Profits Up, Wages Down: What Economics Has to Say

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

It won’t surprise many readers to learn that in recent years profits have been doing a whole lot better than most workers’ wages.

We just learned that for the fourth year in a row, the real median weekly earnings for full-time workers fell slightly. The orange bars show the real, or inflation-adjusted, changes in these medians since 2007. The blue bars show nominal growth, which as you can see, has slowed in response to the weak job market. Interestingly, the only year of substantial growth in the real median was 2009, a year when nominal wage growth actually decelerated. The reason for the earnings gain was thus deflation: prices actually fell slightly that year (the Consumer Price Index was down 0.4 percent). That’s definitely not how we want to make real earnings grow.

Profits, on the other hand, have been putting on a show. As a share of national income, corporate profits were 14.6 percent in the third quarter of 2013, the most recent quarter for which we have data. In the history of these data going back to 1947, there was only one quarter higher than that — the last quarter of 2011. The equity indexes may have gotten whacked last Friday, but for 2013 the Standard & Poor’s 500-stock index was up 27 percent, its strongest showing in 16 years.

The two inverse trends are related. Profits are revenues minus costs, and with growth actually pretty tepid in recent years, at least in advanced economies, profits have been pushed more by squeezing costs, of which labor is usually the largest, than by particularly buff revenues. As a Goldman Sachs analysis put it last week, “the strength [of profits] is directly related to the weakness in hourly wages” and “profits are likely to accelerate in 2014 as G.D.P. and productivity growth recovers but wage growth picks up only gradually.”

Let’s unpack all of this.

It’s not unusual for profits to recover before wages, especially given the increase in global trade, wherein multinationals can sell to wherever the growth is, while relatively immobile labor has to wait for domestic demand to return. But based on the official dating of the expansion, as of this January it’s 55 months old, solidly middle-aged given that the average length of the last five expansions is 76 months (this calculation ignores the short 12-month expansion in 1981-82 to avoid a negative bias to the average).

The simple economic theory of wage formation would argue that workers must be getting increasingly unproductive. That is, if you’ve studied this corner of economics, you may recall the assertion that your hourly wage is equal to your “marginal product,” meaning the dollar value your work adds to the firm’s output. Now, this theory applies to the average worker, so it entertains differences in real wage trends across the wage scale, explaining them by referring to differences in the marginal product of the losers versus the winners.

But there are a lot of problems with the theory. First, even at the average, in recent years real compensation has grown more slowly than productivity. This dynamic, by the way, is behind the historically large decline in labor’s share of national income, a trend that is wholly inconsistent with conventional marginal product theory (which assumes constant income shares for labor and capital or profits).

Second, as the Economic Policy Institute recently pointed out — and it has carefully tracked the “real” wage story for decades — even in the lowest fifth of the wage scale, workers have become more highly educated. The institute’s analysis reveals that since the late 1960s, the share of low-wage workers with at least some college has increased from 17 percent to 46 percent.

Now, it could of course be the case that employers’ skill demands are just outpacing the educational upgrading that has occurred. But while such upgrading is extremely and especially important in generating upward mobility for less-advantaged children, as I pointed out in a recent post, economists are increasingly recognizing that inequality and wage stagnation cannot be explained by unmet skill demands alone.

This next chart is quite revealing in this regard. It plots unit labor costs against unit profit costs. That is, one of the things implied by all of the above is that accounting for productivity growth (which embodies the skill of the labor force), profits have outpaced workers’ earnings. These unit labor cost and profit measures offer precisely that — the growth of wages and profits, net of productivity’s growth (for technical reasons regarding the treatment of interest income, the data are published only for nonfinancial corporations, but including finance would probably strengthen the results). Compensation net of productivity is up a measly 10.5 percent since 2000, while profits net of productivity have doubled. And remember, that’s average compensation. Median compensation has done even worse relative to productivity.

Stagnant wage growth is an extremely deep problem. It is a primary root of the inequality problem and it strikes at the heart of what has historically defined the American social contract: study, work hard, play by the rules and you’ll have the opportunity to get ahead.

If we’re ever going to do anything about it, we must see beyond the marginal product theory, which leads policy makers to exclusively promote more education (again, that’s a crucial part of the solution). Fortunately, there’s much better economic theorizing about wage formation that introduces the crucial concept of bargaining power (Robert E. Hall and Alan B. Krueger provide a useful summary).

In some of these models — the ones that make sense to me — the tautness of the job market is a key factor as employers and potential workers hash out an agreement on wages (or not — some negotiations fail). The employer would like to offer just enough to make the hire, and if there’s a line outside her door, that amount goes down. For the worker, it’s the opposite. As Professors Hall and Krueger note, “the job seekers’ bargaining position … is much stronger if the next job prospect is easy to find.”

The economist Lawrence Katz, an important thinker is this debate because of his deep contributions to the literature on education as a wage determinant, agrees: “The only moments we’ve had of broadly shared prosperity have been in tight labor markets.”

Absent more individual and collective bargaining power for the vast majority of workers who lack it, some of whom have college degrees, we will be hard pressed to turn these wage trends around. Such power is not the only determinant of wages, but it may well be the most important and the one most sorely lacking.