In the previous blog I asked why real wages stopped growing in the 1970s. A host of explanations has been discussed by economists and political commentators (although they tend to focus on the related issues of income and income inequality). David Leonhard, for example, listed 14 possible causes for the income slump during the last decade. A similar list was earlier discussed by Timothy Noah in a series of articles on why income inequality has been growing since the 1970s.
As I said in the last blog, the usual approach is to consider each possible cause in isolation. But that is not how we can weigh their relative importance. Furthermore, societies are complex dynamical systems, in which different causes are interrelated through a web of nonlinear feedbacks. Translated into plain language, this means that everything can potentially affect everything else, and this should be taken into account. Finally, to understand the dynamics of wages and incomes we need to go beyond economics.
To answer the question of why real wages abruptly stopped growing in the 1970s we need a unifying theoretical framework, which can be confronted with data. In short, we need Cliodynamics. Here’s my stab at disentangling the thicket of economic forces that may help explain the dynamics of real wages. (I will discuss the more complex question of household incomes in a later blog.)
The obvious starting point for thinking about wages is to consider how much total income is produced by a society; then divide it by the number of people. A common measure is gross domestic product (GDP) per capita. This quantity is often referred to as ‘per capita income,’ but such language is misleading because the income of a typical person (or a household) can diverge pretty far from GDP per capita.
Still, the real GDP per capita today is 5.6 times higher than in 1928 (for reasons explained later I begin my data series in 1928). Surely such a huge increase in the gross national income should have an effect on how much individual workers earn.
And it does. But it is only part of the story. In 1978 the per capita GDP was 3.2 times higher than 50 years before, but the compensation of production workers increased 4-fold over the same period (again, both GDP and wages are expressed in inflation-adjusted dollars). Even wages of unskilled workers grew faster than GDP per capita (3.5 times between 1927 and 1978).
After 1978 GDP per capita continued to grow at a good clip (in 2012 it was 70 percent higher than in 1978), but the production workers wages stagnated and the wages of unskilled workers actually declined, by 10 percent. As I said, trends in real wages can diverge substantially from trends in the per capita GDP.
What forces cause such deviations? We can divide them into two broad groups: market (economic) forces and non-market factors. The second group includes influences of social norms and institutions, as well as the balance of political (or even coercive) power that various players can wield. I will deal with non-market factors in the next blog.
The first group reflects the operation of market forces. Human labor can be thought of as a commodity, whose cost (i.e., real wages) is affected by the interplay between demand and supply. If demand for labor exceeds its supply, real wages should go up. Conversely, when there is an oversupply of labor, real wages should decline.
Can we put some numbers to this quantity? To estimate how demand changed over the years I take the GDP for a particular year and divide it by current labor productivity. The Bureau of Labor Statistics has measured the average output per hour per worker since 1947, and less precise estimates are available for previous periods. Full time employment (40 hours per week) translates roughly into 2000 hours per year, so hourly productivity multiplied by 2000 gives us productivity per year. Dividing GDP by this number we obtain an estimate of how many workers are required to produce the goods and services in that year.
For labor supply I use the labor force data from the Bureau of Labor Statistics. These numbers include both employed and unemployed, looking for work. (I am skipping a lot of technical details here; in a few days I will post a manuscript that will provide such details.)
When we put the estimated trends in labor demand and supply on the same graph, here’s what we see:
At first the demand curve grows faster than the supply curve, so during this period market forces favored wage growth. During the late 1960s, however, the supply curve accelerated and after 1970 outpaced the growth of demand. One reason for this acceleration was the reversal of immigration policy in 1965 that facilitated the arrival of workers from overseas. By the early 2000s, one in six American workers was foreign-born. However, the initial rise during the late sixties and the seventies was mostly due to the second factor, internal demographic growth. The generation that reached marriageable age during the Great Depression and World War II had fewer babies than the post-war generation (the parents of baby-boomers). When baby boomers started entering the job market in massive numbers after 1965, they quickly drove up the supply curve above the demand.
The gap between the two curves was also affected by developments on the supply side. 1975 was the last year when the US enjoyed a trade surplus. Since the 1970s the trade deficit has been ballooning, exceeding 5 percent of the GDP in early 2000s. Trade deficit subtracts from the GDP; having more imports than exports means that demand for labor is satisfied by foreign workers.
One startling development is that around 2000 the demand curve stopped growing altogether. This remarkable occurrence was due to a combination of sluggish economic growth together with rapid gains in labor productivity, which put a lid on the number of workers needed to satisfy the demand for labor. Notice that the plateau occurred before the Great Recession, and it provides one possible explanation for the ‘jobless recoveries’ following the last two recessions.
Overall, the trends in demand and supply curves appear to yield interesting insights into the forces shaping the dynamics of American real wages. However, before we can quantitatively estimate the relative importance of the effect of the demand/supply ratio on wages, we need to quantify the dynamics of extra-economic factors (in the next installment of this series).
A final note: the demand/supply approach is a very parsimonious way of summarizing various market forces that affect the trends in real wages. Thus, immigration (both legal and illegal) enter on the supply side – by increasing the supply of labor they should depress its price. Foreign trade enters on the demand side. A trade surplus increases demand for labor and should have a positive effect on real wages. Trade deficits do the opposite. We can even assess the relative effects of immigration and trade, even if crudely, by expressing trade deficit in worker units (using average annual productivity of US workers).
To Be Continued