Yesterday, I quoted Michal Kalecki pointing out that wage cuts cannot create full employment. The fact that GDP has flatlined recently as real wages has fallen is consistent with this.This raises the question: could it be that policies aimed at raising wages at the expense of profits would boost the economy? A nice non-technical paper (pdf) by Marc Lavoie and Engelbert Stockhammer discusses the issues.

The case for such wage-led growth is straightforward. If the marginal propensity to spend out of wages is higher than that out of profits, a transfer of incomes from profits to wages will boost aggregate demand. This could happen. Common sense tells us that the badly off tend to spend their incomes, whilst the fact that rising profits before the recession were not accompanied by strongly rising capital spending suggests that the propensity to spend out of profits has been low.

This casual empiricism is supported by a paper by Ozlem Onaran and Giorgios Galanis, who have estimated (pdf) that, in many developed countries, rises in the share of profits in GDP have been associated with lower aggregate demand.

Better still, say Lavoie and Stockhammer, wage-led growth might be self-sustaining, in one of two ways:

- Verdoorn's law tells us that higher output growth is usually accompanied by better productivity growth. This means higher wages might partly pay for themselves, and that they might not be very inflationary.

- Firms might respond to higher labour costs by investing more in labour-saving technology, which would also tend to hold down inflation. If policy-makers respond to this by loosening macroeconomic policy, we could get a virtuous circle of non-inflationary demand growth, investment and rising productivity. This happened in much of the 50s and 60s.

So, what could go wrong? For me, there are three issues here:

1. A rise in wages for worse-off workers (for example through a living wage) would lead to lower payments of tax credits. In this sense, transfering money from capitalists to workers would be partly a fiscal tightening. That would tend to depress aggregate demand.

2. Is the marginal propensity to consume out of low wages high? If households are over-geared, they could use the extra income to reduce debts instead.

3. The relationship between capital spending and profits is unstable, as it depends upon animal spirits. There are two especial difficulties here:

- Capitalists would be happy to invest with low profit margins, if they are accompanied by high expected demand and hence high output-capital ratios and a high profit rate. But confidence that this will be the case requires them to have confidence both that macroeconomic policy can maintain high demand and/or that overseas demand will be high. This isn't certain.

- For the last 30 years, capitalists have been accustomed to policy being made in their own direct, short-term interests. Any disturbance to this might weaken animal spirits by more than the prospect of high demand would improve them.

Such instability is no mere theory. In the 50s and 60s, wage-led growth was feasible because capitalists invested in the confidence that high aggregate demand would be sustained. But in the 70s, this changed as they fretted about the squeeze on profit margins.

These doubts hint at what Servaas Storm calls a "sobering asymmetry". He says:

Lowering real wages will be unambiguously counterproductive, but the opposite policy of raising real wages will not have much of an impact on the economic recovery.

Perhaps the ability of capitalism to provide full employment requires freakish historical circumstances of a sort we saw only in the 50s and 60s. And perhaps it is only wishful thinking by both rightists and social democrats that stops them seeing this.