Should German workers be paid more? Or, Do we have an omitted variable bias?

A recurrent problem in regression analysis is the omitted variable bias: if you estimate a regression and you do not include on the right side a variable that belongs to the model and is correlated with some included variables, the OLS estimates will be biased. The gist of this post is whether we have something of an analogous problem in addressing the current macroeconomic problems in the €-area, namely by not considering the possible influence of income distribution.  
Of course, I am aware that some economists consider unequal income distribution a critical issue, for instance E. Stockhammer titles one of his paper: Rising Inequality as a Root Cause of the Present Crisis [1]. However, this approach has not really entered the main policy discussions, may be just because it has been formulated in a somewhat extreme way, giving too central a role to income distribution.
The emphasis in this post is on the German situation, also because the huge German current account is something of an embarrassment for those, like me, who think that there is a lot to appreciate in the way the German economy is managed, but cannot just ignore the recurrent critique [2] that the insufficient domestic demand in Germany, and the resulting huge current account surplus, is a problem for the €-area and, ultimately, for Germany itself. The overall question raised in this post is whether a higher remuneration of labour, and its close empirical counterpart of more equality in income distribution, would not contribute to increase domestic demand in Germany and thus reduce its mammoth current account surplus. 

I used the term “contribute” in the previous sentence on purpose: there is no pretence that paying German workers more would be “the” solution to the excessive current account surplus of Germany. I think, however, that it is useful to raise the question whether such a change should be part of the solution. 

An answer to this question is made more difficult by the fact that economics is a science not hard enough to be free of political preferences: left-wing economists will always say that there is too much income going to profits and top earners, right-wing economists will constantly say the opposite. It is clear, instead, that there is an optimum functional and interpersonal income distribution and that actual distribution may move away from that optimum in either direction, making fixed views not appropriate. In this post I will attempt to maintain a balanced approach and make the conclusion depend on the reasoning rather than the opposite. In order to do so, I will very briefly recall two concepts of income distribution: functional and interpersonal distribution, then I will summarily report what we know about long term trends of income distribution at international level, in particular over a medium term horizon, before moving to the specific case of Germany. I will then address the links between income distribution, on the one hand, and domestic demand and the current account, on the other hand. Short remarks on policy aspects will close the post.

Conceptually there are two different definitions of income distribution: the functional one, between labour and capital, and the interpersonal one, between rich and poor or, in drier language, between high and low percentiles in the distribution of income. Empirically, however, the two definitions are correlated, given that capital is very heavily concentrated in the hands of rich people and when capital remuneration goes up rich people become richer 
[3] .

The three prevailing long term empirical trends at global level regarding income distribution, at least since the end of the seventies, have been:
  1. An increase of capital income [4];
  2. Increasing inequality among different income percentiles within most advanced and emerging economies [5];
  3. Decreasing inequality across countries, especially because of the vertiginous growth of China over the last few decades.
The joint effect of the increase of within-countries inequality (e.g. rich American got richer and poor American got relatively poorer) and the reduction of across-countries inequality (e.g. the distance between average American and average Chinese got smaller) produced uncertain effects on global inequality, i.e. the inequality among the entire global population, with some economists even identifying a decrease of inequality [6]. In a secular perspective, Bourguignon and Morrisson measure a broad stabilisation in inequality after World War II and until the end of their period of analysis at the beginning of the nineties, following a trend, of strong increase since 1820. [7].
The developments in Germany are quite consistent with the first two points mentioned above about global developments:
  1. In the eighties and nineties [8] the share of labor in income distribution came down by some 8 percentage points, and it came down some further 5 percentage points in the first decade of the new century, even if, due to the cyclicality of profits, the labour share went somewhat up during the recession towards the end of the decade [9],
  2. Interpersonal inequality grew in the seventies and eighties by some 3 per cent (as measured by the Gini coefficient in Harjes [10] and by a further 3 per cent in the first decade of the new millennium (again as measured by the Gini index, in Schmid and Stein, Op. Cit. pg. 19).
The macroeconomic consequences of a move in income distribution toward capital and towards more inequality are obvious. The most evident effect is on consumption as the propensity to consume out of capital income is much lower than that out of wage income and the propensity to save increases very sharply moving from lower to higher income classes (from just above 4.0 per cent for the lowest quartile of the distribution to close to 16.0 per cent for the highest quartile in Germany) [11]. On the other hand, as long as the decrease in profits influences investment more than the prospects of higher consumption, an increase of the capital share and of inequality in the distribution of income will have a negative effect on investment. In addition, as a consequence of higher domestic demand and a possible effect of a higher labour share on export prices, there will also be a downward effect on the trade balance.
Stockhammer and Onaran [12] report a possible quantification of the macroeconomic effects in the euro area of an increase of the capital share in income distribution. Lavoie and Stockhammer [13] report similar quasi-multipliers for a number of economies, including Germany, which has similar parameters to those estimated for the €-area. The relevant values are reported in table 1.
Table 1: Effects of a 1% increase in the profit share
Net exports
Private excess demand
Euro area12

Source: Özlem Onaran and Giorgos Galanis, Is aggregate demand wage-led or profit-led?, ILO, 2012

A back of an envelope calculation, based on the estimates of the increase of the profit share for Germany reported above for the last three decades and the quasi-multipliers in the table above, would indicate that consumption would have been more than 5 per cent higher in Germany if capital remuneration had remained at the level prevailing at the end of the seventies, investment and the trade balance would have been some 4 per cent lower and 1 per cent lower respectively.
Of course the quantification of the macroeconomic effects of an increase of the labour share in income distribution would require a much more careful empirical exercise than the back of the envelope estimates above. One issue, in particular, which I think should be further explored is whether the negative effect on investment would be currently as strong as reported in the table above. Two reasons make this question particularly relevant: first, as income distribution moved in favour of profits over the last three decades, investment in Germany has moved down quite a lot (see Chart 1) instead of growing, second, a strong accelerator effect may reduce the negative effects of lower profits on investment because of the positive prospective effect on consumption.


 Chart 1: Total investment as percent of GDP: Germany 1980-2018
Source: IMF WEO, October 2013
Even taking into account the uncertainty about the quantitative effects, the qualitative conclusion is clear: better remuneration for labour, and the consequent reduction in income inequality, in Germany would help rebalance the economy from excessive reliance on foreign demand.

The further question that immediately arises, however, is what tools a government has to influence income distribution. Pay in the private sector is and should remain a decision of firms and workers. This principle, however, should not be translated into its caricature: that income distribution between capital and labour follows mechanically the respective marginal productivities. Social factors and government action do have an influence on income distribution. The tax system is a first, obvious tool in the hand of the government. It is interesting, in this respect, that Schmid and Stein measure a reduced ability of the tax system  in Germany to redistribute income towards lower income levels since 2003. The government can also have an influence on income distribution by its own wage policy: raising wages in the public sector produces an effect in the private sector as there is competition in attracting workers between the two sectors. Finally, the government can promote a social climate generally in favour of higher labour remuneration, beyond the bland statements to this effect issued by some German government representatives 
[14].  It is, however, unclear how much fixing a minimum wage, as recently done in Germany, helps in redistributing income.

In conclusion, the tentative answer to the question in the title of this post is that, yes, European macroeconomic imbalances would be attenuated if German workers got higher wages and this could be done without damages to the German economy: the issue is not to worsen German competitiveness and make the economy weaker, but just to better remunerate the very high productivity of German workers, tilting income distribution in their favour. An additional benefit for the rebalancing of the European economy would be that higher wages in Germany would allow a recovery of competitiveness in the periphery of Europe with respect to Germany without forcing wages in the negative territory, thus risking bringing the entire euro area into deflation.


*** Research assistance was provided by Mădălina Norocea

[1] Engelbert Stockhammer, Rising Inequality as a Root Cause of the Present Crisis, PERI working paper No 282, April 2012

[2] US Treasury: “Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anaemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many  other euro-area countries have been under severe pressure to curb demand and compress imports  in order to promote adjustment. The net result has been a deflationary bias for the euro area, as  well as for the world economy” Semiannual Report on International Economic and Exchange Rate Policies, Oct 2013

IMF: “significantly smaller current account would be useful” David Lipton, American Academy speech, Oct 2013
EC: “We do need to examine this further and understand whether a high surplus in Germany is something affecting the functioning of the European economy as a whole” Jose Manuel Barroso, referring to the in-depth economic analysis of Germany, launched in Nov 2013
[3] Adler and SchmidFactor Shares and Income Inequality — Empirical Evidence from Germany 2002-2008 , DIW Berlin, Apr 2012
[4] Florence Jaumotte and Irina Tytell , How Has The Globalization of Labor Affected the Labor Share in Advanced Countries, IMF Working Paper Research Department,  Dec 2007
[5] Branko MilanovicMore or Less,  IMF Finance & Development, Vol. 48, No.3, Sept 2011
Anthony AtkinsonIncome Inequality in OECD Countries: Data and Explanations, CESifo Working Paper, No. 881, Feb 2003
Pinelopi Koujianou Goldberg and Nina Pavcnik Distributional Effects of Globalization in Developing Countries, NBER Working Paper No. 12885,Feb 2007
Giovanni Andrea CorniaThe Impact of Liberalisation and Globalisation on Income Inequality in Developing and Transitional Economies, CESifo Working Paper No.843, Jan 2003
[6] Xavier Sala-i-Martin,  The Disturbing “Rise” of Global Income Inequality, NBER Working Paper 8904,Apr 2012
[7] François Bourguignon and Christian MorrissonInequality among World Citizens: 1820-1992 , The American Economic Review, Vol. 92, No. 4, Sept 2002
[8] Thomas HarjesGlobalization and Income Inequality: A European Perspective, IMF Working Papers, July 2007
[9] Kai Daniel Schmid and Ulrike SteinExplaining Rising Income Inequality in Germany, 1991-2010, IMK, Sept 2013

[10] Thomas Harjes, Globalization and Income Inequality: A European Perspective, IMF Working Paper, European department, July 2007
[11] Ulrike SteinZur Entwicklung der Sparquoten der privaten Haushalte – Eine Auswertung von Haushaltsdaten des SOEP, DIW, Dec 2009

[12] Ozlem Onaran and Engelbert StockhammerRethinking wage policy in the face of the Euro crisis. Implications of the wage-led demand regime, International Review of Applied Economics Vol. 26, No. 2, Mar 2012 report the estimates from Onaran, Ö., and Galanis. 2011, Wage-led and profit-led demand: A global mapping. Paper presented at the workshop on ‘Wage-led growth: An alternative to finance-led capitalism?”
[13] Marc Lavoie and Engelbert StockhammerWage-led growth: Concept, theories and policies, ILO, 2012 report the estimates from Onaran and Galanis, reported in footnote 10
[14] “It is fine if wages in Germany currently rise faster than in other EU countries. These wage increases also serve to reduce the imbalances within Europe.” Wolfgang Schäuble, May 2013