The Mirage of Convergence

Workers are essential for the economy. This seemingly leftist idea is also the cornerstone of any market economy. Currently, the pool of available workers in Hungary is as empty as a larder after the annual feast. While the lack of available labour can provide a long term incentive to improve efficiency, so far the domestic case only led to double digit wage growth, which was followed by mild inflation. The crucial question is whether this rapid increase of real wages and the alleged convergence to Western living standards is sustainable. A mere cost push inflation can easily end in recession as it is coupled by unpredictable prices, market failure, and eventually  increased unemployment. In that scenario the mirage of convergence turns into a disillusion. Increasing business costs leaves less efficient enterprises with losses. This crowding out effect of unprofitable businesses by the wage push can be seen as part of creative destruction. However, it is unlikely that its long term benefits will compensate the society in the short run.

Even though the improvement of living standards is a ubiquitous and quite tangible phenomenon, the recent experience in Hungary cannot be called sustainable. In order to understand the trend, let us model the economy with a two-member household, where we only have one breadwinner. One salary must make ends meet and buy all the essentials. However, if the second person would find a job, the purchasing power of the household could double (assuming market based compensation for simplicity). Living standards will undoubtedly improve. Unfortunately the improvement is not recursive, unless we have extra unemployed labour in the household. Even then diminishing marginal effects will apply. Given that with two breadwinners we still earn less than our wealthy neighbours, the convergence will break down.

Source: KSH

Source: KSH

Now let’s expand our experiment from two members to somewhat shy of ten million, which is closer to our Hungarian case. Higher employment means that a smaller share of individual contributions – such as taxes – can satisfy the needs of non-producing members of students, unemployed, and the elderly. Moreover, tight labour markets gives workers the negotiating power necessary to carve a bigger piece from the cake of aggregate production.

Source: KSH

Source: KSH

The depicted expansive model has its limits. At the point when even the last available workers gets a job the economic growth reached its upper boundary. The only option on the table is to switch to an intensive model of growth by focusing on improving productivity figures. This is the only sustainable way to create space for convergence. Unfortunately, recent trends rather fit the expansive growth model with only expanding the quantity of labour, not the quality. Without the necessary reforms to switch the type of growth the economy faces two options. First, a wage-inflation spiral might erode the purchasing power of real wages. Second, the bankruptcy of unprofitable businesses will increase unemployment and put a cap on wage growth.