“you don’t understand my argument. the wage rates of others is outside the market for my savings, yet they recieve some of the benefit as the marginal value of their labour increases with my capital”

Ok, here is how I see it.

Both labour and capital are inputs to the production process. The efficient allocation of labour and capital is such that the marginal rate of technical substitution is equal to the ratio of the marginal costs. The MRTS is determined by technology.

Arbitrarily increasing savings to lower the interest rate to increase the level of capital will lead to an inefficient allocation of resources relative to fundamentals.

Now, if capital and labour are strategic complements then yes there is a “positive externality” and the efficient allocation of capital will be greater – but in cases where the inputs are strategic complements we should be looking at policies that promote co-ordinated activity directly, rather than messing around in the macroeconomy.

Lets fill this out a bit. Looking at this in a strictly GE sense, as you say, under your assumptions a higher level of capital increases wages. So we know that, in this model where forced savings has pushed down interest rates – wages are higher and the cost of capital is lower. As a result, the allocation of resources will be more relatively more capital intensive then in the free market case.

As a result, this differs from the pareto efficient allocation – which according to the first welfare theorem is the free market one.

Now if we accept some type of strategic complementarity there will be multiple parteo ranked eqm, sure – and this implies that a higher capital eqm could be pareto superior.

BUT, where is the strategic complementarity? A firm investing in capital and thereby increasing the marginal product of their own labour isn’t strategic complementarity, as they are choosing their own labour and capital on the basis of this fundamental relationship. Furthermore, doing this increases the wage rate this actually leads to a negative pecunary externality on other firms!

For strategic complementarity to hold in this sense we need to say that an increase in one firms capital directly increase the marginal benefit associated with other firms hiring labour right – which seems like a stretch.

I’d buy it for capital influencing capital – which is the case of increasing returns to scale and spillovers. I would not buy it for capital influences other firms labour through spillovers.

think of a model over time and include increasing returns, you might see what I mean.

voluntary mechanisms won’t work because when I invest, I don’t include these wage returns on my savings because the returns are to others. in fact, I free ride on other’s savings when capital is invested and my marginal value of labour increases. therefore we all free ride on eachother and don’t save as much as is optimal.

I agree that the closer to the market thing in Australia is why they are better off. I saw a study which said Australia’s location makes it 10% worse off than expected, and the location of central/western european countries makes them 7% better off. Therefore Australia is naturally 18% disadvantaged on Europe, NZ is even more. Plus Australia has a greater home market effect, particularly now that it is significantly more capital intensive.

“A market failure is not where there is no price. It is where the equilibrium is not the most efficient.”

A market failure is where we:

1) Have market power,
2) Have an externality,
3) Have a co-ordination problem/public good or some such

There is none of that here.

Because the equilibrium wage is higher with greater capital accumulation isn’t a positive externality. The wage is a market price, the interest rate is a market “price”, these adjust to meet supply and demand in each of the respective markets. There is no externality here – it is all part of the general equilibrium in the economy.

“In this case there are positive externalities to savings which are not captured by the market.”

We have an externality if the voluntary trade of agents has a positive impact on an agent OUTSIDE of the market. We have a market for labour and a market for capital.

Here the efficient ratio of labour to capital is determined by technology, and the prices in the relative markets represent that. Fiddling a price in one market (enforced savings) will change this ratio and lead to an inefficient allocation of resources.

“I was simply pointing out this as a possible reason for government intervention, and a large part of the reason Australia is better off than NZ.”

Forcing people to save more does lead to higher levels of economic activity in the future, yes.

Does it lead to higher inter-temporal welfare? Only if we believe there is some sort of market failure in capital markets (in this case we could appeal to time inconsistency in the savings decision for example). Personally I believe the burden of proof is on those trying to force compulsory saving, both to show:

1) That it does increase welfare,
2) That we can’t solve any identified market failure through voluntary mechanisms (which have the advantage of revealing actual preferences in society – rather than assuming them).

Also I think a larger reason that Aussie is better off then NZ is their closer location to market, greater scale for production, and their greater endowment of resources – it would be interesting to see a full empirical study on that though.

whether you call it market failure or not, I was simply pointing out this as a possible reason for government intervention, and a large part of the reason Australia is better off than NZ.

This isn’t a market failure, as there is a price in the capital market and a price in the labour market. To have a market failure we need an area where there is no price. In general equilibrium there is no mis-allocation here.

The only way we could justify intervention is if:

1) We think there is some persistent cognitative bias,
2) We think there are multiple pareto-ranked equilibrium for the economy and that the “high capital” one is superior.

However, there is no market failure persee.

Therefore there is some justification for intervention to encourage higher savings so that the savings level reflects all the return on investment of both investment return and increased wages. whether this is by subsidy or compulsory savings would have to be evaluated as to which has the best outcome; I suspect there is a case for a combination of both measures.

But those aren’t “social returns” in the sense that we should subsidise them. Why? There are a bunch of markets which price the return on investment, and price of capital, and the return to labour from different choices – so everything is internalised.

In the longer run, with higher capital per worker, workers benefit because they end up being paid the marginal value per worker. Because individuals percieve the savings as only the return on their investment (in a bank or shares etc) and not the additional wages provided to workers, they will tend to save less than is optimal if everyone were saving together (people do not include the public benefit and would prefer to free-ride on others; savings)- hence a reason for government intervention to encourage savings (even if it is different to the reason given when compulsory savings was introduced).

“In Australia, a higher minimum wage and stronger unions meant that firms had to look for alternatives such as innovating and employing more capital, rather than labour. capital was also relatively cheap because of compulsory savings, and comparatively cheaper than labour in the production function.”

So there were two things there.

They increased the relative price of labour – which merely implies that there “budget constraint” was more sharply binding. So this wouldn’t promote growth, but it would likely lead to an increase in the capital-labour ratio.

The second bit is compulsory saving. Now I am sure that this did reduce the cost of capital for firms, and lead to greater investment. After all there is a “home-bias” for capital.

But I can’t get past the fact that the saving is compulsory. We could also increase measured output by making people work 20hrs extra a week for free. Anything that forces people to do something which they wouldn’t otherwise choose, and with which there is no direct social benefit, is unlikely to maximise social welfare.

We are allowing for the possibility that, seeing a one off increase in the general price level, people increase inflation expectations. This is EXACTLY the same thing as the petrol price crisis – when inflation expectations obviously and measurably rose in the face of an obvious relative price shock …

The reason we accept this as a possibility is because peoples expectations aren’t formed in a manner that is compatible with “transaction costless” rationality – people do appear to allow for some degree of adaptive expectations, and the impact that has needs to be mentioned as a possibility when framing a general situation.

Furthermore, we are only saying how the minimum wage COULD influence inflationary pressure – we are not saying that it WOULD. Infact, we spend most of the time stating how a higher minimum wage could potentially REDUCE inflation, not increase it.

The entire post only says what channel the minimum wage change would have to move through in order to influence inflation, it doesn’t state:

1) that it will happen that way (especially since the change in price growth was ambiguous – as it always is with a relative price shock)
2) that it would be a good state of affairs