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A Productive Debate

Is the link between pay and productivity broken?

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.”

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