Taking Labor Markets Seriously

Perplexity over economic statistics – in particular, the decades-long trends of flat median real wages and increasing income inequality, combined with a recent disconnect between productivity growth and wage increases – is provoking serious, sober-minded people on the center-left to worry whether there might be something badly wrong with America’s economic system.

In a well-written piece (subscription required) for The New Republic, Jonathan Chait chronicles how the economic numbers are undermining confidence among Democrats in Clinton-style, pro-growth economic policies. The bottom line: what good is economic growth if it only benefits those at the very top?

Ezra Klein of The American Prospect is among the anxious. He’s written frequently on this point, but here’s a typical formulation of the perceived problem as he sees it: 

What worries me about inequality isn’t what it does, but what’s doing it, namely, a decades-long decline in worker bargaining power and the resultant redirection of productivity increases and corporate profits away from compensation and salaries. 

And here’s another:

[T]hrough mechanisms we’re not entirely sure of, the very richest are siphoning off the economic growth before it flows through the middle and lower classes.  

And here’s yet another that suggests what needs to be done: 

The right has tried to explain this accelerating inequality as an unstoppable structural feature of the new economy: It’s the meritocracy, or computers, or benefits, or global trade. Unfortunately, those explanations are largely bull****. Europe also has computers, and trade, and mobility, and benefits, and has easily avoided the widening chasm we’ve seen. So what makes us different?

In a word, power. Or the distribution of it. Europe has strong unions and active governments; countervailing powers that wrest a portion of the pie for their constituencies. We don’t.  

It’s one thing to be concerned generally about inequality: to hope that all people can participate in the blessings and opportunities that modern capitalism affords, and to look for policies that help those who are lagging. It’s quite another when that concern curdles into a belief that the capitalist system is fundamentally unfair – that workers are failing to get their fair share of the value they create because people at the top are hogging the gains from growth. It’s the difference between being an egalitarian liberal and being a collectivist. Or, in other words, between being a progressive and being a reactionary.

Here’s my question for Ezra et al.: is there something wrong with labor markets? Is there some market failure that is resulting in the systematic exploitation of workers?

I can’t imagine what that market failure would be. Labor markets are pretty vanilla, with lots of buyers (firms) and lots of sellers (workers). Local monopsony problems (e.g., the company town scenario) are unlikely to be significant in a diversified, modern economy with a highly mobile work force. I don’t know of any basis for thinking that firms’ competition for workers is less than robust. Accordingly, there are very strong reasons for thinking that wages and salaries are generally bid into line with the value of the various uses to which labor at a given skill level can be put.

As University of Chicago law professor Richard Epstein puts it:

The single most important thing to understand about the operation of a standard labour market in the world today is that it is immensely boring. It should be thought of in terms of the traditional intersection of supply and demand. It does not present any difficult transactional problems or generate negative externalities that require government control. 

In particular, there is no good reason to think that high earnings for managers and professionals at the top of the pay scale are coming at the expense of everybody else. Firms need workers at various skill levels. Exactly the same incentives guide firms when they are hiring highly skilled workers and when they are hiring less skilled workers. On the one hand, competition will cause them to bid up the price of labor to attract workers away from other job openings; on the other hand, concern with profitability will deter them from overpaying. There isn’t some pot of money in the company safe that’s dedicated to wages and salaries, so that more for some means less for others. Hiring and pay decisions are made at the margin: does adding this worker at this price improve our bottom line? For every new hire, whatever the job description or skill level, firms face strong pressures against either underpaying or overpaying.

(Note: I’m leaving aside for now the question of compensation for top executives, which raises complex issues of corporate governance. For now, it suffices to say that, even if CEOs are being overpaid, the problem affects only a tiny portion of the overall labor market.)

So I just don’t see those “mechanisms we’re not entirely sure of” that Ezra talks about. And just asserting they exist, without providing any theory or evidence of how they might work, won’t cut it as serious analysis.

But what about the decline of private-sector unions? Hasn’t that reduced workers’ bargaining power to their detriment?

Yes, it is true that, through collective bargaining, workers can obtain above-market prices for their labor – just as it is possible for price-fixing cartels to obtain above-market prices for their products. But it is also true that, over the long term, unionization has proved a disaster for affected U.S. industries. By cutting into profits, unions have deterred investment and R&D; the rigid work rules they imposed have hampered innovation and competitiveness; and the unsustainable pension and health care commitments they extracted have turned out to be financially ruinous in the long run.

A resurgence in union power wouldn’t improve the system. Union power distorted the system, ultimately with dismal consequences. Yes, some people came out ahead, but many others have suffered from the effects of underinvestment, inefficiency, and burdensome legacy costs.

Contrary to the fears of Ezra and the rest, America’s labor markets are working fine. Strong incentives are in place for companies to pay people what they’re worth. The system isn’t broken.

Of course you can be disappointed that more people aren’t doing better. In which case, you have a couple of options. Option one is to try to supplement the competitive market system. Let the system work, and accept that the prices it’s generating are offering reasonably accurate information about the economic value of different kinds of work. Then try to find policies that will (a) help people increase their value in the marketplace and (b) mitigate hardships for people with relatively low human capital.

Option two is to try to supplant the system by ignoring market signals and squelching competition. In other words, go against everything we know about how best to encourage innovation and wealth creation. Sure, a lucky minority may get windfalls, but everybody else will suffer from the reduction in economic growth.

Option one is egalitarian liberalism; option two is reactionary collectivism. As a libertarian, I am obliged to point out that perverse incentive effects and political dynamics make it very difficult for option one to work well. But option two is flat out doomed to make matters worse.