Nominal wages are not real wages, and why it matters in the UK

This post is just an extension of a recent tweet from Chris Dillow. I think it is worth writing more about it because it reflects on an issue that is widely misunderstood, by some on both the left and the right. Here is the share of employees compensation and corporate profits in total income since 1948. Note that everything below is about the UK experience: the US is different.

I have gone back to 1948 to show that the wage share can change, and has fallen from the 1950s until the end of the century, from 60% to 50%. But that has not been accompanied by a rise in the profit share, which has stayed pretty close to 20%. The missing pieces, that are the counterpart to the fall in the labour share over this period, are income going to indirect taxes, self employment and unincorporated businesses.

The key point I want to make is that neither the wage share or the profits share has changed over the last 15 years. This busts two myths that you will often see.

Myth 1 Immigration has kept real wages low.

There was a large increase in non-EU immigration at the end of the 1990s: if anything the wage share increased at the same time. The second large increase in immigration, this time from the EU, was from 2004, and there was no noticeable impact on the labour share. Immigration may have been depressing nominal wages, but those lower nominal wages were allowing lower output prices, leaving real wages unchanged. This is consistent with the econometric evidence that immigration has no significant impact on real wages.

This evidence is often dismissed in two ways. The first is that it does not correspond to workers 'lived experience'. But that experience reflects either the impact of immigration on their own nominal wage, or falls in real wages which reflect the lack of productivity growth and sterling’s depreciation. It is just possible that immigration might have discouraged firms from investing in higher productivity techniques, but it is rather more likely that immigration has allowed firms to produce in the UK who would otherwise have produced abroad. For other reasons why intuition on immigration may be misleading see here.

The second way that some people argue that there ‘must be’ a link between real wages and immigration is to invoke simple supply and demand. That is just fallacious: immigration shifts the labour supply curve but it also shifts the demand curve. A slightly more sophisticated argument is that the demand curve does not fully shift to compensate for greater supply immediately after an increase in immigration because it takes time to invest, but if that was the case we would see a temporary fall in real wages and a rise in the profit share following periods of immigration, and we do not.

Myth 2: Real wages have fallen because labour is now weak compared to employers.

Since the Global Finance Crisis (GFC) and subsequent recession, nominal wage growth may be slow because the labour market is weak, but the data shows that employers are not taking advantage of this to increase the profit share. Low wages are being passed on into lower prices.

There are two main reasons why real wages are currently low: almost non-existent productivity growth since the crisis and the depreciation in sterling which has raised the cost of imports and therefore consumer prices.

Note that I am not at all saying that the labour market is not as weak as it appears. In many areas conditions of employment seem to have deteriorated since the GFC. What I am saying is that real wages depend on prices as well as nominal wages, and in the UK at least there seems to be sufficient pressure on firms to pass on low wages into low prices, leaving the relationship between real wages and productivity unchanged.

It is also important to point out that the wage share is different from median wages. As the study by Pessoa and Van Reenen I examine here shows, median wages from 1972 to 2010  declined relative to the average compensation because of rising non-wage benefits and rising inequality. A good part of this rising inequality reflects incomes of the top few percent.  

It is often difficult to convince those on the left that weakening labour power over wages can be a good thing, if lower nominal wages are passed on to lower prices. It can be a good thing because it allows the central bank to raise demand and therefore output by more than they otherwise could while keeping inflation stable. It reduces the sustainable unemployment rate: the NAIRU. Furthermore lower wages are more likely to be fully passed on into lower prices if the goods market is highly competitive, and that is more likely to happen if the economy is open to overseas trade.

Did macroeconomics give up on explaining recent economic history?

The debate that continues about whether a Phillips curve still exists partly reflects the situation in various countries where unemployment has fallen to levels that had previously led to rising inflation but this time wage inflation seems pretty static. In all probability this reflects two things: the existence of hidden unemployment, and that the NAIRU has fallen. See Bell and Blanchflower on both for the UK.

The idea that the NAIRU can move gradually over time leads many to argue that the Phillips curve itself becomes suspect. In this post I tried to argue this is a mistake. It is also a mistake to think that estimating the position of the NAIRU is a mugs game. It is what central banks have to do if they take a structural approach to modelling inflation (and what other reasonable approaches are there?). Which raises the question as to why analysis of how the NAIRU moves is not a more prominent part of macro.

The following account may be way off, but I want to set it down because I am not aware of seeing it outlined elsewhere. I want to start with my account of why modern macro left the financial sector out of their models before the crisis. To cut a long story short, a focus on business cycle dynamics meant that medium term shifts in the relationship between consumption and income were largely ignored. Those who did study these shifts convincingly related them to changes in financial sector behaviour. Had more attention been paid to this, we might have seen much more analysis and more understanding of finance to real linkages.

Could the same story be told about the NAIRU? As with medium term trends in consumption, there is a literature on medium term movements in the NAIRU (or structural unemployment), but it does not tend to get into the top journals. One of the reasons, as with consumption, is that such analysis tends to be what modern macroeconomists would call ad hoc: it uses lots of theoretical ideas, none of which are carefully microfounded within the same paper. That is not a choice by those who do this kind of empirical work, but a necessity.

Much the same could apply to other key macro aggregates like investment. When economists ask whether investment is currently unusually high or low, they typically draw graphs and calculate trends and averages. We should be able to do much better than that. We should instead be looking at the equation that best captures the past 30 odd years of investment data, and asking whether it currently over or under predicts. The same is true for equilibrium exchange rates.

It was not just the New Classical Counter Revolution in macro that led to this downgrading of what we might call structural time series analysis of key macro relationships. Equally responsible was Sims famous paper 1980 ‘Macroeconomics and Reality’, that attacked the type of identification restrictions used in time series analysis and which proposed instead VAR methods. This perfect storm relegated the time series analysis that had been the bread and butter of macroeconomics to the minor journals.

I do not think it is too grandiose to claim that as a consequence macroeconomics gave up on trying to explain recent macroeconomic history: what could be called the medium term behaviour of macroeconomic aggregates, or why the economy did what it did over the last 30 or 40 years. Macro focused on the details of how business cycles worked, instead of how business cycles linked together.

Leading macroeconomists involved in policy see the same gaps, but express this dissatisfaction in a different way (with the important exception of Olivier Blanchard). For example John Williams, who has just been appointed to run the New York Fed, calls here for the next generation of DSGE models to focus on three areas. First they need to have a greater focus on modelling the labour market and the degree of slack, which I think amounts to the same thing as how the NAIRU changes over time. Second, he talks about a greater focus on medium- or long- run developments to both the ‘supply’ and ‘demand’ sides of the economy. The third of course involves incorporating the financial sector.

Perhaps one day DSGE models will do all this, although I suspect the macroeconomy is so complex that there will always be important gaps in what can be microfounded. But if it does happen, it will not come anytime soon. It is time that macroeconomics revisited the decisions it made around 1980, and realise that the deficiencies with traditional time series analysis that it highlighted were not as great as future generations have subsequently imagined. Macroeconomics needs to start trying to explain recent macroeconomic history once again.

The Output Gap is no longer a sufficient statistic for inflationary pressure

One of the features of the latest OBR forecast is that they believe the economy is operating slightly above its sustainable level (a positive output gap), where the sustainable level is the level that would keep inflation constant. To see how startling that hypothesis is, here is the latest version of a chart I have probably posted more than any other since I started writing this blog.

It is UK GDP per head (source), which is a pretty good measure of average prosperity, and a trend line in red for 2.23% growth p.a. So from 1955 to 2007 prosperity grew at an average rate of almost two and a quarter percent each year. Since then it has increased at an annual rate of around 0.35%. And if the OBR are right, none of this is due to unutilised resources and lack of demand.

The shift in trend is just as clear if we look at output per worker. Some people try and rationalise this by saying that 2007 was a boom year, and so trend growth had really been falling long before the Global Financial Crisis (GFC). But the evidence does not support more than a slight downward shift in the growth trend before the GFC: the OBR estimate an output gap of 0.7% in 2006/7 and 1.8% in 2007/8.

I find it extraordinary that most economists still talk about the output gap after the GFC in the same way that it was talked about before the crisis: as a limit to how far and fast the economy can expand. To do that is in my view quite wrong. It ignores what I call the innovations gap: the difference between actual output and the level of output that firms could achieve if they started using the best technology available to them. Because there is currently a large innovations gap, firms are likely to meet additional demand not be raising prices but by investing in these more efficient techniques.

Before the GFC, we could ignore the innovation gap because it was relatively small. But since the crisis that gap for the UK and many other countries must have increased, because it is simply not plausible to assume that since the GFC technical progress has come to a virtual halt. Innovations may not have been increasing at the pre-GFC rate, but they cannot have almost stopped, which is the implicit assumption in the OBR’s analysis. Hence we have in the UK, and I suspect in many other countries, a subsrantial innovations gap which will prevent any excess demand leading to significant inflationary pressure. Some supporting evidence for this comes from the growing productivity divergence between leading firms and the rest.

Why have most firms not been investing in the most productive equipment and techniques since the GFC? I think the simple answer is fixed costs and demand. Investment projects almost always involve a large fixed cost element (disruption, retraining), and with static demand those fixed costs may exceed any efficiency gain. But in a normal recovery from a recession, where demand is growing rapidly, firms are happy to incur that fixed cost because they need to expand capacity anyway to meet growing demand. In a weak recovery, on the other hand, many firms may not need to expand capacity, with any modest increases in demand going to leading firms, firms that do invest in the latest technology. Hence the divergence noted above.

Exactly the same argument applies to the NAIRU: the level of unemployment at which inflation is constant. The NAIRU is almost certainly lower than most central banks think for a variety of reasons, but when it is approached I expected to see a pick up in investment and innovation more than a pick up in wage inflation. Investment and productivity growth go together, as a nice chart in the OBR’s latest forecast report shows (page 43).

A large innovation gap in the UK is being enhanced by Brexit. The more uncertain future demand is the more firms are likely to postpone productivity enhancing investment. It may be politically useful to delay creating a new customs union/SM for goods with the EU to try and keep the Conservative party together (as regular readers will know, I think this is inevitable because of the Irish border), but the uncertainty that delay creates just holds back UK growth. Just one more way in which both Brexit and more generally a Conservative government is an economically destructive project.

The existence of a large innovations gap, both in the UK and elsewhere, means that we need two things. First, we need a monetary policy that is very relaxed about raising interest rates. Second we need, in the UK and pretty well everywhere, a large increase in public sector investment. The first needs independent central banks to be less inflation averse and to stop treating the sustainable level of output as something which is independent of what they do. The second requires governments to stop being obsessed about deficits and instead to start investing in the future of all the people they govern.

A short guide to why we should not raise UK interest rates

Everyone expects the MPC to raise rates on Thursday. This would be a mistake. Discussion about interest rate changes in the press normally involve large amounts of data and charts about the state of the economy. Here I want to do the opposite: to present the minimum you need to know to understand that raising UK rates right now is the wrong thing to do.

Everyone should know that UK inflation is currently around 3% because of the Brexit depreciation. But because the impact of a deprecation on price inflation is temporary if wage inflation remains flat, the Bank said they would ignore this temporary rise. The key is to look at whether average earnings inflation is responding to higher consumer price inflation. The answer is they are not: average earnings growth has been slightly above 2% all this year, which is a little lower than the average for 2016.

But what about unemployment being at a 42 year low? Surely that means earnings growth is just waiting to kick off. The first point is that unemployment is not currently a good measure of labour market slack. A better measure is the Resolution Foundation’s underemployment index, which is still above levels before the global financial crisis. And before you say but that was a boom period, it wasn’t. UK core inflation was below 2% throughout, and earnings growth was consistent with this.

The other thing to say is that it is quite wrong to assume that we know what the level of labour market slack is that would lead to increases in earnings growth (what economists call the NAIRU). The NAIRU moves over time. As just one example of why it might move, a labour force that rents is likely to be more mobile than one that owns a house, and so the trend towards renting should reduce the NAIRU.

So looking at the labour market, there is no sign that we are close to a level where earnings inflation might pick up. And that is pretty well a precondition for inflation to exceed its target of 2% over the medium term. That is all you really need to know. If you want to know why the MPC probably will raise rates, read on.

What I suspect the Bank are worrying about is that Brexit has created what economists call a negative supply shock. In particular, both investment and productivity growth are much lower than the Bank were expecting before Brexit. They will point to various survey measures which show firms do not have any spare capacity. But this reasoning I think indicates a conceptual weakness.

Firms have two responses to lack of capacity: raising prices or investment. By choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, and right now what the economy desperately needs is more investment and the productivity improvements that brings with it. The Bank shouldn’t worry about a bit of inflation that might come with higher investment, because 2% earnings growth is an anchor that will prevent inflation deviating from target for any length of time.

That should be enough, but there are two other reasons why the Bank should not raise rates. First, right now the downside risk on the demand side from Brexit surely exceeds the upside risk. Second, as the OBR chart here shows (look at orange bars), after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but we are currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009. [1]

Finally, it is always important to consider risks. Suppose earnings growth does pick up sharply just after the MPC’s monthly meeting. The Bank always says it wants to be ‘ahead of the curve’, to avoid too rapid an increase in rates. This is the mentality that has led inflation to undershoot in the US and Eurozone since the recession, and if you take out the impact of depreciations by looking at the GDP deflator the same is true for the UK. The problem for the UK economy since the recession has not been too much inflation, but far too little demand.

[1] Specifically, average growth in 2017 is 0.1% per quarter, and averaging quarterly growth rates from 2010 Q1 to 2016 Q4 gives 0.3% per quarter          

The NAIRU: a response to critics

When I wrote my piece on NAIRU bashing, I mainly had in mind a few newspaper articles I had read which said we cannot reliably estimate it so why not junk the concept. What I had forgotten, however, is that for heterodox economists of a certain hue, the NAIRU is a trigger word, a bit like methodology is for mainstream economists. It conjures up lots of bad associations.

As a result, I got comments on my blog that were almost unbelievable. The most colourful was “NAIRU is the economic equivalent of "Muslim ban"”. At least two wanted to hold me directly responsible for any unemployment at the NAIRU. For example: “So according to you a fraction of the workforce needs to be kept unemployed.” Which is a bit like saying to doctors: “So according to you some people have to be allowed to die as a result of cancer.”

I have to say straight away that not everyone responded in that way. Some were much more thoughtful and constructive (like Jo Michell, for example). But the less thoughtful reactions are interesting in a way too.

I need to recap what the NAIRU is, particularly because heterodox economists seem to imagine it is many things it is not. Let’s take a very simple Phillips curve

Inflation this period = expected inflation next period - aU +b

where ‘a’ is a parameter and U is a measure of excess supply/demand in the economy. Unemployment will be one measure of that excess supply, but it is far from a perfect measure. (That my previous post was about excess supply, rather than actual unemployment, was obvious from what I wrote.) ‘b’ stands for a collection of slow moving variables. These could include a measure of union power, or how mobile labour was, or the degree of monopoly in the goods market. The NAIRU is defined as

NAIRU = b/a

If U is less than the NAIRU over a sustained period then inflation will rise, which will increase inflation expectations, which increases inflation further etc.

The concept is of interest to policymakers involved in demand management. They have to decide how much they can push demand before inflation starts rising. If they are independent central banks, they have to accept the world as it is. The NAIRU is a description of how the economy works: nothing more or less. This is why complaints that economists who use or estimate the concept are somehow responsible for those left unemployed are so dumb.

Of course you can criticise the concept of the NAIRU, but logically that has to involve criticism of the Phillips curve from where it comes. It is also reasonable to argue that the concept is fine, but the NAIRU is so difficult to measure that it would be better not to try and estimate it or let it guide policy. I have a lot of sympathy with that view at the moment, which is why I argue that, in the US right now, policy makers should find the NAIRU by allowing inflation to rise above target. But that point of view was irrelevant in my previous post, which was about the concept of the NAIRU, not its measurement.

As far as the concept is concerned, I think the strongest attacks come from thinking about hysteresis, as Jo Michell suggests. But even here, we add a complication to the NAIRU analysis, rather than overturn that analysis altogether. What hysteresis does is to make periods where unemployment is above the NAIRU extremely costly. It also means that periods of being slightly below the current NAIRU might be justified if they reduce the NAIRU itself.

I want to end by adding two reflections. The first relates to modelling the NAIRU. There once was, following the work of Layard and Nickell, an empirical literature that attempted to model for OECD countries a time series for the NAIRU, using proxy variables for things like union power, the benefit regime and geographical mismatch. With the dominance of the microfoundations methodology that work appears to have decreased, although to some extent it is still there in work based on matching models. I would be very interested to know if that time series analysis, now potentially enriched by matching models and flow data, has continued in any way.

The second relates to the sharp reactions to my original post I noted at the start, and the hostility displayed by some heterodox economists (I stress some) to the concept. I have been trying to decide what annoys me about this so much. I think it is this. The concept of the NAIRU, or equivalently the Phillips curve, is very basic to macroeconomics. It is hard to teach about inflation, unemployment and demand management without it. Those trying to set interest rates in independent central banks are, for the most part, doing what they can to find the optimal balance between inflation and unemployment.

Accepting the concept of the NAIRU does not mean you have to agree with their judgements. But if you want to argue that they could be doing something better, you need to use the language of macroeconomics. You can say, as many besides myself have done, that the NAIRU is either a lot lower than central bank estimates, or is currently so uncertain that these estimates should not influence policy. But if you say that the NAIRU has to be Bashed, Smashed, And Trashed, you will not get anywhere.

I also get very annoyed when I hear refutation by reference (as here for example). It would be so easy to write my blog posts that way. Instead I generally try to explain or present an argument that I hope is understandable. Economics is usually not so hard that this is impossible, although finding the right words is never easy. Economics is certainly not a religion, where all you have to do is choose which sect you belong to and then follow great works.     

NAIRU bashing

The NAIRU is the level of unemployment at which inflation is stable. Ever since economists invented the concept people have poked fun at how difficult to measure and elusive the NAIRU appears to be, and these articles often end with the proclamation that it is time we ditched the concept. Even good journalists can do it. But few of these attempts to trash the NAIRU answer a very simple and obvious question - how else do we link the real economy to inflation?

One exception are those that attempt to suggest that all we need to effectively control the economy is a nominal anchor, like the money supply or the exchange rate. But to cut a long story short, attempts to put this into practice have never worked out too well. The most recent attempt has been the Euro: just adopt a common currency, and inflation in individual countries will be forced to follow the average. This didn’t prove to be true for either Germany or the periphery, with disastrous results.

The NAIRU is one of those economic concepts which is essential to understand the economy but is extremely difficult to measure. Let’s start with the reasons for difficulty. First, unemployment is not perfectly measured (with people giving up looking for work who start looking again when the economy grows strongly), and may not capture the idea it is meant to represent, which is excess supply or demand in the labour market. Second, it looks at only the labour market, whereas inflation may also have something to do with excess demand in the goods market. Third, even if neither of these problems existed, the way unemployment interacts with inflation is still not clear.

The way economists have thought about the relationship between unemployment and inflation over the last 50 years is the Phillips curve. That says that inflation depends on expected inflation and unemployment. The importance of expected inflation means that simply drawing unemployment against inflation will always produce a mess. I remember from one of the earlier editions of Mankiw’s textbook he had a lovely plot of this for the US, that contradicted what I just said: it displayed clear ‘Phillips curve loops’. But it was always messier for other countries and it got messier for the US once we had inflation targeting (as it should with rational expectations). See this post for details.

The ubiquity of the New Keynesian Phillips Curve (NKPC) in current macroeconomics should not fool anyone that we finally have the true model of inflation. Its frequency of use reflects the obsession with microfoundations methodology and the consequent downgrading of empirical analysis. We know that workers and employers don’t like nominal wage cuts, but that aversion is not in the NKPC. If monetary policy is stuck at the Zero Lower Bound the NKPC says that inflation should become rather volatile, but that did not appear to happen, a point John Cochrane has stressed.

I could go on and on, and write my own NAIRU bashing piece. But here is the rub. If we really think there is no relationship between unemployment and inflation, why on earth are we not trying to get unemployment below 4%? We know that the government could, by spending more, raise demand and reduce unemployment. And why would we ever raise interest rates above their lower bound?

I’ve been there, done that. While we should not be obsessed by the 1970s, we should not wipe it from our minds either. Then policy makers did in effect ditch the NAIRU, and we got uncomfortably high inflation. In 1980 in the US and UK policy changed and increased unemployment, and inflation fell. There is a relationship between inflation and unemployment, but it is just very difficult to pin down. For most macroeconomists, the concept of the NAIRU really just stands for that basic macroeconomic truth.

A more subtle critique of the NAIRU would be to acknowledge that truth, but say that because the relationship is difficult to measure, we should stop using unemployment as a guide to setting monetary policy. Let’s just focus on the objective, inflation, and move rates according to what actually happens to inflation. In other words forget forecasting, and let monetary policy operate like a thermostat, raising rates when inflation is above target and vice versa.

That could lead to large oscillations in inflation, but there is a more serious problem. This tends to be forgotten, but inflation is not the only goal of monetary policy. Take what is currently happening in the UK. Inflation is rising, and is expected to soon exceed its target, but the central bank has cut interest rates because it is more concerned about the impact of Brexit on the real economy. That shows quite clearly that policy makers in reality target some measure of the output gap as well as inflation. And they are quite right to, because why create a recession just to smooth inflation.

OK, so just target some weighted average of inflation and unemployment like a thermostat. But what level of unemployment? There is a danger that would always mean we would tolerate high inflation if unemployment is low. We know that is not a good idea, because inflation would just go on rising. So why not target the difference between unemployment and some level which is consistent with stable inflation. We could call that level X, but we should try to be more descriptive. Any suggestions?

Did the Bank of England cause Brexit?

Suppose that by the mid-2000s, immigration from the EU (and the potential for additional immigration) had led to an important shift in the UK labour market. The possibility of bringing labour from overseas meant that old relationships between the tightness of labour market and wage increases no longer held.

You might think that was bad for workers, but that is not so. It would mean what economists call the natural rate of unemployment (or NAIRU) has fallen. Unemployment can be lower without leading to wage increases that threaten the inflation target, because workers fear that the employer can resort to finding much cheaper overseas labour. It reduces the power of workers in the labour market, but also leads to overall benefits. (This is just an example of the standard result that reducing monopoly power is socially beneficial.)

But it is only good news if the Bank of England recognises the change. If they do not, we get stagnant wage growth and unemployment higher than it need be. The obvious response is that the Bank will know there has been a change because wages will start falling faster than they would expect based on previous relationships. However that effect may be masked by the well documented employee and employer reluctance to actually cut nominal wages. Add in the shock of the financial crisis, and this change in the way the labour market works might well be missed.

Here is the big leap. Suppose the above had happened, and the Bank of England did not miss the change. Monetary policy would have been much more expansionary, bringing unemployment well below the 5% mark. Nominal wage growth would have been stronger, and a buoyant labour market would have generated a feel good factor among workers. With more vacancies and less unemployment, concerns about immigration would have begun to fade. The Brexit vote would still have been close, but would have gone the other way.

You may say how could monetary policy be more expansionary given how close we are to the Zero Lower Bound? If that was the case the Bank should have said they were out of ammunition, and placed responsibility with the government and austerity. But for the last two years at least, the Bank could have cut interest rates and has not. You could blame the relentless expectation in the media and financial sector that rates would increase, but the Bank should be able to rise above that.

Of course the Brexit blame game is easy to play when the vote was so tight. The most speculative aspect of this chain of thought is the initial premise about a shift in the NAIRU created by immigration potential. While the possibility makes sense, whether the data backs it up is much less clear. Yet there is some evidence of a structural shift in the UK labour market in the mid-2000s, as Paul Gregg and Steve Machin report.