Daniel Starr

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April 13, 2005

Will You Wait Twenty Years for Your Next Raise?

Basically, your paycheck is going to get smaller. We don't yet know it for certain -- the latest numbers could be just a fluke -- but it looks as if most Americans working at ordinary jobs may be in for twenty years of being left stranded even as the economy grows. You can get a taste of what's coming from this New York Times article.

Here's the problem: for the first time in decades, your average real salary has fallen in a year when the economy was strong. By the numbers, when you add in non-salary compensation (mostly health benefits), workers got less than half the gains that would be normal for this level of economic growth -- and much of the raises that were given out went to the top 5 percent of workers. Shrinking paychecks during a recession is grimly normal, but we're years past the 2001 recession. Of course, no one gets big raises when the economy is stagnant, like it was in the 1970s. But the economy as a whole is booming now. In 2004, most people in your community probably had their paychecks stay flat or shrink in real terms -- during a year when our economy grew by a strong 4%.

If you're thinking a strong economy should have meant big raises, you're right. Since World War II, about 75% of the country's growth has usually turned immediately into salary increases for ordinary workers. What's that translate into? Well, for an ordinary worker in a year like 2004 when the economy grows by about 4%, you could expect a real raise of about $1500. But last year, only about 30% of the country's growth went to salaries and benefits -- that translates into a typical real raise of $600. The worst part is those shrunken gains are likely to continue.

We tend to think that it's only natural for a growing economy to make workers better off, but the dirty little secret is that's not actually guaranteed. When it's easy for workers to switch jobs, then it's easy for workers to hold out for good pay, and ordinary people end up capturing a big share of economic growth. But when it's hard for workers to find jobs, and easy for companies to replace unwanted workers, then companies keep most of their profit growth for themselves and their investors -- and workers get screwed.

It all comes down to unemployment. The closer unemployment comes to zero without setting off inflation, the bigger the share of economic gains go to employees. A full-employment economy is a big-raise economy is a "rising tide raises all boats" economy. But if for some reason unemployment is stuck at a level of 6% instead of 4%, that doesn't just mean 2% of workers can't find jobs; it means 90% of workers find it very hard to get the leverage for a good raise. And that's where we're at now in America: unemployment is stuck at a higher level than it should be. Modern business practices made it possible in the 90s for the economy to run at 4% unemployment without inflation -- yet now unemployment is almost half again as large. As long as unemployment stays high, most Americans are going to see their paychecks stay flat or shrink.

So why is unemployment high? Because companies are running out of raw materials and customers before they run out of workers. There's no point in a construction firm hiring more workers when it can't afford to buy more concrete and steel. There's no point in a factory running extra shifts when it can't afford to burn the oil and gas it takes to keep the machines running. And there's no point in a hospital hiring more nurses if it doesn't have more patients. In the last few years, supplies and new customers have been scarce, while workers have been plentiful, and so companies have been expanding to the limit of their supplies and customer bases instead of to their limit of available workers; which means high unemployment, which means no raises.

There seem to be two big reasons for this paycheck-starving state of "scarce supplies, scarce customers, plenty of workers": one is China and India connecting themselves to the industrialized economy, and the other is the shift in America away from producing manufactured goods and toward producing services. If you add up the populations of the industrialized countries, you get about 2 billion people. China and India have another 2 billion people. Now that both China and India have finally gotten their laws, roads, and telephone systems to the point where all kinds of businesses can set up shop in those two countries, essentially the supply of workers in the world has just doubled. The same amount of new business and the same amount of raw materials are suddenly trying to spread themselves over twice as many workers. China and India represent for the rest of the world a drought of materials, and a glut of workers. Eventually China and India will become developed enough that their citizens will buy lots of consumer goods and services from the rest of the world, so that they'll create even more new businesses in other countries than they suck away. But that's going to take twenty years.

But there's another plausible reason that America has more workers than business openings is right here at home: we've shifted to a service economy, but haven't yet figured out how to quickly grow service businesses. When most Americans were in the business of making products that sat on shelves, it was straightforward for successful new businesses to grow rapidly: they bought or built more factories, turned out more goods, and sent them out to more store shelves to be sold. But now the typical new American job is as a nurse in a hospital, or a hairdresser in a salon, or a technician in a computer repair firm. Bringing in new business to a hospital, salon, or computer repair shop turns out to be a lot trickier and slower than putting more refrigerators or fuzzy dice into stores.

Consider the difference between "picking a good car" and "picking a good doctor." The average American uses several thousand dollars a year in (mostly insurance-paid) medical care, and by the time you're 40 it's easy to feel that a quality doctor is probably more important than a quality car. Yet between the two purchases, both important and expensive, you can get an absolute flood of information from Autobytel, Edmunds.com, Car&Driver, etc. about just what car will be best for you -- but almost no information beyond friends' recommendations about what doctor will be best for you. Or consider "picking the right TV" versus "picking the right plumber." Or "picking the best shirt" versus "picking the best hair salon".

As buyers, we're not able to research and hunt for a really good deal in services the way we take for granted when looking for physical goods. And that means that the successful service businesses, the ones that want to expand and hire more workers, can't expand their customer base that quickly, so can't hire those workers that quickly -- and so more people stay unemployed, and nobody gets a raise.

In the long run, we'll somehow develop a reputation system for services, an Amazon.com for doctors and cafes and hair salons, and then this country's next Starbucks will be able to expand just as fast as the next iPod. But meanwhile, our shift to a service economy means that we may have too-high unemployment for many years to come.

We didn't have these kinds of problems in the 90s, but in the 90s, the stock market was so juiced up that everybody could expand without worrying about an immediate profit. We paid for that devil-may-care expansion with the recession of 2001, but it now looks like that boom was covering up bigger problems.

So what can we do to get back ordinary people's share of economic growth? Well, there's a stupid answer, a leftist answer, and a technocratic answer. The stupid answer is to cut off trade with India and China. But that would bring huge price rises in all the ordinary goods Indian and Chinese businesses make for us, which give the average familly a trade benefit that amounts to about a ten percent boot to annual income -- so should we really give everyone a ten percent cut in family income now to get better pay raises later? The leftist answer is to raise taxes on corporations, investors and the rich to allow a corresponding lowering of taxes, and effective income increase, for the working and middle class. But it's been a long time since we had a tax measure that drastic, and it certainly won't happen unless there's a Democratic President, a Democratic Senate, and a Democratic House of Representatives -- which is three more than there are right now. The technocratic answer is to have the government make it easier for businesses to hire more workers, whether by taking up more of the costs of health care, or giving credits or low-interest loans to expanding businesses, or any of a number of policies. But historically politics tends to corrupt these kinds of government interventions and make them misfire. So there are no easy answers.

On the other hand, the 2004 numbers could be just a fluke. Maybe this will all go away. But maybe, with India and China providing tons of workers and using tons of materials, with American service businesses at home not yet able to expand their customer base the way manufacturing businesses could -- maybe we're in for a long nasty decade or two where unemployment is too high, and worker leverage low, and nobody but the top few get a good raise.

It's happened before. Back in England in the mid-1800s, an amateur economist looked at the historical data and observed, correctly, that the course of English economic growth had somehow made ordinary workers worse off: to take the crudest measure, an English peasant of 1700 could count on getting significantly more to eat than his descendant in 1840. As it happened, just at the time this fellow was writing a book on this apparently inevitable "immiserization" of the working class, things were changing around. From the mid-1800s on, new cheap-commodity businesses began to expand their customer base and soak up the available labor at a huge rate, and the Englishman of 1900 lived better than his grandfather. Today, the Englishman of 2005 enjoys medicine, entertainment, and even food and clothing options that are not only better than an English peasant of 1705, but better than even an English nobleman of 1805. But that author of political-economic books in the mid-1800s didn't know that things were changing; he thought that the workers' share of economic growth in the past he could observe was going to continue to be the workers' share in the future. As a result, this author made a bunch of confident economic predictions, all based on the future being just like the past, all disastrously wrong. We shouldn't make the same mistake.

The political economist's name? Karl Marx, author of The Communist Manifesto.

[E1] Brad DeLong is also twitchy about this, but not as twitchy as I am: he has his best-guess explanations here; Tyler Cowen comments here. Matt Yglesias has his bemused take here.

[E2] Added link to the Beltway Traffic Jam and the Mudville Gazette.

Posted by danielstarr at April 13, 2005 04:42 AM

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