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JDI Roundtable on Manufacturing Competitiveness in New Brunswick

The ‘cost disease’ of our economic illness

Herb Emery

New Brunswick’s economy is sick and I think we can identify the reason.

“Baumol’s cost disease,” named after the late American economist William Jack Baumol, is a chronic condition that has emerged in New Brunswick since the 2008 recession. While we try to treat bad economic symptoms with increased immigration, the long term cure for what ails us is investment and innovation to drive productivity growth.

Baumol’s cost disease refers to a situation where there are increases in wages and salaries – in jobs that have experienced little or no increase in labour productivity – as a result of competition for labour from jobs which have experienced productivity growth.

For the slow-productivity-growth jobs, this Baumol effect lowers the competitiveness of the firms employing workers, or in this case of the public sector including health care and education, it raises the tax burden of paying for services. 

Labour productivity refers to the value of output that is produced by an hour of work. When labour productivity is increasing, there is more revenue that can go toward paying workers without reducing a firm’s profitability. In contrast, if the amount a worker is paid per hour rises when labour productivity is not, firm profitability is lower and businesses are less competitive. 

In the decade prior to 2008, after adjusting for inflation, average hourly wages in New Brunswick increased by 0.6 per cent per year and labour productivity rose by 1.8 per cent per year (see the graph). But in the decade since the 2008 recession, wages have been increasing by around one per cent per year but labour productivity is increasing by only 0.5 per cent per year. This is Baumol’s cost disease.

New Brunswick has had lower labour productivity and wages than other provinces for a long time. While productivity growth has been slow in other provinces, New Brunswick loses a sizable part of its potential workforce to provinces where pay and labour productivity are higher.

Prior to 2008, New Brunswick was a labour-abundant economy, meaning that competition for workers wasn’t an issue for employers in the sense that if you lost one worker, there were others around willing to work at the going wage rate. That means that out-migration did not put upward pressure on New Brunswick wages. Competition among workers for jobs tended to temper the growth rate of wages even when labour productivity was rising.

Since 2008, though, the aging of the workforce and the decline of the population has made New Brunswick no long labour-abundant. This means out-migration and competition for New Brunswick workers is putting upward pressure on wages. 

Employers in New Brunswick struggle to pay higher wages because labour productivity is not rising. Labour costs are worsening the bottom line and undermining business competitiveness.

Where it gets interesting is that the problem has been compounded by a series of labour policies, programs and regulations. With no productivity growth, increases in WorkSafeNB premiums, a paid statutory holiday and a higher minimum wage relative to the average wage are all added payroll costs that cannot be covered out of higher labour productivity.

In turn, employers have even less room to raise wages to meet the wage competition from other provinces or employers in New Brunswick. 

The Baumol’s effect weakens business capacity to absorb the impacts of carbon pricing, rising energy costs and – should it happen – property taxes applied to the value of machinery and equipment. In short, government policy has eliminated any surpluses or reserves available for business investment that could raise productivity and cure the disease.

Baumol’s cost disease is also relevant to the problem often labelled a “labour shortage” in the province. Economic theory says the solution to a labour shortage is higher wages; in turn, the higher wage will attract workers to firms and the higher labour cost will temper the demand for labour. 

The mystery for many economists like me has been this: In New Brunswick, why aren’t wages rising to end the shortages? Baumol’s cost disease helps explain it.

The interpretation of New Brunswick’s economic challenge as one of a labour shortage, rather than a cost disease, has led to a focus on trying to fix the situation by increasing labour supply through immigration, education and training. But if this approach to alleviating the symptoms is going to work, then New Brunswickers need to overcome their indifference to out-migration. 

Ultimately, though, treating the symptoms is not leading us to a cure. Baumol’s cost disease can only be cured with productivity growth. The competitive pressures that raise wages are not likely to abate simply because our labour productivity, and wage levels, remain lower than in other places. 

So we need to raise our labour productivity and that means returning to the levels of private sector and non-residential investment from before 2008. It means we need to encourage investment in advanced manufacturing processes (automation) that raise labour productivity.

It means we need to continue to invest in research and development to drive productivity-enhancing innovation. 

For any of that to happen, we need a provincial government that understands it has the power to cure this disease.

First, the government can take steps to address all the harms listed above that have been done to business competitiveness in the province since 2007.

Second, the long-term health of the province’s economy needs an attitudinal shift by our political leaders, who presently see their role as maintaining business health while seeking to feed labour more to gain votes.

But continuing to feed labour a larger portion of a stagnant economic pie – rather than giving them more because the pie is growing – will only make us sicker.

Herb Emery is a Brunswick News columnist and the Vaughan Chair in Regional Economics at the University of New Brunswick.

This article first appeared in Brunswick News publications – Aug. 7, 2019

The JDI Roundtable on Manufacturing Competitiveness in New Brunswick is an independent research program made possible through the generosity of J.D. Irving, Ltd. The funding supports arms-length research conducted at UNB.