Wages, Productivity and inflation

Posted on May 08, 2016 by Tom Healy

Tom Healy, Director NERI
Tom Healy, Director NERI

Wages are rising again for most workers in most sectors of the economy. The increases are moderate and in many cases the settlements made stretch out over a number of years and are, typically, related to ‘productivity’ measures.  Growth in wages and in productivity is good news all round. Yet, the pace of change and the distribution of change by sector and occupation has wider implications across society and not just for those immediately impacted. A policy of wage repression practiced in many European countries (Germany being a noted example during the lean years of the late nineties and early noughties) has been cited as good reason for competitive wage restraint as a means of competitive trade advantage on global markets - not just for sales of goods and services but for attracting inward investment and containing business costs.

Yet, the momentum of change in the Irish economy – one of the most open and internationally exposed among the EU28 with the exception of Luxembourg – has been towards increases in wages, productivity and competitiveness in the modern, high-skilled and traded sector.  At the same time, traditional sectors with more of a focus on domestic markets have seen modest developments in wages and productivity not least in the services sector where productivity is notoriously difficult to measure.

But by how much is productivity rising?

By how much has productivity increased in the transport sector? If, as we can observe, 95% of the people on the train or the bus this morning glued to their phones courtesy of free wifi provided by the transport company can we be sure that the service we getting has improved not just in the time it takes to get from A to B but by virtue of the ‘free goods and services’ we benefit from (I fully acknowledge that a significant number of people do not have the luxury of smartphones, internet access let alone access to transport because of where they live or because of some personal constraints). The financial services sector is another example. More and more banks are becoming distanced from customers, I would suggest, in terms of substitution of online banking for direct contact. Which would one prefer – wait 30 minutes on a Thursday evening to cash your wages cheque in 1980 or check how much overdrawn you are online in 45 seconds (assuming that broadband covers the region where you live)! The point is that productivity is a moveable feast and issues of quality, preference, values complicate the mundane task of quantifying output and, for that matter, input in some production function of services.

There has been a remarkable and positive turnround in the fortunes of the economy in the Republic of Ireland – almost as fast and unexpected as the crash that took all of us by surprise in late 2008 and throughout the following two to three years.  Employment is growing again, unemployment is declining slowly while output, income and expenditure are all rising rapidly. Profitability is surging ahead in many of the modern, multinational and trading sectors as is evident from corporation tax returns.  True, some of this is inflated by technical and statistical classification issues but it is clear that the underlying growth rate in GDP, GNI or investment is very significant. One is mindful, also, of the 100,000s of children in deprivation, lone parents, indebted and distressed mortgage holders and precariously employed persons for whom talk of ‘recovery’ is not true.

The picture in Northern Ireland is much less rosy even though the impact of the economic collapse and subsequent fiscal austerity was not as dramatic there compared to the Republic.  The economy in Northern Ireland is growing again but at a very modest rate compared to the South.

What explains the 'recovery'?

Many factors – external as well as internal explain the resurgence in economic activity south of the border. The idea that the people ‘took the pain’ and enabled their elected representatives to make the very necessary and painful decisions fails to convince me. The claim that ‘austerity works: just look at little Ireland and how quickly it bounced back’ does not stand up to critical empirical scrutiny. Time does not permit a proper treatment of this issue but suffice it to say that much of the fiscal adjustment that happened in the period 2008-2012 was done in the wrong way and was coupled with what I would consider a very harmful policy of insulating lenders who had taken a risk but walked away with repayments of loans largely intact and without any write-down.  The ‘rules of capitalism’ were not applied and instead, we had ‘socialism’ for the top bankers and investors. Rapid and wholesale nationalisation of the banking sector might not have equated to the commanding heights of the economy but it came close to it and represented a remarkable and historically unprecedented bail-out of private sector lenders and asset holders at the expense of most citizens who took up the bill by way of reduced public services, cuts in social transfers and higher charges and taxes compared to the situation in 2007.  Young people and new entrants to the labour market paid a particularly high price the anomaly of unequal pay for equal work constitutes a huge challenge for all concerned today not least  but by no means exclusively in the wider public service.

The future is very uncertain

What does the future hold for the economies of Northern Ireland and the Republic? The answer is tied up in part with the future prospects of the UK, the Eurozone, the European Union, Europe and the world. Interest rates, the price of oil, the future political configuration of Europe, the outcome of talks on TTIP (the Transatlantic Trade and Investment Partnership). Uncertainty and risk abound on all sides. The continuing scandal of huge youth unemployment in southern Europe is not consistent with a stable and cohesive European Union and economy in the medium-term.  Ireland – north and south – stands to lose or gain depending on world events.  We simply do not know where we are going to be in 5 years time. We may assume an annual average real growth rate of around 3% per annum but we do not know. A slowing down in the pace of recovery is surely possible and even likely in the medium-term where medium-term is understood in years and not months.

In this context the setting of wages takes place sector by sector and occupation by occupation and grade by grade and even in some cases individual by individual.  The overall rate of nominal wage increase was in the order of only one a half percent in 2015 (using average weekly earnings as a representative measure). Wage increases are likely to pick up this year. It is important to distinguish between wages settlement which could be in the order of 2-3% per annum currently and actual average wage increases as measured by the CSO. The difference is explained in part by shifts in the workforce where certain sectors are growing more than others or where, in some cases, lower paid workers are replacing higher paid ones due to retirement, restructuring etc.

Price inflation and the cost of living

In discussing wages we need to consider two important and sometimes slightly neglected subjects in public discourse

  • The ‘cost of living’
  • The quality and quantity of ‘public goods’ we consume as citizens

There are many ways of measuring price inflation (or price deflation as we had it in 2009). The most commonly used one in recent times has been the Consumer Price Index in the republic of Ireland. I like the CPI because it includes mortgage costs – a reasonable item to include surely in reviewing changes to the cost of living. The standard European statistical measure is the Harmonised Index of Consumer Prices (HICP).  You might be interested to know that the HICP excludes motor insurance, the local property tax and trade union subscriptions! To confuse matters further, the Department of Finance publishes a Personal Consumer Deflator. If we take last year the HICP  increased by 0.1% while the CPI increased by 0.2%. The personal consumption deflator increased by 0.4%. The medium-term forecast by the Department this year is for 0.8% according to the personal consumption deflator and 0.4% according to the HICP. To confuse matters yet further economists and statisticians in Northern Ireland refer to the HICP as the UK ‘consumer price index’. Take your pick! Clearly, price inflation has been extremely low. It does not feel that way for many as we pay more and more every year for public transport (as governments cut back on subvention much more than in mainland Europe) and the cost of motor insurance, third level education, private health insurance are rising sharply. But, we must trust and accept the official national statistics for price inflation ‘on the round’. In the longrun all of these price measures will probably converge with mismatches in opposite directions from year to year. The important thing is to be consistent over time in terms of methodology and referencing.

Social wage

Much more difficult to assess is the quality and quantity of ‘public goods’. How many people in Northern Ireland have private health insurance?  I suspect a small minority going by general UK statistics which suggest something around 10% of the population. Not so in the Republic of Ireland where, to be blunt, just under half of the population pay for the privilege of jumping the queue when it comes to consultations or treatment. The difference on this island is summed up in three letters – NHS. For all its faults and limitations and despite continuing inroads into the public health space in the UK, the NHS has provided since 1948 a single tier universal health service that those closer to Boston on this side of the island only dream of. The relevance of public goods to a discussion on wages is that we get what we pay for in taxes. If we run with an ever lower overall effective tax rate of income that is well below that of most other European countries then we can expect a corresponding level of public service. All of this is relevant to a consideration of wages including that all important and much neglected topic of the Social Wage.  None of this is to deny that improvements in the efficiency and accountability of public services are still required. As in every other sector of the economy we can always do better and do more with the same or even less. In the case of education and health it is a question of doing more with more.

What factors – in addition to the cost of living – are relevant to wage patterns?

‘Productivity’ is surely a key consideration – almost impossible as it is to measure it in the services sector.  A good way of checking out wage trends for the economy as a whole is to watch the share of wages in total national income. The Republic of Ireland is among those countries where the share of wages has declined consistently over recent decades. This has been well documented (such as in a recent Monday Blog here). Part of the explanation lies in the extraordinary growth in the multinational sector where, in spite of much higher wages compared to other sectors the overall share of wages in total ‘value added’ is relatively low. Also relevant to a declining share of wages are long-term patterns of technological change and industrial restructuring. Some labour market economists believe that there is a trends towards a ‘hollowing out’ of the middle in terms of the loss of clerical and administrative support jobs to the rise of high-skill and low-skill jobs at both extremes. This pattern may not be sustained, however. On the horizon is a debate about the impact of artificial intelligence on economic activity with the potential for loss of even some high-skill jobs in the future. We stand at the cross-roads in terms of competition, technology and changes in patterns of collective bargaining. 

Future wage patterns

Economists tend to focus on unemployment or under-employment as an important indicator of ‘slack’ in the labour market and, therefore, potential for wage increases. However, the degree of slack may be very particular to some sectors or occupations and we have to acknowledge the influence of legislation, customs and norms in relation to many areas of pay. The concept of a living income and a living wage has come much more to the fore in recent times.  The traditional pattern of ‘wage leadership’ in key industries or sectors has changed while the development of a parallel Irish economy around large (often non-unionised in the case of new) firms in the multinational sector has changed the context.

Wages are likely to grow in the coming years. The pace of increase will depend on relative demand in different sectors as well as the overall increase in output or productivity not to mention union strength and tactics. If wages were to keep pace with the underlying increase in productivity as well as price inflation over 2017-2021 then a medium-term nominal average per employee annual increase of somewhere in the region of 3-4% seems not unreasonable at least as a starting point. This magnitude includes an inflation increase of 2% per annum (the medium-term projection by the Department of Finance) combined with a Department of Finance projected increase of around 1.4% in labour productivity per annum over the period 2017-2021. But these are very indicative and very average numbers. A war there, a slump here, a gas and gas discovery over there and an exit from the EU or the Euro over here could make all the difference. A significant slowing down in the Irish or UK economy could dramatically change things very quickly from fiscal space to wage space to profitability space. If there is one thing economists must admit based on the experience of recent times: for sure the unexpected will happen and the expected may not. The unknown unknowns trump economic forecasting!


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