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A Productive Debate

Is the link between pay and productivity broken?
Edward Teach, CFO Magazine
December 1, 2006

If there's anything like an elixir for an economy, it's productivity growth. Economic theory holds that when output per worker rises, so should wages, and hence living standards. In practice, that's what transpired so impressively in the United States during much of the last century.

But recent data suggests that for many workers, the elixir has lost its potency. Last August, the Economic Policy Institute announced that while U.S. labor productivity rose 16.6 percent between 2000 and 2005, the median family income fell nearly 3 percent after adjusting for inflation. Similar outcomes have been reported for individual states. In New York, for example, the Fiscal Policy Institute said that although productivity in that state has risen more than 9 percent since 2000, average real wages have grown just 1.6 percent. In Massachusetts, productivity growth has increased nearly 50 percent since 1989, but median annual earnings have risen just 1.2 percent after inflation, according to the Center for Labor Market Studies at Northeastern University.

As a result, many observers contend that the link between productivity and pay is broken. Employees are working harder and smarter, they charge, but are reaping no reward for the extra effort. A slack job market, globalization, immigration, and the decline of unions are commonly blamed for the lack of wage growth.

Some economists, however, are more sanguine about the apparent disconnect. They note that wages have steadily fallen as a share of total compensation; benefits like health care and pensions now account for nearly 30 percent of overall pay. Growth of total compensation provides a better comparison with productivity growth, they maintain, and on this score, they see little cause for alarm in the latest numbers.

Tale of Two Deflators
One thing is clear: since 1995, productivity growth has experienced a strong revival. In the prosperous years between 1947 and 1973, productivity grew on average about 2.8 percent a year. Then, for reasons that continue to be debated, annual growth slowed to 1.4 percent between 1973 and 1995. Productivity growth has since picked up, averaging about 2.8 percent a year between 1995 and 2005.

How well total compensation has kept up with productivity depends on how you adjust for inflation. Last July, Edward Lazear, chairman of the White House's Council of Economic Advisers (CEA), celebrated U.S. productivity in a speech at the National Economists Club. A chart accompanying his speech showed that growth in average real hourly compensation has closely tracked productivity growth since 1950. Lazear used the price index for nonfarm business output to adjust compensation for inflation.

And that is how it should be done, according to Gregory Mankiw, former CEA chairman and professor of economics at Harvard University. "Productivity is calculated from output data," commented Mankiw on his blog last August. "From the standpoint of testing basic theory, the right deflator to use to calculate real wages is the price deflator for output."

But in a draft paper released last October, economists Jared Bernstein and Lawrence Mishel of the Economic Policy Institute also plotted compensation on Lazear's chart using a consumption deflator (see "Mind the Gap?" at the end of this article). The result is that compensation begins to fall behind productivity in the 1970s, and the gap widens to the present day. In justifying use of the Consumer Price Index deflator, which has grown faster than the output deflator, Bernstein and Mishel argue that "consumers are not buying machine tools and drill presses; they are buying gas at the pump, housing services, haircuts, and so on, all of which are weighted more heavily in the CPI than in the [output] deflator."

Wage growth may be expected to lag productivity growth when an economy emerges from recession. Lazear is confident that wages will eventually begin to catch up, as they have before. "2006 has seen significant increases in nominal wages above the levels of past years," he said in July. But Bernstein and Mishel are far more skeptical.

Meanwhile, some observers worry that total compensation growth is slowing down. Last August, The New York Times noted that the inflation-adjusted value of worker benefits has fallen since the summer of 2005.

Unequal Wage Growth
Robert Gordon, a professor of economics at Northwestern University and a prominent productivity expert, insists that "data issues" explain away the 3.4 percent annual growth gap between productivity and average real hourly wages for the four years ending in Q1 2005. Those issues (which include different deflators) are discussed in Gordon and Ian Dew-Becker's 2005 paper, "Where Did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income."

The authors point out that labor's share of national income has remained more or less constant over the past 50 years. "Somewhat surprisingly," they write, "in light of comments about labor 'losing out' from the productivity growth upsurge, labor's share in the total economy actually increased at an annual rate of 0.25 percent over the period 1997–2005."

But Gordon and Dew-Becker see a disturbing trend in the distribution of labor's share. According to their analysis, only the top 10 percent of nonfarm workers saw their wage growth match the average rate of productivity growth since 1997. Within the top 10 percent, another disproportionate amount of wage growth accrued to the top 1 percent. Overall, they reckon, half of labor's income gains since 1997 went to the top 10 percent of the income distribution.

"The post-1995 productivity growth revival did not automatically signal good news for the majority of American workers and households," conclude Gordon and Dew-Becker. "Indeed, to the extent that the productivity growth 'explosion' of 2001–2004 was achieved by cost-cutting, layoffs, and abnormally slow employment growth...the historical link between productivity growth and higher living standards falls apart. Not only have the bottom 90 percent of American workers failed to keep up with productivity growth, many have been harmed by it."

Significant or not, the gap between pay and productivity is a subject that won't go away, particularly now that control of Congress is passing to the labor-friendly Democratic Party. There is much talk of raising the federal minimum wage from its current $5.15 per hour, perhaps to $7.25. Jared Bernstein says that lawmakers could reintroduce the Employee Free Choice Act, which would make it easier for unions to organize. Expect politicians to explore other, perhaps more dramatic, ways to bring pay and productivity together.

Edward Teach is articles editor of CFO.