Europe’s wage paradox

European leaders should find inspiration in Keynes' insight – that the world becomes richer when economies raise productivity and allow wages to keep pace.

In a Financial Times article following his December trip to China, President Emmanuel Macron wrote about growing global trade imbalances affecting Europe. ‘We must acknowledge’, he said, ‘that these imbalances are both the result of weak EU productivity and China’s policy of export-driven growth.’

President Macron was only partly right. While the second half of this statement is broadly correct, the first is technically not. Countries do not run trade deficits because of low productivity any more than they run trade surpluses because it is high. This is simply not what drives global trade imbalances. The most obvious counterexample is the United States. American workers are more productive than European workers and several times more productive than Chinese workers, yet it is the US that runs the world’s largest trade deficits, while China runs the largest trade surpluses.

What actually matters for trade imbalances is not productivity itself, but the relationship between productivity and wages – in other words, the household income share of GDP. Trade imbalances largely reflect how income is distributed between households, businesses and the state. When wages are high relative to productivity, households capture a larger share of national output and are able to consume a larger share of what is produced. When wages are low relative to productivity, household consumption is suppressed and, which is the same thing, national saving rises.

This helps explain why the US, where wages are high relative to productivity, runs chronic trade deficits, while China, where wages are among the lowest in the world relative to productivity, has one of the highest saving rates ever recorded and runs large and persistent trade surpluses.

This pattern holds more generally. Countries that run sustained trade surpluses tend to have a lower household income share of GDP than countries that run sustained deficits. Because of lower household income share, surplus countries are able to price manufactured goods more cheaply than their trade partners. Low consumption and manufacturing competitiveness are simply two sides of the same coin.

When Macron described European productivity as weak, what he really should have said is that wages in Europe are higher relative to productivity than they are in major trade partners such as China. This distinction matters because high wages are not a weakness. On the contrary, high wages are what drive demand. Production can only be sustained when consumption keeps pace with rising productive capacity. Rising wages create the demand that justifies production, and also incentivise businesses to invest in productivity-enhancing technologies. The result is a virtuous circle in which productivity growth supports rising wages, which, in turn, support further productivity growth. From the perspective of global welfare, Europe’s relatively high wages and strong social safety nets are not liabilities; they are among Europe’s most important contributions to global growth.

These same features do not necessarily contribute to European growth under current global conditions. This is where much of the conventional discussion of trade goes wrong. Europe’s supposed lack of competitiveness is blamed on a range of factors that are often conflated, but it is essential to distinguish between policies that undermine manufacturing efficiency and those that undermine manufacturing competitiveness. Excessive regulation, underinvestment in research, and inadequate infrastructure can weaken manufacturing efficiency. High wages and a strong social safety net do not, even if they reduce Europe’s global manufacturing competitiveness.

The reason is that efficiency and competitiveness are not the same thing. Efficiency concerns how effectively an economy uses resources to create value. Global competitiveness, by contrast, depends largely on how income is distributed within an economy. It is primarily the direct and indirect distribution of domestic income, rather than underlying manufacturing efficiency, that determines global competitiveness.

A recent ECB survey earlier this year illustrates this clearly. It found that the main constraint on business investment in the euro area is weak demand. When weak demand is the binding constraint, policies that raise wages – and thereby consumption – should be part of the solution. Unfortunately, in a hyperglobalised world in which the costs of transportation, communication and financial transfers are extremely low, the additional demand created by higher wages does not necessarily translate into higher investment and production at home. Instead, it can just as easily support investment and production abroad, especially in economies that deliberately suppress wages relative to productivity in order to boost manufacturing competitiveness.

This creates a paradox similar to the one identified by the Polish economist Michał Kalecki in 1933: individual countries can grow faster and become more competitive by suppressing wages, even as widespread wage suppression slows overall global growth. This is why, as John Maynard Keynes argued at Bretton Woods in 1944, the solution is not to force high-wage countries to cut wages in order to compete. That would only further depress global demand, or else require deficit countries to increase debt to offset the loss of demand. The appropriate solution is instead to raise wages in economies where they are low relative to productivity. In that case, rising demand would drive rising supply, and global growth would be both stronger and more stable.

This distinction implies that the policies needed to address Europe’s manufacturing inefficiencies are entirely different from those needed to address its lack of global manufacturing competitiveness. Europe can improve manufacturing efficiency by streamlining regulation, increasing investment in research and infrastructure, and removing obstacles to a genuinely unified internal market. But unless wages are prevented from rising in line with improved efficiency, none of these measures will restore Europe’s global manufacturing competitiveness.

That is because European manufacturing is uncompetitive relative to manufacturing in economies such as China, South Korea, Taiwan, Singapore, and – until relatively recently – Germany and Japan, primarily because European workers are paid more relative to their productivity than workers in these economies. Moreover, these economies are generally able to maintain this advantage only because they intervene actively in their external accounts, through trade and capital controls, currency intervention, and directed credit policies.

Europe therefore faces a stark choice. It can dismantle its welfare state and force wages down relative to productivity – a course that would be damaging not only for Europe but for global growth – or it can change the terms of trade under which it operates. The latter requires Europe to intervene in its external accounts to offset the intervention of its trading partners. If surplus countries will not allow wages to rise sufficiently to erode their manufacturing competitiveness, and will not permit their currencies to appreciate in response to persistent surpluses, Europe must adopt policies that allow its own manufacturers to compete. This necessarily entails intervening in its external accounts, whether through currency measures or through the kinds of capital and trade policies long employed by manufacturing powerhouses such as China. This is precisely the direction in which the United States has moved under both the Trump and Biden administrations.

This is not protectionism. It is an effort to neutralise protectionist policies abroad and restore balance to a system that currently rewards the wrong behaviour by allowing countries that suppress domestic wages to export the costs of their domestic policies. It is also why Joan Robinson, one of Keynes’ most perceptive collaborators, described such trade surpluses as ‘beggar-thy-neighbor’. The only sustainable solution, in other words, is not to suppress wages in order to compete, but to reform the global trading system so that it no longer rewards wage suppression.

The current trading system rewards countries that suppress wages and penalises those that do not by shifting the global distribution of manufacturing toward the former. This outcome benefits no one in the long run. Rather than competing ever more aggressively within such a system, Europe should recognise that many of its most criticised features are, from the perspective of global welfare, genuine strengths. France, Europe and the world benefit from rising European wages. Unless the global trading system is reformed to eliminate free-riding by economies that intervene in their external accounts, less competitive countries will be left with little choice but to either intervene themselves or to accept a continued loss of their share of global manufacturing.

The world becomes richer when economies raise productivity and allow wages to keep pace with it. As Keynes explained nearly a century ago, it becomes poorer when countries can improve their manufacturing competitiveness by suppressing wage growth relative to productivity. If Europe is unwilling to follow that path — and it should be — it must instead change the terms of trade under which it operates.