Neoclassical economists do not or cannot tell you why the supply-sided pathway for rapid growth, like labour market flexibility, worsens the situation in a world of shrinking aggregate demand. But you can find a nice demystifying analytics in this regard in Bhaduri (1996). You must now catch his old and golden argumentation as follows.
It has become fashionable, following the orthodox neoclassical theory, to say that industrial growth via industrial restructuring requires a more flexible labour market in terms of (a) flexibility of real wages, especially in the organized industries; (b) freer ‘hiring and firing’ of labour by entrepreneurs and managers; and (c) free ‘exit policy’ by firms, that are incapable of competing despite real wage flexibility and freer hire and fire. This is the typical supply sided argument that firms will be induced to produce more as their production cost diminishes through lower real wages.
Under textbook assumptions, the lower real wage would be equated to the lower marginal product of labour at higher employment and output, enabling firms to reach their profit maximizing equilibrium. If anything, free ‘hire and fire’ of labour would strengthen further this supply sided argument. Besides, a more flexible real wage as well as freer hire and fire would encourage economic efficiency by a sort of ‘carrot and stick’ policy vis-à-vis labour. More efficient workers could be paid higher (even internationally competitive) wages as ‘carrot’, while labour discipline would improve through the fear of loss of jobs. A free exit policy would go a step further by weeding out inefficient firms and their ‘indisciplined labour’.
However, this quintessential neoclassical view loses sight of how aggregate demand is formed in an economy, i.e. how the size of the overall market where they collectively sell their products is influenced by such ‘flexible’ labour market policies. A general lowering of real wages redistributes income against the working population with a higher consumption propensity in general. Thus, private consumption demand declines. Both government consumption and investment also decline due to the financial discipline and credit restrictions imposed by the IMF-style reform programmes. More importantly, net exports contribute to aggregate demand as exports add to aggregate demand by increasing the size of our foreign market while imports do exactly the opposite by providing the foreigners with a part of our domestic market. In the Indian context, for example, while exports have increased quite substantially during the period of post-1991 structural reforms, imports have increased even more rapidly due to trade liberalization. There is no indication that exports net of imports would increase so rapidly that it would solve the problem of aggregate demand in the foreseeable future.
Increase in private investment could solve the aggregate demand problem in so far as the effect of investment expenditure gets magnified through the ‘multiplier process’. But the picture has also been bleak in this respect. Unfortunately, so far, we have had relatively little direct foreign investment while most of capital inflows have been in the portfolio form which may ‘fly out’ of the country at very short notice. Furthermore, to the extent that a part of the foreign exchange earned through portfolio investments is used up to support the import bill in excess of export earnings, it would have a strong contractionary effect on the level of domestic economic activity and employment through the multiplier. It is analytically wrong to mention that simply more efficient foreign import is replacing inefficient domestic production in order to enhance competition. This is merely the initial impulse in the multiplier process. Subsequent to that first round effect, some domestic workers lose their jobs and domestic profits of industry also decline. This reduces purchasing power in the economy leading to further contraction in output and employment in the successive rounds of the multiplier. These successive rounds of contraction fall on all domestic producers, efficient as well as inefficient. Thus, the central point is that foreign capital flows in a liberal trade regime, unless either are in the form of direct foreign investment, or matched by a corresponding increase in domestic investment through appropriate financial intermediation, would tend to have a contractionary impact on the economy.
Since the Indian economic reforms and monetary policies have not only allowed the interest rates to rise drastically but even more disastrously used the higher interests at home to attract portfolio investments from abroad, any such financial intermediation is extremely difficult. Whatever cost advantages a lower level of real wages in a flexible labour market might give to the Indian entrepreneur, would tend to get neutralized largely by the higher cost of borrowing finance for investment, especially for working capital, due to the steeper lending rates by the banks. And since this happens in a depressed macroeconomic situation where most of the major components of aggregate demand decline due to the economic reforms, they generate negative feedbacks in the form of a ‘reverse acceleration’ type effect on the level of investment.
In this scenario, no degree of labour market flexibility and other similar supply sided measures are likely to be effective. The alternative lies in going for larger and worthwhile public investments with little direct import content (e.g. water control, rural communication, land utilization, etc.) in agriculture where labour productivity is lagging behind increasingly over time in relation to the national average. Most of the labour market flexibility debate applies to the organized industrial sector which is quantitatively far less important. An important point in this connection to be noted in the post-1991 period is the increase in labour productivity in the secondary sector in relation to the national average. Given that existing evidence does not seem to suggest a neutralizing increase in real wages of the manufacturing sector, labour cost per unit of secondary sector output most probably has declined. Thus, the argument about the desirability of making real wages flexible downwards for improving the profit margin of manufacturing does not seem to be empirically so well grounded in India.
This tentative conclusion of Bhaduri (1996) got firm empirical support from Nagaraj (1996) who argued that the ILO (1996) report’s thesis of lack of wage flexibility in the organized sector is unsustainable; for, his estimates of unit labour costs—product wages divided by labour productivity—showed clearly a rapid fall in the cost of employing a worker in the organized manufacturing sector over nearly two decades from the mid-70s to the early eighties.
It is high time, thus, you dropped textbook Micro and picked up Bhaduri’s Macro in order to arrive at the plan of action proposed in Bhaduri (2005), which is the best thing to happen in India or any country—full employment at a decent social wage and internal market development based on the Keynesian spending multiplier and accelerator effects.
After all, at the end of the day, we ought to be interested in evidence-based economics, as stressed by the neoclassical economists Acemoglu et al. (2019). But if you do not highlight evidence based Bhaduri’s macroeconomics as above, then what is the point of their saying, “We love Economics”, and “Today economic analysis has expanded its conceptual and empirical boundaries and, in doing so, has become even more relevant and useful”?
By Annavajhula J.C. Bose
Department of Economics, SRCC
Acemoglu, Daron. et al. 2019. Economics. Pearson Education Limited. Global Edition. Second Edition.
Bhaduri, Amit. 1996. Employment, Labour Market Flexibility and Economic Liberalisation in India. The Indian Journal of Labour Economics. Vol.39. No.1. January-March.
Bhaduri, Amit. 2005. Development with Dignity. National Book Trust India. New Delhi.
ILO. 1996. India: Economic Reforms and Labour Policies. ILO-SAAT. New Delhi.
Nagaraj, R. 1996. A Comment on Chapter 2 : Wage Policy. National Tripartite Workshop on Economic Reforms and Labour Policies in India. September 3-4. New Delhi.