Do workers reap the benefits of productivity growth?

Today’s post is from James Plunkett, Secretary to the Commission on Living Standards which is hosted by the Resolution Foundation

Median hourly wages and labour productivity show strong gross decoupling

Few findings from our recent work at the Resolution Foundation  are more worrying than those that suggest a weakening of the relationship between economic growth and gains for ordinary workers. In the last twenty years of the 20th century, each pound of UK GDP growth was accompanied by around 90 pence of median wage growth. From 2000 to 2007 that figure fell to just 43 pence. This bears worrying similarities to the experience of the United States; with US median wages now flat for a generation, the pay of Americans in the bottom-half has decoupled from productivity growth.

A new report from the Resolution Foundation by Professor John van Reenen and Joao Pessoa of the London School of Economics looks at how the relationship between productivity and compensation for workers has changed in the UK and in the US, building on similar work carried out in the US by Jared Bernstein.

The report defines two types of decoupling, each of which tells a very different story. For “net decoupling”, defined as the relationship between productivity and average hourly compensation, compensation for ordinary workers has not fallen behind productivity, just as economic theory would predict. The only explanation for the two diverging would be if labour’s share of national income fell versus the capital share. While others have suggested that just such a decline has taken place, Van Reenen’s results suggest it has not.

In the second type of decoupling— “gross decoupling”—the measure of productivity used is GDP per hour worked in the UK economy. But this time worker benefits are represented by median hourly earnings. Using this measure the picture looks very different. Median pay has diverged markedly from labour productivity in the UK in the last twenty years. In other words, the pay of ordinary working people has not kept pace with the average value of output that workers produce.

So what’s the difference between the two types of decoupling—and which one should we care about most?  The answer lies in three differences between the two measures used to represent the benefits that accrue to workers.  

First, net decoupling is based on an average measure rather than a median.  As a result, it captures the total compensation going to workers in the economy divided by the number of hours worked (rather than the hourly wage of the middle worker). As an average, this measure is therefore pulled up when pay grows very strongly at the top, just as it has in the UK in the past ten years.

Second, net decoupling looks at total compensation rather than just wages. This means it includes things like employer pension contributions and employer National Insurance Contributions. As such, there’s a reasonable argument that it’s a better measure of the complete rewards derived by workers. And, again, recent years have seen a widening gap between these two measures. As non-wage aspects of compensation have grown significantly, compensation has grown faster than wages.

The third difference, and the most technical, is that the two measures are calculated using different inflation indexes. The first, used for net decoupling, is calculated using the GDP deflator, while the second uses the Retail Prices Index (RPI).  What’s the difference and which one is right?  The answer is that it depends what you’re analysing. If you want to compare productivity and pay fairly you should use the same deflator for both—that is, the GDP deflator. But if you want to know how the purchasing power of pay is changing over time, you want to use the RPI. These two measures have moved apart very slightly in recent years, but the implication of this change for living standards is hard to interpret.

You might say these are just arguments over definitions without much bearing on policy debates. It’s true that their significance rests very heavily on interpretation. Broadly speaking, there are two ways of thinking about this. On the one hand, we could find Figure 1 reassuring. It confirms the theory that, over the long-term, productivity should track average compensation. In fact, looked at this way, we might even think Figure 2 is simply wrong; once we use the “right” measure of the benefits accruing to workers, as theory dictates, the decoupling turns out to be a phantom.

This argument is not without merit. It’s fair to say, for example, that total compensation is a more complete measure than wages. But what if we look at the question another way, from the viewpoint of a worker in the bottom half of the earnings distribution?  Looked at this way, the question that matters for living standards is not which measure should theoretically track productivity, but which most accurately captures how well off people feel, and whether we’ve seen a change in the relationship between that measure and output, our central indicator of economic health.

Saying that decoupling is just a statistical quirk of using the median rather than the mean doesn’t make it less of a problem that the wages of low paid workers in the UK are stagnant and no longer tracking productivity in the way they used to; it just helps to explain why life now feels particularly hard in the bottom half and—in the run up to the crisis—particularly out of step with an ostensibly sunny economic climate.  Likewise, the growing gap between wages and compensation doesn’t make the stagnation of pay packets any less real, it just helps to explain that stagnation. As Jared Bernstein pointed out in a seminar to discuss Van Reenen’s results: whatever the theory says, if workers weren’t getting better off over time even when the UK economy was growing and productivity was rising, we have a problem on our hands.

It’s important that we better understand what sits behind this trend. The Resolution Foundation report shows that that inequality has played a big role in the decoupling of median pay and productivity. So has growth in non-wage compensation. We need to ask which of these trends represents a price worth paying and, for those that don’t, how we can avoid a repeat of the past. Only then will we bring into focus one of the most important aspects of the crisis now facing living standards: the fraying of the golden thread that joins pay and productivity, which for much of the twentieth century helped pull prosperity to unprecedented highs.

Useful links

Going for Growth, an OECD study covering some of the issues discussed above, will be released in March. In the meantime, you can download these:

Reducing income inequality while boosting economic growth

Under shock: How to spread macroeconomic risks more fairly

Risk sharing

Less income inequality and more growth – Are they compatible?

Roses are red, violets are blue, here is an Insights blog, just for you

Oh darling, do tell me more about the policy implications

It’s Valentine’s Day (wasn’t it Saint Valentine’s Day at one time?) and here at this most romantic of international organisations we’re happy to see lovers the world over celebrating causes so close to our red velvet heart as trade and innovation  (or flowers and chocolate, to use the technical terms). On this special day, let’s leave the cynics to their grumbling and enjoy being nice to somebody by sharing the fruits of technology transfer, competition, economies of scale and opportunities for learning, as described by Nobuo Kiriyama in the latest OECD Trade Policy Working Paper.

History provides some vivid illustrations of what Nobua is talking about. In the era of the Silk Road, China’s competition policy regarding the silk trade was simple: anyone caught trying to export silkworms, cocoons or eggs was executed. This crude but effective barrier protected Chinese manufacturers until around 200 BCE when Chinese immigrants to Korea started production there too. A hundred years later, a princess smuggled eggs to India in her hair. A hundred years after that two monks smuggled eggs on the orders of the Byzantine emperor and the industry gradually became established in the West.

Silk shows that new technology doesn’t have to be imported readymade, and that knowledge transfer can be more important (it also raises questions about whether and by how much the economy as a whole benefits from protecting intellectual property).

Chocolate is another interesting case. The link to international trade is obvious – cacao beans can’t grow in most places and have to be imported by manufacturers. But there’s a link to migration too. Spain was the first European country to develop a chocolate industry, but the persecution and expulsion of the Jews in the late 15th and 16th century forced many Jewish chocolate makers to flee, with some of them setting up business around Bayonne in southern France or in Belgium and Switzerland, still famous for high-quality products today, while Spain was left behind. (Another OECD report on entrepreneurship and migrants argues that modern migrants may be a source of job creation provided they have adequate support to gain access to capital, learn the language and deal with regulation.)

The flowers you offer your sweetheart tell a whole story too (including about you if you bought them at the last minute from a service station as you were filling up the car). Chances are they came from Kenya, India or another developing country. Exporting firms in these countries are usually more productive than non-exporting ones, and have to innovate for a number of reasons, for example to meet hygiene or other standards in potential markets or to make sure the products get to the market in a saleable condition. In doing so they learn from their clients as well as their partners.

You may have noticed that none of these examples actually talks about inventing a new product. Innovation covers this too of course, but these days it more frequently means something else – for example crossing a hard drive and a music player to create an MP3 device or crossing different genetic traits to try to produce angora chickens. Coca Cola for instance has been highly innovative throughout the company’s history without inventing a new drink. Removing the cocaine was an example of product innovation while selling it in cans or from machines were marketing innovations.

Innovation can also mean applying a technology in a new way. The introduction of mobile phones to fishers in India led to an increase of 8% in the profits for the fishers and a decline of 4% in consumer prices as the fishers could use their phones to call several nearby markets from their  boats to establish where their catch would fetch the highest price.  Fish, phones and innovation seem to go together. The first call ever placed  on a commercial GSM phone was on 1 July 1991 when Harri Holkeri,  governor of the Bank of Finland, telephoned the mayor of Helsinki  to talk about the price of Baltic herring.

So if you’re tongue-tied when you call your Valentine tonight, try discussing the price of kippers. For more policy advice, see below.

Useful links

OECD Innovation Strategy

OECD work on trade

OECD work on new sources of growth

Solving the sovereign debt crisis

The sovereign would like a word with you about his debt

On September 5th 1661, Louis XIV ordered D’Artagnan and his musketeers to arrest Nicolas Fouquet, the “Surintendant des finances”, for the capital offences of embezzlement and crimes against the state (or Louis XIV as it was known in those days). Fouquet was accused of ruining the king through exorbitant interest rates on sovereign debt as well as diverting some of the financial flows from lenders to the royal coffers into his own pocket.

Fouquet defended himself well though, and after a three-year trial was exiled rather than executed. However today he’s mostly remembered for parties that even the Sun King found a tad extravagant (although Louis did build the Palace of Versailles as a bigger, blingier version of Fouquet’s château at Vaux-le-Vicomte).

There’s a lot of truth in the popular image, but it doesn’t tell the whole story. Fouquet tackled problems that would be familiar to any European finance minister today, using means that are still part of the policy response to the current crisis such as cutting public spending, rescheduling debt and raising taxes and improving their collection. (He also used a few that aren’t so common or so blatant anymore such as selling public offices to his cronies.)

Fouquet understood something that is key to the present crisis: the need to restore confidence and get the economy moving. He did this thanks to a number of instruments including reassigning to solvable funds sovereign debt that had in today’s terms become junk bonds and even providing collateral himself for sovereign borrowing.

So, restore trust, fix the financial system, stimulate growth. Three and a half centuries later, you can read a similar argument in a paper by Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. In Solving the Financial and Sovereign Debt Crisis in Europe, Blundell-Wignall looks at why the crisis is worse in Europe than elsewhere and what can be done.

Monetary union means that euro members can’t devalue their currencies to help exports, and pressures on international competitiveness are transmitted directly to the labour market, leading to increased unemployment. Some governments responded by allowing their deficits to grow, and debt with it. Moreover, monetary union has resulted in high levels of debt in the household and corporate sectors in many of the countries that are in the worst competitive positions, leaving little hope that savings can be spent to stimulate growth.

The crisis and recession have increased indebtedness, contributing to underlying financial instability. One of the main reasons the situation is worse in Europe is the nature of its banking system. European banks mix traditional business such as loans to firms and households with activities in capital markets. Countries with large capital markets banks are heavily exposed to the sovereign debt of larger EU countries like Spain and Italy. Traditionally, holding this dull but dependable debt was a safe form of collateral for other activities, but the sharp price fluctuations that are now typical of sovereign debt trading affects the true value of this collateral and the price that shares in this debt could be sold for at any given time.

Deregulation and innovation in financial markets are to blame too. Apart from capital market banking, “re-hypothecation” has grown massively – the practice of reusing the same collateral repeatedly. This increases risk, given that the value of this collateral can drop suddenly, plus the fact that the banks are doing deals for themselves using collateral originally pledged by clients. As the number of deals using the same collateral multiplies, so does counterparty risk, the risk that one of the parties involved can’t meet their obligations.

Blundell-Wignall argues that underpricing of risk is the core cause of the financial crisis and that excessive risk in banking can always be traced to two basic causes: too much leverage, and for a given leverage, increased dealing in high risk products. Far from acting to contain the risk of the proliferation of these products, such as derivatives, regulators cleared the way for them, for example by removing barriers to mixing different types of banking business such as those in the Glass-Steagall Act in the US.

At one time, derivatives were used for practical day-to-day business operations, such as an airline hedging against a big rise in fuel prices, but they rose from 2.5 times world GDP in 1998 (already a staggering figure) to 12 times world GDP before the crisis.

Derivatives trading needs collateral and the price shifts we mentioned above can result in calls for collateral the banks can’t meet. This provokes a liquidity crisis, and the banks don’t have time to recapitalise through earnings, so they stop lending to businesses, especially small and medium-sized enterprises, adding a further twist to the downwards economic spiral.

It’s easy to feel helpless in the face of such arcane and seemingly uncontrollable forces, but solutions exist. Fracturing the eurozone would be one, but while this may lead to a short-term improvement for certain countries, it would weaken the status of the euro as a global currency, increase pressure on countries that stayed in the euro, and create legal uncertainty about financial contracts in euros.

A more coherent approach would include solving the Greek crisis via a 50% or bigger “haircut” on its sovereign debt (reduction in its stated value) and granting the European Financial Stability Facility a bank license. The European Central Bank should continue to support economic growth and investor confidence via funding for banks and putting a lid on sovereign bond rates in key countries. Private banking should be reformed too, with investment banking separated from traditional retail and commercial banking.

That said, sending musketeers to arrest the financiers would appeal to many people.

Useful links

OECD work on restoring public finances

OECD Insights: From Crisis to Recovery

OECD work on financial markets

Angels in America, and elsewhere

Click to see the book on OECD iLibrary

The OECD has just published a report that “aims to provide some qualitative and quantitative information on the angel market”. However, if you’re looking for advice on selling yours, you’ll be disappointed. Financing High-Growth Firms: The role of angel investors is actually about investors who finance new ventures at the start-up phase and sometimes help them with operational expertise and contacts as well. These “business angels” borrow their name from their counterparts in the theatre, people who put up money to pay for new shows.

They fill an important gap by providing external seed capital and early-stage equity, and in many countries they’re far more important than the better-known venture capitalists. The sums they invest are much smaller, around $25,000 to $500,000 compared with $3 to 5 million for venture capital, but it’s vital given how hard it is for new businesses and young entrepreneurs to get loans.

With hindsight, we’d all have invested in Google, Apple, Microsoft and the like, but these were among hundreds of start-ups with little or no collateral and practically no assets other than a good idea, optimism and clever geeks. Yet you can see why banks would be reluctant to lend them money, especially in the present financial environment, and given what’s known as “moral hazard” – in this case the (not unrealistic) fear that the money would end up subsidising a drug and booze-fuelled lifestyle rather than the next Facebook.

Financing High-Growth Firms mentions that angel investors tend to be experienced entrepreneurs and business people who put money in sectors they know well and favour local start-ups, but it would be interesting to see how the angels decide to invest in one project rather than another. I remember reading an interview with a man who’d done well on the stock exchange by putting his money into companies whose products he appreciated and whose market seemed likely to expand, but that’s easier than spotting the potential of something that scarcely exists outside the mind of its inventor. (And even then, there’s no guarantee – do you know anybody who still uses a typewriter?)

Analysis is complicated by the fact that terminology is often vague, with angels, informal investors (founders, family, friends) and informal venture capital used interchangeably. As well as that, individual angel investors usually keep information about their investments private, despite increasing professionalisation and the formation of groups and networks of investors.

Some governments are supporting these groups, and also intervening via other programmes and policies to encourage angel investment, including from tax incentives to co-investment funds.

However, the report points out that there has been little formal evaluation of these policies and programmes to date and policies that worked in one country may not necessarily work the same way, or be as successful, elsewhere.

Useful links

OECD work on innovation

OECD work on new sources of growth

OECD symposium on the New Geography of Innovation and the Impact of the Economic Crisis

OECD Centre for Entrepreneurship, SMEs and local development