Ifo Viewpoint No. 82: Cars Buy Cars

Hans-Werner Sinn
Munich, 21 March 2007

Detlev Wetzel, the North Rhine-Westphalian representative of the metalworkers’ union IG Metall, justified his demand for a 6.5 percent wage increase with a quote attributed to Henry Ford: “Cars don’t buy cars”. Hefty wage increases are needed to create purchasing power and boost private demand.

How moving it is to see IG Metall concerned about the welfare of the country. Unfortunately, however, the purchasing power argument is incorrect even for logical reasons: A wage increase is identical to a profit decrease, and to the same extent to which wage increases boost the purchasing power of the employees, they lower those of the employers. The existing purchasing power is simply distributed in a different way. Although the employees’ consumption rises if, at the given employment, higher wages are paid, the willingness to invest declines because the wage increase pushes many investment projects below their profitability thresholds, and that reduces demand.

Investment also constitutes demand: You can eat up the gross national product, in which case it is consumption. Or you can put it on the pile that is called the capital stock, in which case it is an investment. Both constitute demand for the products of current output. Maybe cars don’t buy cars, but investors buy machinery, equipment and buildings. A wage increase reduces this part of domestic demand. Mr. Wetzel ought to take this into consideration.

And investment is more than just one of many demand components that determine the pace of economic activity, it is a particularly important one. Investment fluctuates much more than consumption over the business cycle because it depends on the replacement cycle and on strongly fluctuating profit expectations, which in turn are significantly determined by wage costs. Since 1970, German unemployment has risen in cycles of about ten years and by chance was always at a cyclical low at the end of a decade. And this low always coincided with a peak in equipment investment: Investment is the cycle maker.

Union bosses usually counter this with the statement that the demand for consumer goods is the objective of all economic activity. The demand for capital goods is said to be only a derived intermediate demand, which in the end will only be realised if more demand for consumer goods is expected, and that is why wage increases are necessary.

The argument is partially correct, but it neglects the trade-off between short-term and long-term wage increases. A society that has low wages relative to its aggregate productivity and thus permanently invests a higher percentage of its national income and consumes a lower percentage builds up its production capacity faster and therefore grows faster, too. Its output and its wage income rise faster, which in the longer term is reflected in higher wages and a higher level of consumption despite the original wage restraint. The higher investment is itself the cause of the higher consumption for which it is needed.

High consumption is bad for economic growth and unnecessary for an upswing of the business cycle. The present boom of the German economy proves best that an economic boom does not depend on an immediate increase in consumer demand. Last year, in addition to export growth, it was once again primarily the increase in investment demand that was responsible for the rise in aggregate demand. Although consumption stagnated, the economy surged. Whereas consumer demand rose by a meagre 0.8 percent, investment demand grew by 5.6 percent and GDP by 2.7 percent. If the unions achieve their goal of high wage increases, they will smother the recovery very soon because they undermine the firms’ willingness to invest. It is a game that has been observed time and again in Germany and elsewhere.

IG Metall in particular ought to reconsider. German industry workers are by far the most expensive of all big industrial countries. This is true not only in absolute terms but also in relation to overall labour productivity. As reported in the latest Ifo Schnelldienst, nowhere is there such a high ratio of wage costs of industrial workers to aggregate productivity as in Germany. And this is true whether only blue-collar industrial workers are considered or all industrial employees, including white-collar staff.

And contrary to conventional wisdom, Germany’s top rank in labour costs has little to do with non-wage labour costs. Although these are high, they are still much lower than the average of EU countries. No, the explanation is clearly to be found in the extremely high gross hourly wages that in the 1970s and 1980s were pushed to the high level, from which they cannot now descend. That Germany’s manufacturing employment is in free fall and even declined in the boom year of 2006 is primarily explained by this. The wage-bargaining parties bear the responsibility for a cooling industrial core and the fact that fewer and fewer people can warm themselves there.

Hans-Werner Sinn
Professor of Economics and Finance, University of Munich
President of the Ifo Institute

Revised version. Earlier published as "Cars Don't Buy Cars". Published as "Gefahr für den Aufschwung", Wirtschaftswoche, no. 12, March 19, 2007, p. 178.