22 March 2023 Other

Could High Wages Help Solve the Productivity Problem in Advanced Economies?

One of the more worrying global trends in recent decades is that economic growth in advanced economies has fizzled out. The economic historian Robert Gordon suggests the US economy is struggling with demographic trends like a rapidly ageing society, but he also believes that the easy gains from innovation have been made. Some economists now argue that it is getting harder to find new ideas – research productivity has fallen sharply, which has obvious implications for future economic growth.

Labour productivity growth has fallen for decades now (Chart 1). Following World War II, US productivity growth averaged 2% for several decades. There was a modest decline in the 1970s followed by a temporary surge during the 1990s internet boom. However, with the Global Financial Crisis, productivity declined substantially and has only been averaging 1%.

One of the biggest puzzles in modern macroeconomics is why all the technological changes in recent decades have not led to more economic growth. Maybe recent innovations have increased consumer welfare instead of labour productivity – think of streaming services and social media. Or maybe life-changing innovations are getting harder to find.

Whatever the reason, the decline in productivity growth is impacting economic progress. Productivity gains are the most important contributor to long-run economic growth and thus improvements in living standards. Think about an economy in which per capita income is growing at 2% annually. With such a growth rate, incomes roughly double every 35 years. If per capita growth slows down to 1%, though, it takes a full 70 years for incomes to double.

The economic slowdown across advanced economies has therefore led to slower improvements in US and European living standards than in the decades after World War 2 when growth rates were more impressive.

Today’s Labour Market Has Seen Deep Structural Changes

Things may be changing for the better, though. The Covid-19 pandemic created deep structural changes in the economy and labour market. For the first time in many decades, labour markets are suddenly super tight. The ratio of vacancies to unemployed has surged throughout 2021 and 2022 to historic highs. Employers are struggling to fill positions, and this means bargaining power is shifting back to workers.

With more bargaining power, workers have also been able to push for more flexibility and higher wage growth. And in this tight labour market, job switching has increased too. Data from the Fed shows that job switchers are experiencing higher wage gains over the last two years than ‘stayers’, and employers are realizing they must offer higher salaries in this inflationary environment or workers will go elsewhere.

Nominal wage growth has been the highest in 2021 in more than 40 years! Even on an inflation-adjusted basis, workers have not seen wage growth this high for many decades (2022 saw a temporary drop due to the spike in inflation).

Another area where workers have gained some bargaining power is related to non-monetary benefits. The rise of remote work during the pandemic will also most likely become permanent. Workers save massively on commuting costs, both in terms of times and money, especially in large metropolitan areas like London. Daily time savings of remote work easily exceed one hour across most advanced economies. A recent Bloomberg report outlines that most workers would quit their job in London if employers were abandoning the hybrid model of working from home.

And employers gain as well. New research shows that the daily time savings from working from home are split between workers and their employers, effectively increasing working time. Most companies have implemented the hybrid model for workers that can work from home and only enforce a couple of days in the office per week.

Will We See Higher Productivity Growth Soon?

Insights from research into the Industrial Revolution suggest labour scarcity and British high wages relative to the rest of the world created an incentive to produce labour-saving technologies. Given we are currently seeing very tight labour markets across advanced economies, which is leading to higher wage gains, could this lead to technological developments and ultimately higher growth rates?

Economist Daron Acemoglu’s research shows how technological improvements in an environment of labour scarcity are generally labour-saving. And if labour is the constraint, then labour-saving technologies will lead to higher growth. As many advanced economies face demographic challenges and will soon see their working-age population stagnate or even shrink, companies may have an incentive to adopt and create labour-saving technologies that can compensate for those headwinds.

With the tight labour market, businesses are now reporting that labour is the most limiting production factor. While labour scarcity is also constraining growth as open positions remain vacant, it will increase the incentive to adopt technologies to alleviate the problem.

The US economy saw a temporary surge in labour productivity during the start of the pandemic. The enormous amount of job-switching and reshuffling that happened in the labour market over the last two year were probably a temporary headwind to productivity. However, this will now subside as the “Great Resignation” ends. And with unit labour costs being much higher than before the pandemic, businesses will increasingly look to automation and new technologies to reduce cost.

Large language models (LLM) are one such example how new technologies can potentially boost productivity in the years to come. In a new NBER working paper, Anton Korinek outlines how ChatGPT can support research on various fronts. ChatGPT can improve writing by synthesising, editing, and evaluating large texts. It can also help with idea generation and background research. Finally, it can also support with coding and data analysis. Artificial intelligence has come a long way in recent years and hopefully will turn out to be the productivity booster that advanced economies desperately need.

Conclusion

Predicting future innovations or the rate of technological progress is a fool’s game. However, there are reasons to be hopeful.

The labour market has seen some massive changes since 2020, and workers gave gained back some of the bargaining power they lost during the globalisation and financialisation in 90s and 2000s. We are now seeing extremely tight labour markets across advanced economies, which is leading to higher wage gains.

This is a reason to be optimistic. It is good for workers and might turn out to be good for the entire economy as well if more labour-saving technologies are adopted that lead to higher growth rates in the years to come!