The economic experience in the United States and Europe in the past quarter-century strongly suggests that high wages are important for economic growth. Economic growth and rates of capital investment were strongest when wages rose robustly in the United States between 1996 and 2000. When wages rose weakly in both the United States and Europe, capital investment and GDP growth were modest, despite rising profits.

What are we to make of this? By coupling demand-led theory and empirical observations, we can draw intriguing conclusions about the policy implications. According to the prevailing growth theories today, economies are generally self-adjusting. Even when conventional growth theories endorse public investment, they also simultaneously favor minimizing government regulation and other intervention. These theories are steeped deeply in the lore of Adam Smith’s invisible hand, but without his many useful caveats.

Today’s conventional wisdom holds that the best policies are to reduce government interference in the markets, make labor markets as free as possible from market-inhibiting institutions such as labor unions or laws like the minimum wage, and balance national budgets to maintain high savings in the economy. More conservative advocates of the theory believe budget deficits are tolerable if driven by tax cuts and are less sympathetic to government investment. Endogenous growth theory, however, has justified government investment in education and R&D to the extent that it can enhance the rate of productivity growth.

Demand-led growth theory leads to a bolder set of conclusions, including, most importantly, fiscal, monetary, and social policies that support full employment and high wages. We should be clear that demand-led theory does not suggest that demand can be expanded or wages raised without limit. Limited productive capacity in the short run and demand shifts toward labor-intensive services are constraints that warrant our attention (Cornwall and Cornwall 2001, ch. 8). On balance, however, demand-led growth theory justifies serious changes in current conventional wisdom about public policies, including:

• First, emphasis should be placed on the maintenance of demand through fiscal and monetary stimulus.
• Second, increases in wages can themselves lower what policy makers consider the benchmark inflation rate, i.e., the non-accelerating inflation rate of unemployment, or NAIRU. Specifically, the unemployment rate can be driven lower without incurring accelerating inflation. In general, the Federal Reserve should take the risk of erring on the side of producing annual inflation rates greater than 2% by tolerating lower levels of unemployment and higher levels of wage growth. More demand will help generate higher levels of productivity, enabling business to pay higher wages and maintain profit margins without raising prices.
• Third, should more expansive monetary policy stimulate dangerous levels of financial speculation, which it has done over the last 10 years, regulations and tighter watchdog policies should be imposed. The nation can have expansive monetary policy and limit speculative excess simultaneously.
• Fourth, aggressive social policies, including minimum wages, living wages, and laws favorable to the organization of labor, may not only raise the level of social justice but can also improve the rate of growth of productivity.
• Fifth, policies and institutions can be adjusted to make the U.S. economy wage-led rather than profit-led. These efforts may include financial reforms. Thus, GDP growth could be generated with a more equitable and socially just distribution of income.
• Sixth, in light of the need for persistent strong aggregate demand, higher budget deficits can be tolerated. Because higher aggregate demand due to fiscal stimulus can enhance productivity, such deficits can help generate more growth over time, and therefore more savings to support investment.
• Seventh, deficits created to support needed public investment are eminently affordable. They have both demand-side and supply-side effects, supporting aggregate demand on the one hand and education, infrastructure, and R&D on the other. A systematic and ongoing effort should be established by the CBO to score the effects of such investment dynamically on the future federal budget.

America is a rich nation, but since the difficult economic circumstances of the 1970s it has acted like it is not. One of the inappropriate lessons America learned then was that too much government is bad. Sadly, mainstream economics contributed to this view. The lesson that should have been learned is that bad government is bad. At times, government has done its job poorly, but good government has a central part in the economy. That role has been tragically restricted for a generation, partly because of the new economic conventional wisdom. Government should have access to a far wider range of policy options than many advisers now offer. Without such options, the nation will not meet the needs of a changing time.

This solution is excerpted from an article of the same name, originally published June 22, 2007 by the Economic Policy Institute. It is used here with permission.
© 2007 Economic Policy Institute