 years or more and the “wage equalization process” also implies that “easy to find labor” should have a decreasing market value, which means that rich-world labor is at risk of continued real wage stagnation for large portions of their populations.

Since 2002, 80% of US workers have not seen notable improvements in real wages, health coverage or costs, non-wage benefits, better (less) work hours, mental health indicators, access to education, or any other metric you want to look at.

Total real GDP per capita is growing, yet little seems to be happening for 80% of the population, as can be seen by comparing real GDP per capita and real median household disposable income since 1990. Part of the drop in the median household income is due to a falling household size, but that happened significantly more between 1975 and 1995 and much less since the mid 1990s, so the household stagnation is NOT due to household size at all.

Real GDP per capita (red) vs Real median disposable household income (blue), 1985–2015 (1985 = 100)

The gains are concentrated in the top-10% income earners. This may signal that the value creation process is happening mostly in the top 10% and the rest of the economy is not changing and creating extra value. In other words, most people are doing the same job with the same tools and the same process as 20 years ago and more, and the income gains in the upper income brackets are disconnected from the majority.

So why are we probably overpaid? Because unless you have highly specialized skills and knowledge that can’t be done by the masses of available workers in emerging markets, your pay is probably still related to the old world — the one before globalization and automation (before 1990), and the market value of your labor input in the production process is probably NOT reflective of unit labor cost differentials with most of the rest of the world, especially if we include non-wage costs to the firm: taxes, regulation costs, etc.

In a global competitive market, prices tend to converge to the same price, and that includes the price of labor, hence wages. The issue is that the price of labor is directly related to its relative scarcity (and market value of output), or “supply and demand”, if you will… and supply of low-cost labor has exploded across the globe to a point it is pretty much infinite, and wages have not even nearly adjusted “enough” to reflect this change.

What happens then? Since wages did not adjust downward, jobs were destroyed in the high-cost world and were created in the low-cost world, thus creating a great global convergence. This is perfectly in line with economic theory, but it is quite a hard situation for the masses that are not in the top 20%.

So, the first “myth” has some truth to it, because wage differentials do not reflect productivity differentials, or “market value of output per employee,” which means that emerging markets do indeed attract production activity, which is great for poorer countries but not that cool for the everyday American Bob exposed to emerging market competition, although it IS great for people in rich countries, as their purchasing power increases due to lower priced goods.

Now let’s look at the second myth, that multinationals are greedy to seek out “cheap labor” in emerging markets instead of using “local” labor content in the production process.

I have a small company myself. When I get too busy, I hire assistants. I don’t do this because I get up in the morning thinking that I “want to create a job” … I do this because I need help due to strong demand! In the same way but on a bigger scale, a firm produces goods or services that it sells to customers. In this “process”, it does not “want” to hire employees, it hires workers because the process requires a lot of work. The more demand there is for it’s goods and services, the more employees it will hire. The work is then coordinated by managers and supervisors who make sure that the process is done efficiently and that the end-product satisfies quality standards and good timing for market demand and other considerations. The goal of a firm is not and must not be to have lots of employees. That said, arrangements can be made to limit job loss, as Germany shows.

If the goal was to “create jobs”, we could simply hire the entire population to shuffle paper around and dig holes in the ground. This would show an impressively low unemployment rate of zero percent, but the value created during production would be very low, which ultimately means that the company (or State) would not create value, and the economy would have low living standards for everyone. This is typical of socialist states that “create jobs” by beefing up public administration and satellites of the government — it may seem “not as simple as the paper shuffling example” but this simple example does expose the dangers of “job creation initiatives” by the State. Creating low-value jobs is just institutional growth without value creation and it is not clear that it helps society in the long run.

Governments are not subject to the direct efficiency constraints of producing value for sale at a cost that is lower that the willingness and ability to pay of customers, but the private sector IS subjected to this constraint, and this is precisely what allows the “system” to create value and foster improving material standards of living in the long run.

The State does have an important role to play in the economy, which is not the subject of this article. I am no libertarian and I am not of any specific “school of thought” either, as associating my identity to a specific “ideology” always struck me as self-limiting and dogmatic, and I am a facts-based pragmatic idealist. Although the public sector is very important, even the State’s goal should not be to “create jobs” — it should be to deliver public services, infrastructure and a host of other missions at a “high value per tax dollar.” Unfortunately, politicians have their own constraints: getting their party to power and getting elected themselves and staying there.

Short story: a private firm produces goods and services in the name of the owners. The owners want a return on their investment, and this is normal. Obviously, the firm must respect rules and regulations, but it seeks to always increase market share and price and to decrease production costs. Prices and market share are “kept in check” by competition. Prices to consumers are lower if competition is strong and production costs are low.

That is the reality of the firm: produce and create value for owners and customers. The “process” generates income for owners and employees and goods and services that people can and want to buy. Firms will produce in a way that is most efficient, and for many that has been and might continue to be to seek overseas partners to outsource the production so that costs are lowered… and THAT process exposes all of us to the quasi infinite labor supply of emerging markets.

Most of us are “overpaid” because the value of our production is not “that much higher” relative to what a lower-wage worker can produce in an emerging market. The global labor supply shift started to really “hit home” starting in the early 2000s, and the effect is not about to slow down, quite the contrary.

The global convergence has barely begun, and it does benefit some categories of incomes and workers and makes us pay lower prices than otherwise would be the case, as well as increasing total GDP, but the gains are not all that visible to the masses, while the costs are increasingly “visible” indeed, and we see this in mental health and obesity issues, social dislocation, violence, stagnating real incomes, stagnating employment rates, and more, even with the growth of average GDP per person.

Note that this process of labor reallocation and convergence eventually “stabilizes” … the problem is that this “adjustment process” can take 30 years, and that is a long time for wage stagnation and high inequality, because it creates frustration and social unrest. The “rage of the masses.” That underlying frustration can act as a catalyzer of ideological divisions and social tension.

There seems to be no stone left unturned. This is a world of hyper efficiency and competition, and it has little place for any form of “ordinary worker” that is paid more than the market value of his output and his relative scarcity. Sad but true.

But believe it or not, this global labor supply shock and its associated “hyper competitive” labor market is not the main driver of stagnating incomes and job creation for the majority — it only adds to existing pressure from automation…

Pascal Bedard