One of the most important lessons from Econ 101: Nominal figures tell us nothing.
The media likes to report nominal figures which can give news consumers a false sense of the trends. But in a monetary economy with inflation (increasing prices), nominal figures tell you almost nothing. Using real numbers, which are adjusted for inflation, give you a much better sense of what is really going on in terms of actual gains and purchasing power for workers. For example, if your salary has increased 2-percent, but the cost of everything has also increased 2-percent, you are not earning more than you did before in real terms. So when you see news media reporting nominal figures, you should be skeptical of any reported trend, and what it means for the economy, until you see the REAL figures.
Exhibit A: Bloomberg recently reported that compensation benefits are going up. Reporting on the Employment Cost Index (ECI) from the Bureau of Labor Statistics (BLS), their key takeaway was that these “latest results [from the report] indicate employers are offering better compensation packages to workers amid an ongoing shortage of qualified workers”, and more or less leave it at that. Exhibit B: The Wall Street Journal, reporting from the same ECI release, declared “ U.S. workers received their biggest pay increases in nearly a decade over the 12 months through June, a sign the strong labor market is boosting wages as employers compete for scarcer workers.” Other media outlets that have picked up on the good news have shown a little more skepticism, but little effort to find out the REAL story. The problem is that this is not exactly what the ECI report said in the first place, and it doesn’t account for inflation.
The first thing you should know about the Employment Cost Index is that it reports total employment compensation costs in nominal terms across the economy. It also breaks it down into private and public sectors. Looking at private sector employment costs, the report does indicate that compensation costs have risen 2.9-percent year-over-year (i.e. in the past 12 months). This includes both wages and salaries (which account for 70-percent of compensation costs) and benefits (which make up the other 30-percent).
Let’s focus on wages and salaries first. According to the ECI report, wages and salaries increased in the last 12 months 2.9-percent in nominal terms. Conveniently, the BLS also releases a report on REAL wage earnings. According to the most recent release, from May to June 2018, real average earnings increased only 0.1-percent. That’s one-tenth of a percent people, that’s nothing! And when the BLS looked back further, it found there has been no change at all in the past year: “From June 2017 to June 2018, real average hourly earnings decreased 0.2 percent, seasonally adjusted. Combining the change in real average hourly earnings with a 0.3-percent increase in the average workweek resulted in no change to real average weekly earnings over this period.” Let’s breakdown what that means. Private sector workers are earning less than they were 12 months ago, and are working more hours to makeup for it to maintain the same level income. That is a much bleaker picture than what the nominal figures suggest.
What about the benefits in these “better” compensation packages. It should also be noted that ECI includes healthcare insurance benefits. The report does indicate overall benefit costs have increased by 2.9-percent between June 2017 and June 2018, but it also indicates 1.9-percent of that increase was due to increasing health insurance costs. So that leaves 0.3-percent increase in the last 12 months for monetary benefits other than healthcare insurance. But this is still a nominal figure. After you account for inflation, it evaporates. The most recent release of figures for inflation by the BLS as measured by the Consumer Price Index shows an increase of 2.9-percent for the same period before seasonal adjustment. But even after adjustment, what are the chances it gets revised down more than 2.6-percent to break-even on those “greater” benefits workers supposedly are getting? Quite low you can be sure. Which means that when it comes to REAL gains in benefits, workers are actually in the red while real earnings have not moved.
I’m not sure who all gains from a rosy picture of the economy. Certainly President Trump. Some media outlets perhaps are just looking for a positive story given our democracy may be on the verge of implosion. Who knows. But these supposedly economic literate media outlets are not doing you any favors by reporting nominal figures that misrepresent what workers in the economy are actually experiencing in terms of real purchasing power even as real profits continue to increase for businesses (see Figure above). This little extra piece of context makes the story even more bleak. Businesses are earning more in real terms than they were before the recession, but not sharing the gains with workers whose purchasing power is eroding to the extent that they need to work more hours to maintain their standard of living. That is the REAL story behind these ECI numbers, but that would be the less than flattering for the “strong labor market” narrative.
Given the recent Supreme Court decision in Janus v. AFSCME, the public sector union case, I thought it worth explaining why labor unions are so important aside from the usual explanations given.
In 1956, Richard Lipsey and Kelvin Lancaster, developed the Theory of Second Best for the Walrasian model. They demonstrated in their paper that when one optimality condition cannot be satisfied, manipulating other variables away from optimum can create a second best outcome in an economic model. In other words, if one market distortion cannot be removed, then a second best equilibrium can be achieved by imposing a second market distortion. The Theory of Second Best can explain why labor unions are not distortionary, but counter distortionary to the general state of the labor market.
If you have taken an introductory economics course, you might be vaguely familiar with the argument that unions create a distortion to the economy. By unions demanding higher compensation above the equilibrium wage, the union creates a surplus of labor since labor demand at the higher wage is lower than the equilibrium wage. The problem with this argument is it assumes a perfectly competitive labor market. The reality is that in most labor markets have significant imperfections. Labor market frictions are pervasive. Regional monopolies are pervasive creating monopsony markets for certain labor skills (if you are unfamiliar with the concept of monopsony, I have written about it before here). Even while certain regions encompass enclaves of industry, differentiation between firms can produce inadequate alternatives based on individual preferences. Commuting distances and tenure benefits create disincentives to move between jobs. Imperfect information between firms and workers is also a crucial assumption of the perfectly competitive market, yet we know perfect information is not possible, nor even desirable to both parties. All of these market imperfections give firms a non-negligible influence over wages; evidenced by the fact that real wage earnings have been stagnant since the 1970s.
The natural state of the labor market is a distorted state which carries with a less than social optimal equilibrium. The market imperfections are not easily corrected or removed. Technology may reduce search frictions by increasing the probability of matches through online job search sites, but fixing geographical distances, compensating differentials, and reducing the monopolies requires structural adjustment to the economy that come at no small cost. This is why unions are so important. They were created in response to these imperfections which gave firms undue influence over wages. Unions become a countervailing force to the monopsony power of firms.
The decision in Janus of course has dealt a significant blow to financing of public sector unions. For those that don’t know—which is understandable given our crazy news cycle these days—this Supreme Court overturned 41 year old precedent set in Abood v. Detroit Board of Education (1977) which permitted unions to charge an “agency fee”. Agency fee was a compromise the court made for non-union employees who may have disapproved or did not want to contribute to the political activities of unions, but nonetheless enjoyed the compensation gains earned from union bargaining activity. Since non-union employees were only paying for bargaining activity, agency fees were less than actual union dues. The arrangement seems to have worked pretty well for over 40 years until Janus, which ruled that agency fees were unconstitutional. This puts unions, whose influence and power have already been diminished considerable over the last couple decades, between a rock and a hard place. The law of the land is that unions still have to represent all employees of a company, state, or municipal government. However, it can no longer charge the agency fee, which will create free riders, and unions will now have to divert funds into union member recruitment and retention. There is no question it’s a significant blow in the short-term, but there is an argument to be made that it could make unions stronger in time. Only time will tell. And it’s imperative that they do because unions are crucial the balance of power between monopolies and labor, and the theory of second best explains why.
Aaron Medlin is a PhD student at the University of Massachusetts Amherst studying macroeconomics of private debt, monetary economics, international finance, and comparative economic systems.