Friday, July 21, 2006

Who cares about wages?

David Altig of Macroblog argues (continued here) that we should just ignore wages and look at total compensation. Greg Mankiw agrees. Brad DeLong disagrees, but only because we don’t have good enough data on total compensation. I would suggest, however, that there are a couple of reasons we should care about wages for their own sake.

First, even though compensation is the theoretically correct variable that rational firms and workers should care about, their behavior in the real world may reflect rules of thumb that give precedence to wages over benefits. As a result, the behavior of the Phillips curve – the short-run tradeoff between inflation and output – may depend on the exogenous behavior of benefit costs. Recent increases in the real cost of health insurance have, in my opinion, had an inflationary impact. In principle, they shouldn’t: firms facing rising benefit costs should just keep wages down. In practice, I suspect this is often not what they do. I can’t prove it, but I believe that the weak wage growth in recent years has been the result of weak labor market conditions – conditions that would normally have been disinflationary – and not the result of increasing benefit costs.

At the place I used to work, I was there for 6 years, and every year, they would announce a 5% wage increase. I found it kind of amusing because the memo always said what the inflation rate was, but it never seemed to make any difference: we automatically got a bigger real wage increase in years when the inflation rate was low. Since our benefits included health insurance, we also got a bigger increase in total compensation in years when the cost of health insurance rose more rapidly. (That part wasn’t even in the memo.). Firms have to take benefit costs into account in making employment and pricing decisions, but when it comes to wage-setting decisions, I would guess that a lot of firms behave like my old employer.

The second reason has more troubling implications. Wages, I think, have a lot to do with the subjective sense of prosperity. “Honey, I got a raise!” sounds a lot better than, “Honey, they expanded our health insurance to cover several newly developed procedures!” Even though rising benefit costs largely reflect real improvements in the quality of health care, these improvements don’t make us feel richer. Unfortunately (this is the troubling part) they really represent an acknowledgement that we weren’t doing so well to begin with. There are all kinds of health problems we could get, and it’s a good thing when new solutions are developed, but for those who are currently healthy, it is much easier to ignore the potential problem when we don’t have to pay for a potential solution.

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Blogger Gabriel Mihalache said...

I don't know. Many people (especially around capital markets) like to talk about cost-push inflation but as far as I can see that's in rather theoretical disrepute.

Appealing to the short-term seems to muddy the issue here. The data discussed by the people you quote is long term. Also, many things are possible in the short run if we appeal to all sort of imperfections, as you do.

So, no sale here. Sorry.

Fri Jul 21, 09:04:00 PM EDT  
Blogger Gabriel Mihalache said...

P.S. Just to satisfy my curiosity, in case anyone would assent to comment on a poor graduate's speculations...

If benefit costs increased, and demand stayed the same, then "rational" firms would reduce the number of employees, scale back production, and therefore unemployment would rise. By the short-term trade-off mentioned then we should expect disinflation following the cost increase.

Where am I going wrong?

Fri Jul 21, 09:10:00 PM EDT  
Anonymous Bruce Wilder said...

"Even though rising benefit costs largely reflect real improvements in the quality of health care"

Assumes facts not in evidence, I think.

The ratchet in health care probably has something to do with perverse incentives to research and market proprietary drugs and treatments with a biased character, and to neglect research on non-proprietary drugs and treatments.

The ideal drug for Big Pharma would be a patented form of heroin: cheap to produce, and likely to lead to chronic use.

Ulcers stand as an object lesson. Twenty-five years ago, Big Pharma started poring money into ulcer treatments: a demographic increase in chronic stomach ulcers made chronic treatments appear likely to be very profitable. Some doctors in Australia proved that most stomach ulcers are a consequence of a bacterial infection, treatable with antibiotics. Naturally, there was some ugly controversy as the paid mouthpieces of Big Pharma dutifully tried to discredit the Australians.

The world, nevertheless, got a whole bunch of expensive antacids, like Nexium and Pepcid, which may not be appreciably more effective than Tums for many conditions. (Tums, itself, is addictive, which accounts for it's economic success, but, at least, it's cheap.)

We've got a whole bunch of expensive versions of aspirin, aimed at ineffective and chronic "treatment" of the symptoms of arthritis.

And, we've got Sunday feature articles wondering where the next generation of antibiotics are going to come from, and the U.S. has not a single supplier of the annual flu vaccine.

Fri Jul 21, 09:53:00 PM EDT  
Blogger knzn said...

Gabriel, it depends what you mean by “demand stayed the same.” To simplify, let’s start from a zero-inflation equilibrium and introduce a benefit shock. If firms take product prices as given, then they will reduce employment, but this is not disinflationary (deflationary), because it is premised on constant product prices (i.e. no deflation). If firms expect prices to rise sufficiently, then they won’t reduce employment. There must also be some intermediate expectation that is consistent with both rising prices and falling employment. Which result you get depends on how firms form their expectations.

If you don’t care about the short run, I guess there isn’t much I can say, except maybe to bring up the “greasing the wheels” theory. The argument is that it’s very difficult to cut nominal wages, so the economy is more efficient when the equilibrium nominal wage in declining industries is constant (i.e. when there is inflation, so real wages can fall without cutting nominal wages). If you also assume that it’s very hard to cut benefits, then rising benefit costs will increase the optimal inflation rate. (Maybe this point deserves a whole post.)

Bruce, You bring up another point which would be another reason to care about wages (i.e., because real benefits are mismeasured and aren’t really rising as fast as the statistics say).

Sat Jul 22, 01:55:00 PM EDT  
Blogger Gabriel Mihalache said...

No, you're right. I was thinking of something else, too wrong to repeat in public. :-)

Even so, for a constant supply of money, some prices will need to go down if benefits are to go up (and all prices that reflect benefits) -- the monetarist critique of cost-push inflation.

But if there's downward stickiness, then there's a choice between inflation (by increasing the supply of money) and recession (including unemployment). So it seems that this is yet another issue to be settled by the data.

From this p.o.v. you seem to think that your Fed will allow for inflation by loosening the money supply rather than risk recession, if I'm not misreading your again.

Sat Jul 22, 09:56:00 PM EDT  
Blogger knzn said...

I’m not saying that the Fed would necessarily intentionally accommodate a benefit shock. If you take the idealized case where (1) the Fed is willing and able to control monetary aggregates and (2) the velocity of money is well behaved, then a benefit shock would (I think) still be a little bit inflationary because it would reduce real national income, so that more of the nominal income would take the form of inflation (MV=PY, Y down with MV constant implies P up). (I haven’t worked out the details, but I think it would be similar to an oil shock.)

In any case, in practice, the Fed no longer tries to control monetary aggregates, and the experience of the early 80s shows that it didn’t do a very good job of it when it did try. Moreover, velocity is not well-behaved. (In particular, I suspect that health insurers make much more efficient use of money than consumers do, so if one were to control a monetary aggregate, one would end up increasing nominal income in response to a benefit shock.) In practice, the Fed controls interest rates in the short run. In the intermediate run, they seem to target output to potential and react after the fact to changes in the inflation rate, much like a Taylor rule. To the extent that they target output to potential (assuming their estimate of potential is accurate), a benefit shock would be inflationary (assuming my model of wage-setting is correct), because output at potential would imply a constant rate of wage growth, thus a higher rate of compensation growth and price growth.

However, I’m really thinking of this more from the point of view of a private forecaster (specifically me). If a forecaster mistakenly fits a price-price version of the Phillips curve, assuming he has the NAIRU right, he is going to underestimate the inflation rate when there is a benefit shock. So from that point of view, the benefit shock is an unanticipated source of inflation. Anyhow that’s my excuse (well, one of my excuses) for why my forecasts of inflation have been too low for the past few years.

Sun Jul 23, 02:13:00 AM EDT  
Blogger Gabriel Mihalache said...

I think that Friedman's original idea was that these kinds of chances are structural to Y and p so in a sense it might not be clear, a priori, what would happen to the aggregates. But your suggestion of decreased real output makes more sense. Maybe you should give up "private [forecasting]" and give academia a try. What you're saying makes more sense than the classes of the synthesis dinosaurs left in *some places*.

Sun Jul 23, 06:26:00 AM EDT  
Anonymous Tymbrimi said...

Wage growth has significantly accelerated. It was up .5% in June, the third month in a row at this rate. :) Because of this recent acceleration, the last 12 months have now seen a growth in wages of 3.9%. If July's wage growth matches the previous 3 months, that 12 month figure will increase. And the price of oil has begun to pull back. :)

Wed Jul 26, 12:40:00 AM EDT  
Blogger true dough said...

Knzn, I hope I'm not overlooking something glaringly obvious, but it seems to me that economists could do better to consider non-wage benefits. You make a good point with the health care example, but couldn't the velocity of money be more accurately calculated by considering non-wage benefits?
Here is an example: A waitress is working 5 hours a day for minimum wage and collecting awesome tips. The minimum wage is set to increase, but it makes no difference to her because her wage is a fraction of what she takes home. She's unlikely to increase her supply of labour in the workforce; however, policy-makers have overlooked this. Anyone reading the statistics would say: i) this waitress is an unfortunate soul scraping by on minimum wage; and, ii) the velocity of money in this region is weak (which it's not).
I'm thinking in particular of the oil towns speckled across Northern Canada comprised of services catering to riggers. The minimum wage up there could be $1/hr for all they care! Another example would be the “actors” serving tables in Manhattan – they're likely taking home quadruple their wage or more. Perhaps they pay 7x their wage in rent, but the point is they're gaining a sense of prosperity through a non-wage benefit.
It could be argued that gratuities are too difficult to calculate. In parts of Europe they're included on the bill – pretty objective.
Anyway, where am I going wrong? If your focus is on non-monetary benefits, I can think of a particular mother and father who are reluctant to leave the labour force because their pensions will make them richer tomorrow!

(h/t to Canadian Econoview for mentioning ignorance over tips)

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