JEFFREY D. SACHS Harvard University and National Bureau of Economic Research Wages, Profits, and MalcroeconomicA djustment: A CornparativeStudy THE BEHAVIORof real wages has complicated macroeconomic policy in the industrializedworld duringthe 1970s. Many commentatorshave dis- cussed the extraordinaryincrease in wage inflationin Europe and Japan at the end of the last decade.1Few have noted that the nominal wage gains resultedin remarkableincreases in real wages. The five large econ- omies outside North America in the Organisationfor Economic Co- operationand Development (OECD) had rapid growth of real hourly compensationin 1969-73, along with high rates of increaseof nominal compensation.In most large OECD economies, real wages in the late 1960s grew faster than productivity,so that the distributionof income shiftedtoward labor, while the rate of returnon capitalwas substantially reduced. 1. For a thorough econometric study, see George L. Perry, "Determinants of Wage Inflation around the World," BPEA, 2:1975, pp. 403-35. Another important study that focuses largely on the 1969-76 period is Robert J. Gordon, "World Infla- tion and MonetaryAccommodation in Eight Countries,"BPEA, 2:1977, pp. 409-68. Further evidence for extraordinarywage behavior in the late 1960s is provided by Erich Spitaller, "Semi-Annual Wage Equations for the Manufacturing Sectors in Six Major Industrial Countries," Weltwirtschaftliches Archiv, vol. 112, no. 2 (1976), pp. 300-37. In addition, from a vast sociological literature that focuses on wages and trade union behavior in the late 1960s, see the collections of essays in Solomon Barkin, ed., WorkerMilitancy and Its Consequences, 1965-75: New Direc- tions in Western Industrial Relations (Praeger, 1975); and Colin Crouch and Alessandro Pizzorno, eds., The Resurgence of Class Conflict in Western Europe Since 1968, vol. 1: National Stucdies,and vol. 2: Comparative Analyses (Holmes and Meier, 1978). 0007-2303/79/0002-0269$00.25/0 ?) Brookings Instituttion 270 BrookingsPapers on Economic Activity, 2:1979 In Europe and Japanthe profitsqueeze intensified after the oil, food, and productivityshocks of the 1972-74 period. Real wages decelerated only slowly in the face of these disturbances,and much of the burdenof the supplyshocks was shiftedto the quasi-rentsof capitalin the shortrun. In the UnitedStates, on the otherhand, real wages deceleratedmarkedly in 1973 and 1974. In Canada,a large net exporterof primarycommodi- ties, the shift in termsof trade towardthese goods increasedprofits and the scopefor growthin realwages. Becauseof the externalsupply shocks and contractionarypolicies, the world economyentered the deep slump of 1974-75. The policy debate that followed is at the center of this paper. In a varietyof international forums,the UnitedStates urged expansionary policy in Europeand Japan to bringabout a cyclical recovery.2The advice was largelyrejected, and not merelybecause Europe and Japanhad differenttastes for unemploy- ment and inflationin the short run. The distinctpolicy choices followed fromdiffering views on manyissues. Two differenceswere particularly im- portantfor this analysis:whether a decelerationof real wages after 1974 was a prerequisitefor sustained recovery, and whether expansionary policyor austeritywas the best approachto moderatingreal wages.Euro- pean and Japanesepolicymakers answered the firstquestion affirmatively. In lightof the rapidgrowth in realwages since 1969 and the failureof real wages to deceleratesufficiently in responseto the supplyshocks in 1972- 74, they adopteda classical interpretationof the businesscycle, arguing 2. In ministerial meetings of the Organisation for Economic Co-operation and Development (OECD), the United States endorsed a "locomotive" strategy, in which joint expansion of West Germany, Japan, and the United States was to lead smaller economies out of the recession. Continuing the transport metaphor, the United States later heralded a "convoy" approach, in which strong economies both large and small would lead to a world economic expansion. A good source for study- ing the U.S. policy position over time is the Economic Report of the President, various years. Throughout, there is a sustained argument for vigorous expansion of demand and a minimization of the risks of expansion in conditions of widespread unemployment.It is argued that monetary expansion will not lead to greater infla- tion, except under conditions of high utilization of capacity. A typical proposition is found in the 1978 Economic Report, pp. 114-15: "A program for achieving full recovery in the industrial economies must begin with measures to raise domestic demand and capacity utilization. Only then is sufficient investment likely to be forthcoming to achieve structural objectives.... Both monetary and fiscal policy can make a contribution.With excess capacity everywhere, world recovery can pro- ceed without undue concern that reasonable expansionary policies will trigger a new round of inflation." JefFreyD. Sachs 271 that real wages were too high for full employment.They pointed to low ratesof profitabilityas a barrierto rapidexpansion. Moreover, there was widespreaddoubt, voiced by economistsin West Germanyin particular, that expansionarypolicies could moderatereal wages.And they rejected the Keynesianview that the stickinessof nominalwages made it possible for policy-inducedprice inflation to reducereal wages. Differentconclusions on both issuescould be drawnfrom U.S. data.In the United Statesreal wages slowed sharplyduring 1973-75, in part be- causeof the stickinessof nominalwages, so that a classicalexplanation of the recessionfound few adherents.The deep recessionin the UnitedStates was attributedto demand factors, including the failure of monetary authoritiesto accommodatethe increase in oil prices, the transferof wealthto OPEC, and perhapsa decline in investmentdemand from the complementaritybetween energy and capital. Expansionaryfiscal and monetarypolicies were seen as desirableinstruments to effectrecovery. In this paperI focus on the differingpatterns of real wage behaviorin these largeindustrial economies and on the resultingdifferences in views about macroeconomicpolicy. I argue that the concern in Europe and Japan about real wage behaviorand profitabilityhas been appropriate, in light of the progressivesqueeze on profitsuntil the mid-1970s. On a more subtle point, I present evidence to show that moderationin real wages could not be achievedin Europewith inflationarypolicy. Because of wage-settinginstitutions outside North America, little opportunity arisesto exploit nominalwage rigiditiesin policymaking.To be explicit, unionizedlabor marketsin the United States and Canadahave the dis- tinctive feature of overlapping,long-term wage agreements,which are only partiallyindexed. The othereconomies each have some combination of short-termcontracts, high indexation,or centralizedbargaining. Ac- cordingto the theorypresented in the last section, these institutionalar- rangementslead to a relativelystrong link betweenmonetary policy and output in the United States, and to a dominantlink between monetary policy and pricesin the Europeanand Japaneseeconomies. Econometric evidencesupports this conclusion,as do specifichistorical episodes in a numberof countries. The paperbegins with a descriptionof wagebehavior in the sevenlarge OECD economiesduring 1969-78. I look at the wage boom in the late 1960s and the consequentshifts in factorshares and profitability.In some empiricalwork that follows, I discussthe quantitativeimplications of the 272 BrookingsPapers on Economic Activity, 2:1979 shocks in terms of trade and productivityfor real wages in 1973-75, and conclude that a second profit squeeze followed these disturbances in Europeand Japan.In the second section I examinethe impact of the wagemovements on outputand profitability.The slowergrowth of manu- facturingsince 1970 appearsto be closely linked to the profit squeeze followingthe wage boom. In the final sectionof the paper,I offer a brief summaryof the wage-settinginstitutions in the variouseconomies and an analysisof how these institutionshelp to shape the appropriateuse of monetarypolicy for recovery from a profit squeeze or for control of inflation. Real Wagesin MajorOECD Countries, 1969-78 This section covers the developmentsin real wages in the seven large OECD economies,describing the shared as well as the specificfeatures of the patterns.The tables that follow focus mainly on four subperiods: 1962-69, 1969-73, 1973-75, and 1975-78. The 1962-69 period serves as a benchmark;in that period, the rate of growthof productwages was almost identicalto that of productivityin most countries.The first and largestpart of this section is devotedto 1969-73, which displayeda sig- nificantacceleration in real wagesin Japanand the four Europeancoun- tries. I then turn to the interestingsubsequent developments in 1973-75 and 1975-78. It is importaintto relate the behaviorof nominalwages, W, both to the pricesof the goods and servicesproduced by workersand to the pricesof the goods and servicesthat they buy as consumers.With Pv representing the deflatorfor value-addedat factorcost, the ratio W/PVmay be denoted as the productwage. When TYis dividedby the consumerprice deflator, Pa, the resultingratio is the real wage. In addition,I highlightthe shareof laborcompensation in total value-added,WL/VPV, where V is real value added and L, labor input, measuredhere as total hours worked. Thus labor'sshare is equivalentlythe ratio of the productwage