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?

Guest author

13 comments to “Do workers reap the benefits of productivity growth?”

You can leave a reply or Trackback this post.
  1. Sean Fernyhough (@Sean_Fernyhough) - 22/08/2012 Reply

    Using mean rather than median seems flawed for the reason indicated. Also Pension contributions are deferred pay, the eventual value of which are subject to a great deal of uncertainty.

Leave a Reply