Capitalism in 2010: a grossly simplified view

I’m trying to think through one of the key dilemmas we face in the world today and here’s a vast simplification.  Suppose we have just two price structures in the world – low and high.  The structures exist both between states and domestically within states.  We have low industries with associated low prices and low wages and high industries with associated high prices and high wages.  In a world with only low or only high structures, there’s no problem since real wages would be the same in either one.  (I’m ignoring things like slave and child labor, indecent exploitation, etc. here).  But when they co-mingle freely as they do in our globalized world, we have a problem.  Many industries in the rich world are based on the high structure.  They can’t sell much to the lows since the lows have little relative purchasing power.  Whatever production can possibly go to the lows will naturally flow there since it’s cheaper.  As the number of low industries expand, the problem worsens for high workers as sales are increasingly squeezed.  It’s good for low workers though since more goods become affordable.  We should expect to see an ever greater pressure on high structure workers as fewer numbers can afford their products.  Those workers in the increasingly few secure jobs in the high structure will see their real incomes rise but that should be temporary since all jobs will eventually be pressured by the lows.

How will this affect profit margins?  Capital tends to price in order to hit a return on equity (ROE) target which is theoretically independent of whether an industry is low or high.  But as an industry shifts from a high structure to a low, the ROE can’t be maintained unless the profit share to total income increases.  We’ve seen expanded profit shares over recent years in our national income data and I think this is a partial explanation.

It may be helpful to show an example.  Let’s assume a 10% return on equity in a company with $10m of equity and with initial annual wages of $2m which then drop to $1m as it shifts to a low structure.

Before:

ROE at 10%                         $1,000,000

Wages                                   2,000,000

Total Price of Goods                3,000,000

After:

ROE at 10%                          $1,000,000

Wages                                    1,000,000

Total Price of Goods                 2,000,000

In this example, profit share goes from 33% to 50% because ROE is maintained while wages decline.  To maintain a constant percentage to total income, ROE would need to decline to 5%, a 50% drop.  Ultimately, I would think something like that would happen as reduced purchasing power from wages would force reduced equity returns.  This would have a massive affect on stock market values.  We can see the basic force in play today with the current low levels of interest rates.

So, unchecked, workers in high structure countries will see wages and prices decline and an increasing wage disparity as some workers are lucky enough to hold on to higher wages for a time.  Workers who transfer from a high structure to a low will see their real wages decline since some prices continue at the high level.  Corporations should experience great pressure on profit margins and the stock market will be pressured on the downside as high industries experience ongoing sales pressure and ROE’s are pressured per above.  We seem to be heading for serious deflation – in prices, wages, and profits.

All debts in rich countries are enumerated in a currency that’s based on a high structure and deflation will create massive rates of default, which of course we’ve already seen to an extent in real estate.

To add to the problem, technology is expanding at an ever faster pace that is putting a great squeeze on even low structure jobs.  We should expect higher technological unemployment.

We are in a massive hole.  The fed’s fear of deflation makes total sense.  What options do we have to counter this logic?  Quantitative easing will do little here.  A huge decline in the currency value versus low structure countries seems to be the only possibility within orthodoxy.  It would prop up domestic prices and avoid deflation but it would result in drastically reduced real wages as previously low structure products are forced higher in price while domestic wages cannot rise.  There seems no doubt this is the direction all “rich” country leaders are choosing.  We are headed towards an extremely unstable world, one that could undercut the capitalist system itself.  What we see in France is probably just the tip of the iceberg.  At a time of tremendous technological capacity, workers are witnessing an historic destruction of their living standards.  Such is one of the fundamental contradictions of capitalism.

I might add that an outside of orthodoxy option does exist.  The government could massively expand purchasing power in the economy by spending via monetary creation.  There’s no obvious downside to this strategy and it’s not readily apparent why it’s not being tried.  The fed, after all, is willing to print money through quantitative easing.  Putting cash in the hands of bond holders, though, is far more acceptable than putting the same cash in the hands of desperate workers.  It all comes down to power.