Tyler Cowan wants to know how profits of companies can be so high while apparently demand is too low. Tim Duy notes that labour’s share of income has been falling for quite a while. I think that these are two symptoms of the same phenomenon and I want to propose what I think is a fairly simple explanation.
If we take the trading world’s economy as a whole, as one big closed economy, then the opening of china over the last 10-15 years has basically been a very large increase in the available labour force. This has left the capital:labour ratio in the trading world too low. The appropriate response then is to have an increase in investment spending to build the world’s capital stock up to its desired level. The low interest rates and high stock prices that most of the western world has seen since the mid-90s is just the normal market signal for a high level of investment. The increase in capital’s share of income is just what you’d expect of the relatively scarce factor.
Now of course there has been a spanner thrown in the works in the form of Chinese capital controls. Clearly, since the added labour is all located in China, the additional capital should also be located in China. However Chinese capital controls, associated with their exchange rate peg, interfere with this. In order to maintain the peg the Chinese are forced to invest a substantial proportion of their savings in the already capital rich west (causing us trouble when we try to invest all those savings) instead of investing them at home where capital is scarce, labour abundant, and thus the marginal product of capital is highest. Finally, and most importantly, the capital formation that has happened in China has been directed by the government into the export sectors and kept out of the rest of the economy.
The result is that in capital rich manufacturing industries in China labour is competing directly with cheaper labour from their general economy and this depresses their real wages. The goods produced in these sectors are exported and thus these low wage workers are competing directly with workers in similar industries in the west. Since labour is substitutable across industries (generally we think capital is specialized and labour is substitutable) this translates into depressed wages even in the more capital intensive industries in the west and since these industries aren’t in direct competition with Chinese production the result for them is simply a gift of higher margins and profits. Effectively, by this mechanism, scarce capital at the world level is translating into capital having a higher value and taking a greater share of income, more or less as you’d expect.
Of course, increasing capital’s share of income should be a standard price signal that it is scarce and valuable and thus should spur investment but, again, capital controls are preventing this. It is worth pointing out that by most standards it does appear that China is in fact doing a lot of investing but at the same time simply looking at the huge amount of savings that they export to the west shows that they should be investing much more. After all, this is a country with a population that is (I guess) double the population of the US and Europe combined and it is extremely capital poor. China should be investing at unprecedented levels.
Most importantly, if China had the appropriate level of physical capital formation happening then the west would have much less of an unemployment problem, China would send us consumption goods and we’d send back capital goods. What’s going on now is better for neither the west nor China, we have unemployment and they remain poorer than they should be. More real capital in China would mean higher wages for the Chinese and less deflationary pressure exported to the west, it would be win-win, just as trade should be.
Senior Quantitative Portfolio Manager, Co-Fund Manager
Jul 13, 2010 at 12:26pm