Where Did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income

It's no secret that the gap between the rich and the poor has been growing, but the extent to which the richest are leaving everybody else behind is not widely known. . . . It's like chasing a speedboat with a rowboat.

—Bob Herbert, The New York Times¹

There is no question that a huge gap has opened up between productivity and living standards. . . . Not since World War II have productivity and income diverged so sharply.

—Louis Uchitelle, The New York Times²

The first half of this decade has witnessed a sharp contrast between strong output and productivity growth, on the one hand, and slow employment and median income growth, on the other. The strong growth in output combined with weak growth in hours worked has resulted in an explosion in labor productivity growth, implying an underlying trend that is rising faster than in any previous subperiod of the postwar era. Yet who received the benefits? Median household income actually fell by 3.8 percent from 1999 to 2004 and grew from 1995 to 2004 at a rate of only 0.9 percent a year, a much slower rate than that of nonfarm private business (NFPB) output per hour over the same period, at 2.9 percent.³ Similarly, the median real wage for all workers grew over 1995-2003 at an average rate of 1.4 percent a year, less than half the rate of productivity growth.⁴

The failure of the productivity growth revival to boost the real incomes and wages of the median family and the median worker calls into question the standard economic paradigm that productivity growth translates automatically into rising living standards, as in this quote from Paul Krugman:

Productivity isn't everything, but in the long run it is almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker . . . the essential arithmetic says that long-term growth in living standards . . . depends almost entirely on productivity growth.⁵

This paper should be read in the spirit of a detective novel, whose title might be "The Case of the Missing Productivity Payoff." Our detective story is divided into two parts, macro and micro. The macro part begins with the standard identity stating that productivity growth equals real wage growth if labor's income share is constant. We examine the aggregate data that compare productivity growth with growth in alternative real wage measures, and we then ask how the post-1995 acceleration in productivity growth enters into the econometrics of price and wage dynamics. In past incarnations of dynamic Phillips curves, productivity growth has been a sideshow to the main story, if mentioned at all. The paper provides a new look at price and wage dynamics in order to assess the causes of low inflation in the decade after 1995. In light of the strong demand of the late 1990s, why was inflation so low? What role did the revival of trend productivity growth play, in contrast to other beneficial supply shocks? Did the productivity growth slowdown of 1965-79 play a parallel role in creating high inflation in the 1970s? Can dynamic wage and price equations reproduce the behavior of the changes in labor's income share observed in the data?

The investigation begins with the Gordon inflation model that explains price changes by inertia, demand shocks, and supply shocks but does not include wages. A unique contribution of this paper is then to bring wages back into the study of inflation dynamics and to develop a model that includes both price and wage equations and allows each to feed back to the other. This model can capture the effect of changes in trend productivity growth on inflation, nominal wage changes, and changes in labor's income share. In dynamic simulations of the wage-price model, we find that changes in the productivity growth trend had major effects in boosting inflation during 1965-79 and in slowing it down between 1995 and 2005...