A Productive Debate

Is the link between pay and productivity broken?
Edward TeachDecember 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.

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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
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

Edward Teach is articles editor of CFO.