Labor Markets – Then and Now: An Adverse Supply-side Shock?

Kash discussed the recent good news on compensation last Thursday and the lackluster increase in payroll employment on Friday. Kevin Drum noted how one story thought higher compensation wasn’t good news, and CNN notes one economist found weak employment growth “non-threatening” for investors and policy makers. This economist was likely thinking about monetary policy , which has been concerned about the alleged tightening of labor, which Kash also discussed on Friday.

If Kash is the Jedi Master of charts, I’m likely the Padawan. Kash has been busy graphing not just the average workweek and real wages but also real compensation versus productivity – as well as this discussion on the various measures of real earnings. All that is left to the Padawan is to update my chart on why I put less stock in the unemployment rate than the population ratio. Notice, however, that the employment-to-population ratio did rise a bit last month as the Household Survey showed a much larger employment increase than the Establishment Survey (which was also picked up by one of the National Review’s pseudoeconomists who only think they know more economics than Paul Krugman). Note also that this ratio is still far below the levels enjoyed five years ago. While I can understand the FED’s reasoning for tight money five years ago (although why George W. Bush and Lawrence Lindsey were proposing fiscal stimulus back then puzzled me), I’m in the camp of those who would argue against tight money now as the labor market still appears weak to me.

Kash also noted that DeLong-Samwick dialogue how to read the employment-to-population ratio and the decline in the labor force participation rate – with Brad’s contribution being that compensation has not increased as fast as productivity, which he interprets as a signal that the demand for labor curve has shifted downwards versus Andrew’s implied suggestion that the supply curve has shifted inwards. In addition to Kash’s charts, let me add this chart of real wages and real fringe benefits using the data source suggested by Brad. Whether real wages have risen slightly in the last couple of years (Kash’s chart) or fallen slightly (my chart) depends on which subsector we are talking about (albeitLawrence Kudlow would have the non-supervisory employees rejoice in the fact the nominal wages rose at all), but the main message seems to be that much of the increase in real compensation comes from fringe benefits such as health insurance premiums, which Kash claims “yield little or no actual improvements in health care for the average person”.

Kash later notes:

But let me reiterate the point that I have made several times now: just because real compensation is rising, that doesn’t mean that people are better off, particularly if nearly all of the gains are just going to paying higher health insurance premiums. This data persuasively illustrates that nearly all of our real compensation gains today (and I do think we’re seeing them) are being eaten up by the monster that we call a health care system in the US. Until we address the profound inadequacies of our health care system, this trend will only get worse.

Kash has made this point several times. I would like to add a couple of items – one being the implications of this insight for the labor demand / labor supply debate and the other being an attempt to offer a wee bit of empirical evidence drawn from BLS data on Employer Cost for Employee Compensation. In various papers on the effect of minimum wages, Walter Wessels has argued:

when employment costs rise, employers may eliminate some fringe benefits such as training, paid insurance, transportation, or parking, so that the total compensation of workers does not rise even though wages increase. Employers may also raise their expectations of workers, including requiring greater work effort, punctuality, and less absenteeism in the workplace.

His labor demand = labor supply model asserts that labor demand depends on the cost of the employee compensation package, while labor supply depends on the value to the worker. Kash is arguing that an increasingly inefficient health care system has drives a wedge between the demand for labor curve and the supply of labor curve. In other words, there is an adverse supply-side shock from unfortunate policy decisions that have let the health care system become even less efficient.

The beginning point of my empirical comment comes from the paper by Joseph R. Meisenheimer:

Paid leave and health insurance benefits also compose large shares of employers’ total compensation costs, with each type of benefit accounting for 6.5 percent of the total cost in December 2003. Increases in health insurance costs have received considerable attention in recent years from both employers and workers. From December 2002 to December 2003, the Employment Cost Index for private-sector health insurance rose 10.5 percent (not adjusted for consumer price inflation). In the prior year, employers’ health insurance costs rose 10.2 percent.

While a 20% nominal increase over two years is quite substantial, note that health insurance costs are only a portion of overall fringe benefits. The following table breaks down real compensation costs (2000$ using BEA’s PCE deflator) into wages, health insurance costs, and other fringe benefits for 2002QI versus 2004QIV. The reported Real wage increases were a mere 1.4%, while the increase in real health insurance costs was 17.2% even though workers may have received less insurance. Also note, however, that the real cost of other fringe benefits appear to have increased by 8.3%. Of course, higher costs are not necessarily an indication of greater value. Kash’s inefficiency effect appears to be part of the growing wedge between real wages and real compensation cost and possibly a reason for us natural rate of employment-population ratio = 64% types to be more humble in our estimates of how large the Keynesian output gap is.

Alas, the Federal Reserve cannot control the ill-advised actions of our Congress and the White House (although a few of us wish its Chairman would refrain from campaigning for some of these ill-advised proposals). Those who have to set monetary policy on the basis of whether we are near full employment might wish to ascertain whether the natural rate of the employment-to-population ratio is as high as 64% level I have suggested versus whether this natural rate has declined. I doubt that the natural rate has declined to 62.7% but I could be wrong. What I will continue to argue, however, is that looking at the unemployment rate as one’s guide is strange unless one is sure that the labor force participation rate would be once we reach full employment.