Monday, July 17, 2006

How Government Budget Deficits Reduce Wages and Raise Profits

In recent years there have been growing complaints over slow growth in wages compared to profits. Those who make the complaints usually offer little in the way of explanation. Here is a part of the explanation: growing government budget deficits.

Government budget deficits are financed partly by the creation of new and additional money. But for the rest, they are financed by selling government securities to the citizens, who pay for the securities with money that already exists and which is part of their savings. If the government had not been running at a deficit and had not needed to sell these securities, the citizens would have used most of the savings with which they buy the government securities to buy corporate securities and in other ways to make their funds available to business firms.

Those savings, in the hands of business firms would have been used to purchase capital goods and to pay wages. These wages, however, never come into existence if the savings out of which they would have been paid are diverted to the government to finance its deficit. Thus, wage payments in the economic system are smaller because of government deficits.

Yes, it is true that the government itself pays wages to some extent. But it is unlikely to do so to the same extent as do business firms. And to whatever extent the additional wage payments it makes out of the proceeds of its securities sales are less than the wage payments that business firms cannot make because of the diversion of part of what would have been their capital funds to the government, total wage payments in the economic system are reduced.

In addition to this likely reduction in overall wage payments in the economic system, the effect of government budget deficits is an increase in the aggregate, i.e., total, economy-wide, amount of business profits. Here’s why.

Whether business gets money to finance its purchase of capital goods and payment of wages, or the government gets money to buy goods and services, including meeting its own payroll, and, of course, simply to give money away in carrying out various welfare-state functions, the amount of business sales revenues in the economic system will be pretty much the same. This is because a dollar from the sale of a good to a business firm and a dollar from the sale of a good to the government is still a dollar of sales revenues. A dollar from the sale of a good to an employee of business or dollar from the sale of a good to a government employee is again still a dollar of sales revenues. And finally, a dollar from the sale of a good to someone who has received his money under one or another of the government’s welfare-state programs is no less a dollar of sales revenues than a dollar spent by someone who had earned that dollar.

But here’s a crucial difference: The dollars spent by business firms in buying capital goods and in paying wages sooner or later show up as costs of production. Those costs of production, of course, must be deducted from sales revenues in calculating profits. Aggregate profit in the economic system reflects their subtraction.

To the extent that government budget deficits divert funds from the purchase of capital goods and the payment of wages by business firms, their effect is sooner or later to reduce the magnitude of costs of production in the economic system and equivalently to increase the aggregate amount of profit in the economic system. Costs reflect prior outlays of money. To the extent that those outlays are less, the costs will be less. The reduction in costs of production raises profits equivalently, because, as we have just seen, the amount of sales revenues in the economic system is the same either way; it’s the same with or without the budget deficits. In the face of the same aggregate sales revenues, reduced aggregate costs mean equivalently higher profits.

So growing budget deficits are part of the explanation of profits rising relative to wages.

Before concluding, it’s necessary to point out that a rise in profits achieved in this way is not a cause for joy. What is present is an illustration of the dichotomy identified by Ricardo that often exists between monetary value and physical wealth. (See his Principles of Political Economy and Taxation, chap. XX.) Aggregate money profit is up, but in large part that is the result simply of the expenditure for capital goods being down. What that signifies is less previously produced wealth being available to serve in the production of future wealth. A part of the output of the economic system that would have gone into the production of future output is instead diverted to the government’s consumption and to the consumption of those to whom the government gives money.

The effect of this cannot fail to be that the productivity of labor in the economic system will be less than it otherwise would have been and that real wages in the future will consequently suffer from production being less than it otherwise would have been and thus from prices being higher than they otherwise would have been. And, ironically, as an integral part of these developments, while total costs of production in the economic system, are lower, unit costs of production will be higher than they otherwise would have been, because of the reduced output that results from the smaller total outlays of business and the consequent reduction in the supply of capital goods available for use in further production.

In sum, the effect of government budget deficits is lower money wages, higher money profits, and lower real wages to the extent that the deficits serve to increase prices and unit costs on top of reducing money wages.

This article is copyright © 2006, by George Reisman. Permission is hereby granted to reproduce and distribute it electronically and in print, other than as part of a book and provided that mention of the author’s web site is included. (Email notification is requested.) All other rights reserved. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. This article is an application of his theory of profit/interest presented in Capitalism. It is based specifically on the discussion on pp. 829-830 of his book.