Over here, a huge stack of exams, sitting ungraded since… no, I can’t say, it’s too embarrassing. There, a grant proposal that extensive experimentation has shown will not, in fact, write itself. And I still owe a response to all the responses and criticism to my Disgorge the Cash paper for Roosevelt. So naturally, I thought this morning would be a good time to sit down and ask what we can learn from comparing the path of labor costs in the Employment Cost Index compared with the ECEC.
The BLS explains the difference between the two measures:
The Employment Cost Index, or ECI, measures changes in employers’ cost of compensating workers, controlling for changes in the industrial-occupational composition of jobs. … The ECI is intended to indicate how the average compensation paid by employers would have changed over time if the industrial-occupational composition of employment had not changed… [It] controls for employment shifts across 2-digit industries and major occupations. The Employer Costs for Employee Compensation, or ECEC… is designed to measure the average cost of employee compensation. Accordingly, the ECEC is calculated by multiplying each job quote by its sample weight.
In other words, the ECI measures the change in average hourly compensation, controlling for shifts in the mix of industries and occupations. The ECEC simply measures the overall change in hourly compensation, including the effects of both changes in compensation for particular jobs, and changes in the mix of jobs.
Here are the two series for the full period both are available (1987-2014), both raw and adjusted for inflation (“real”).
What do we learn from this?
First, the two series are closely correlated. This tells us that most of the variation in compensation is driven by changes within occupations and sectors, not by shifts in employment between occupations and sectors. This is clearly true at annual frequencies but it seems to be true over longer periods as well. For instance, let’s compare the behavior of compensation in the five years since the end of the recession to the last period of strong wage growth, 1997-2004. The difference between the two periods in the average annual increase in nominal wages is almost exactly the same according to the two indexes — 2.7 points by the ECI, 2.6 points by the ECEC. In other words, slower wage growth in the recent period is entirely due to slower wages growth within particular kinds of jobs. Shifts in the composition of jobs have played no role at all.
On the face of it, the fact that almost all variation in aggregate compensation is driven by changes within employment categories, seems to favor a labor/political story of slower wage growth as opposed to a China or robots story. The most obvious versions of the latter two stories involve a disproportionate loss of high-wage jobs, whereas stories about weaker bargaining position of labor predict slower compensation growth within job categories. I wouldn’t ask this one piece of evidence to carry a lot of weight in that debate. (I think it’s stronger evidence against a skills-based explanation of slower wage growth.)
While the two series in general move together, the ECEC is more strongly cyclical. In other words, during periods of high unemployment and falling wages in general, there is also a shift in the composition of employment towards lower-paid occupations. And during booms, when unemployment is low and wages are rising in general, there is a shift in the direction of higher-paid job categories. [1] Insofar as wages and labor productivity are correlated, this cyclical shift between higher-wage and lower-wage sectors could help explain why employment is more stable than output. I’ve had the idea for a while that the Okun’s law relationship — the less than one-for-one correlation between employment and output growth — reflects not only hiring/firing costs and overhead labor, but also shifts in the composition of employment in response to demand. In other words, in addition to employment adjustment costs at the level of individual enterprises, the Okun coefficient reflects cyclically varying degrees of “disguised unemployment” in Joan Robinson’s sense. [2] This is an argument I’d like to develop properly someday, since it seems fairly obvious, potentially important and empirically tractable, and I haven’t seen anyone else make it. [3] (I’m sure someone has.)
What’s going on in the most recent year? Evidently, there has been no acceleration of wage growth for a given job, but the mix of jobs created has shifted toward higher-wage categories. This suggests that to the extent wages are rising faster, it’s not a sign of labor-market pressures. (Some guy from Deutsche Bank interprets the same divergence as support for raising rates, which it’s hard not to feel is deliberately dishonest.) As for which particular higher-wage job categories are growing more rapidly — I don’t know. And, what’s going on in 1995? That year has by far the biggest divergence between the two series. It could well be an artifact of some kind, but if not, seems important. A large fall in the ECEC relative to the ECI could be a signature of deindustrialization. I’m not exploring the question further now (those exams…) but it would be interesting to ask analogous question with some series that extends earlier. It’s likely that if we were looking at the 1970s-1980s, we would find a much larger share of variation in wage growth explained by compositional shifts.
Should we adjust for inflation? I give the “real” series here, but I am in general skeptical that there is any sense in which an ex post adjustment of money flows for inflation is more real than, say, The Real World on MTV. I am even more doubtful than usual in this case, because we are normally told to think that changes in nominal wages are the main determinant of inflation. Obviously in that case we have to think of the underlying labor-market process as determining a change in nominal wage. Still, if we do compute a “real” index, things look a little different. Real ECI rises 14 percent over the full 1987-2014 period, while real ECEC rises only 5 percent. So now we can say that about two-thirds of the increase in real wages within particular job categories over the past three decades, was offset by a shift in the composition of employment toward lower-paid job categories. (This is all in the first decade, 1987-1996, however.) This way of looking at things makes sense if we think the underlying wage-setting process, whatever it is, operates in terms of a basket of consumption goods.
This invites another question: How true is it that nominal wages move with inflation?
Conventional economics wisdom suggests we can separate wages into nominal and “real” components. This is on two not quite consistent grounds. First, we might suppose that workers and employers are implicitly negotiating contracts in terms of a fixe quantity of labor time for, on the one hand, a basket of wage goods, and on the other, a basket of produced goods (which will be traded for consumption good for the employer). This contract only incidentally happens to be stated in terms of money. The ultimate terms on which consumption goods for the workers exchange with consumption goods for the employer should not be affected by the units the trade happens to be denominated in. (In this respect the labor contract is just like any other contract.) This is the idea behind Milton Friedman’s “natural rate of unemployment” hypothesis. In Friedman’s story, causality runs strictly from inflation to unemployment. High inflation is not immediately recognized by workers, leading them to overestimate the basket of goods their wages will buy. So they work more hours than they would have chosen if they had correctly understood the situation. From this point of view, there’s no cost to low unemployment in itself; the problem is just that unemployment will only be low if high inflation has tricked workers into supply too much labor. Needless to say, this is not the way anyone in the policy world thinks about the inflation-unemployment nexus today, even if they continue to use Friedman’s natural rate language.
The alternative view is that workers and employers negotiate a money-wage, and then output prices are set as a markup over that wage. In this story, causality runs from unemployment to inflation. While Friedman thought an appropriate money-supply growth rate was the necessary and sufficient condition for stable prices, with any affect on unemployment just collateral damage from changes in inflation, in this story keeping unemployment at an appropriate level is a requirement for stabilizing prices. This is the policy orthodoxy today. (So while people often say that NAIRU is just another name for the natural rate of unemployment, in fact they are different concepts.) I think there are serious conceptual difficulties with the orthodox view, but we’ll save those for another time. Suffice it to say that causality is supposed to run from low unemployment, to faster nominal wage growth, to higher inflation. So the question is: Is it really the case that faster nominal wage growth is associated with higher inflation?
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| Wage Growth and Inflation, 1947-2014 |
A simple scatterplot suggests a fairly tight relationship, especially at higher levels of wage growth and inflation. But if we split the postwar period at 1985, things look very different. In the first period, there’s a close relationship — regressing inflation on nominal wage growth gives an R-squared of 0.81. (Although even then the coefficient is significantly less than 1.)
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| Wage Growth and Inflation, 1947-1985 |
Since 1985, though, the relationship is much looser, with an R-squared of 0.12. And even is that driven almost entirely by period of falling wages and prices in 2009; remove that and the correlation is essentially zero.
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| Wage Growth and Inflation, 1986-2014 |
So while it was formerly true that changes in inflation were passed one for one into changes in nominal wages, and/or changes in nominal wage growth led to similar changes in inflation, neither of those things has been true for quite a while now. In recent decades, faster nominal wage growth does not translate into higher inflation.
Obviously, a few scatterplots aren’t dispositive, but they are suggestive. So supposing that there has been a delinking of wage growth and inflation, what conclusions might we draw? I can think of a couple.
On the one hand, maybe we shouldn’t be so dismissive of the naive view that inflation reduces the standard of living directly, by raising the costs of consumption goods while incomes are unchanged. There seems to be an emerging conventional wisdom in this vicinity. Here for instance is Gillian Tett in the FT, endorsing the BIS view that there’s nothing wrong with falling prices as long as asset prices stay high. (Priorities.) In the view of both Keynes (in the GT; he modified it later) and Schumpeter, inflation was associated with higher nominal but lower real wages, deflation with lower nominal but higher real wages. I think this may have been true in the 19th century. It’s not impossible it could be true in the future.
On the other hand. If the mission of central banks is price stability, and if there is no reliable association between changes in wage growth and changes in inflation, then it is hard to see the argument for tightening in response to falling unemployment. You really should wait for direct evidence of rising inflation. Yet central banks are as focused on unemployment as ever.
It’s perhaps significant in this regard that the authorities in Europe are shifting away from the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and increasingly talking about the NAWRU (Non-Accelerating Wage Rate of Unemployment). If the goal all along has been lower wage growth, then this is what you should expect: When the link between wages and inflation weakens, the response is not to find other tools for controlling inflation, but other arguments for controlling wages. This may be the real content of the “competitiveness” discourse. Elevating competitiveness over price stability as overarching goal of policy lets you keep pushing down wages even when inflation is already low.
Worth noting here: While the ECB’s “surrender Dorothy” letter to the Spanish government ordered them to get rid of price indexing, their justification was not, as you might expect, that indexation contributes to inflationary spirals. Rather it was that it is “a structural obstacle to the adjustment of labour costs” and “contribute to hampering competitiveness.” [4] This is interesting. In the old days we would have said, wage indexing is bad because it won’t affect real wages, it just leads to higher inflation. But apparently in the new dispensation, we say that wage indexing is bad precisely because it does affect real wages.
[1] This might seem to contradict the previous point but it doesn’t, it’s just that the post-2009 recovery period includes both a negative composition shift in 2008-2009, when unemployment was high, and a positive compositional shift in 2014, which cancel each other out.
[2] From A Theory of Employment: “Except under peculiar conditions, a decline in effective demand which reduces the amount of employment offered in the general run of industries will not lead to ‘unemployment’ in the sense of complete idleness, but will rather drive workers into a number of occupations [such as] selling match-boxes in the Strand, cutting brushwood in the jungles, digging potatoes on allotments which are still open to them. A decline in one sort of employment leads to an increase in another sort, and at first sight it may appear that, in such a case, a decline in effective demand does not cause unemployment at all. But the matter must be more closely examined. In all those occupations which the dismissed workers take up, their productivity is less than in the occupations that they have left.”
[3] The only piece I know of that makes the connection between demand and productivity variation across sectors is this excellent article by John Eatwell (which unfortunately doesn’t seem to be available online), but it is focused on long run variation, not cyclical.
[4] The ECB’s English is not the most felicitous, is it? The Spanish version is “contribuyen a dificultar la competitividad y el crecimiento,” which also doesn’t strike me as a phrase that a native speaker would write. Maybe it sounds better in the original German.