Is Compensation Finally Catching Up?

The US economy has achieved incredibly rapid productivity improvements over the past few years. Yet until recently, firms have been able to keep those gains to themselves rather than increasing the compensation they offer their workers. Over the past year or so, that appears to have started to change. From today’s BLS release on productivity and compensation:

Productivity rose 2.9 percent in the nonfarm business sector during the first quarter of 2005, reflecting a 4.0-percent rise in output and a 1.1 percent increase in hours of all persons (table 2). In fourth-quarter 2004, nonfarm productivity grew 2.3 percent as output grew 3.7 percent and hours increased 1.4 percent.

Hourly compensation increased 6.3 percent in the first quarter of 2005. After revision, this measure grew at a 10.2 percent annual rate in the fourth quarter of 2004–faster than in any quarter since the first quarter of 2000, when hourly compensation increased 14.5 percent. When the rise in consumer prices is taken into account, real hourly compensation rose 3.9 in the first quarter of 2005. Real hourly compensation had increased 6.4 percent in the previous quarter.

This is a welcome change. The economic downturn of 2001-03 caused a significant wedge to grow between what workers were producing and what they were receiving in compensation, as the following chart shows.

Source: BLS.

The divergence between productivity and compensation in the period 2001-03 was almost certainly due to the weak US labor market during that period. As the labor market in the US has strengthened (note that I’m not saying that the labor market is strong right now, just that it has strengthened relative to where it was during 2001-03) workers have begun to be able to extract higher compensation from their employers.

Two last notes. First, it’s worth mentioning that “globalization” or “international competition” are not likely explanations for the weak compensation growth of the period 2001-03. The following chart shows one simple measure of international competition on the US: the ratio of imports to total GDP.

Source: BEA, NIPA.

If greater international competition causes lower labor compensation, then we would have expected to see compensation do poorly during 1998-2000 and 2004-05, when imports were growing rapidly, and for compensation to do well during 2001-03, when imports went down. In fact, we see just the opposite.

Finally, one should also keep in mind that higher compensation does not necessarily translate into higher take-home pay for most workers. Much of whatever increases in compensation that workers have received in recent years have been simply in the form of higher health insurance benefits, as the last chart illustrates.

Source: BEA, NIPA. Series deflated by the PCE deflator.

Whether or not individuals are actually benefiting in any real sense from their increased compensation is a whole different topic. Given that much of those compensation gains simply go toward covering large increases in health insurance premiums that yield little or no actual improvements in health care for the average person, I’d say the answer is no. For more on this, check out some of our posts under “The U.S. Health Care System” on the left of this page.

But at least compensation is starting to rise. This is a good indicator of some slowly gaining strength in the labor market, and with luck it will continue a bit more before the next economic slowdown…

Kash