Saturday, May 21, 2016

Why wage growth is so weak

Are we waiting with ever-growing impatience for the economy to get back to normal, or has the economy shifted to a "new normal"?

I think that's the central question in macro-economics today – not just in Oz but throughout the developed world.

To put that question in econospeak, are the changes we see before us "cyclical" – just part of the normal ups and downs of the business cycle – or are they "structural", a lasting change in the way the economy works.

Trouble is, neither I nor anyone else can say with confidence what the answer is.

But further evidence that things in our economy are looking far from normal came this week with the news that wage growth over the year to March – as measured by the  Bureau of Statistics' wage price index – decelerated to 2.1 per cent, the slowest since this series began in 1997.

Why is wage growth so weak? Because the rise in consumer prices is so weak. Why are prices growing so slowly? Because the rise in wages is so weak.

Yes, there is a circular, chicken-and-egg relationship between wages and prices. When prices rise, workers need a pay rise of at least that much just to preserve the purchasing power of their wages.

But when they have to pay higher wages, firms pass their higher costs on to customers. That's why – in normal times, at least – we always have some degree of inflation.

So don't bother wishing prices were rising faster so wage growth would be higher – that wouldn't get you anywhere.

No, what matters to wage-earners is the difference between the rise in their wages and the rise in consumer prices – that is, the change in their "real" wages. In normal times, wages should be rising comfortably faster than consumer prices.

Why? Because increased business investment in more and better machines increases the productivity of workers' labour (output per hour of labour input), and competition for the services of workers should ensure they receive a share of the improved value of their labour.

Here the news is better, though not great. Although wage growth over the year to March slowed to 2.1 per cent, the rise in consumer prices over the same period slowed to 1.3 per cent, implying real wages grew by about 0.8 per cent.

This is better than for most of the past two years, but the "normal" rate of productivity improvement should be nearer 1.5 per cent a year, even 2 per cent.

So what's going on with wages? This is what Professor Jeff Borland, of the University of Melbourne, tried to discover in a recent paper. He used a different measure of wage growth – average weekly earnings for adult male full-time employees – because the series goes back much further to the early 1980s (when the stats were more sexist than they are today).

He found that the rate of growth in "nominal" wages – that is, before adjusting for the effect of price inflation – is lower than at any time in the past 30 years.

Real wage growth – after allowing for inflation – is also low, but real wage growth has been negative in several periods over the past 30 years.

Borland tests to see how much of the weaker growth in nominal wages over the two years to the end of 2015 can be explained by lower growth in consumer prices and labour productivity, which he does by comparing them with the figures for the five years to 2013.

He finds that weaker prices and productivity growth explain about 70 per cent of the weaker wages growth but, obviously, that leaves 30 per cent of it unexplained.

Next among the usual suspects is weaker growth in employers' demand for labour. It's well established that the strength of wages growth varies to some extent with the business cycle.

Wages should grow faster when demand for goods and services is strong and firms need to attract more workers, but grow more slowly when demand is weak. Indeed, it's common for employers to skip wage rises during recessions, when workers are more worried about hanging on to their jobs.

Economists use the "Phillips curve" (named after the Kiwi economist Bill Phillips) to study the relationship between wage inflation and the demand for labour, using the rate of unemployment as an inverted "proxy" (stand-in) for labour demand. Borland uses a broad definition of unemployment by adding to the official rate the rate of under-employment.

He finds, as expected, that wage growth is lower when unemployment is higher. But he also finds that a structural shift in the relationship between wage growth and broad unemployment occurred in the mid-1990s.

His figuring suggests that any level of demand for labour is now associated with a lower rate of wage growth than it used to be, and that an increase in labour demand now leads to a smaller increase in wages.

He lists various potential explanations for this structural shift, of which I think the most plausible is our move in the early 1990s from centralised wage-fixing to enterprise bargaining.

But a change so long ago can't explain why wage growth has been abnormally low in just the past two years or so – more than can be accounted for by lower inflation and productivity improvement.

Borland's best explanation for this is the weak growth in "output prices" – the prices charged to customers by employers, including the prices of exports. Slower growth in output prices will have constrained employers' capacity to pay higher wages.

So maybe wage growth will return to the post-1990s norm once coal and iron ore prices have stopped falling.

But my suspicion is that other global developments – including digitisation and the greater ability to move businesses to cheap-labour countries – has permanently weakened workers' bargaining power.