In this series, I will be examining an economic event known as The Great Decoupling its causes, and how they drive economic inequality. The first part of the article will deal solely with delving into the background of the Great Decoupling and developing a theory for what caused it. Part 2 will go into wealth and income inequality and how they are caused/driven by those factors.
What is The Great Decoupling
The Great Decoupling is a term that has been coined to describe the sudden divergence between productivity growth and wage growth in the early 1970s. Prior to that going back to at least the end of World War 2 wages and productivity moved in lockstep indicating that they were tightly coupled and that in effect workers were claiming a constant percentage of their growing productivity. You can see this graphically in images like the one below.
And that graph does tell us that something profound happened to the economy in the early 1970s and if you look closely at the graph that it is clear that this event was not a form of slow gradual change but rather a specific event that occurred between 1972 and 1974. What the event was the cause for the decoupling of wages from productivity is not so clear.
Before I go into my own theories for what is behind this event, I will go over the 2 most commonly promoted/believed theories and examine them to see if they have any validity to explain the phenomenon.
There are a few other theories for what caused the Great Decoupling but none of them are particularly widespread or developed as these and so I will not go into them but suffice it to say that every theory I have seen proposed for the cause of the Great Decoupling has been lacking and not backed up by any evidence that fits the evidence
Theory 1: Automation driving workers out of their jobs
The basic idea behind this theory is that as automation of factory jobs grew demand for labor shrank and while it never shrank enough to create mass unemployment, it did deprive workers of the negotiating power needed to demand higher wages. Being an essentially neo-Luddite theory, you will often see this mixed with some claims about declining union membership/power as an aggravating factor.
In fairness, there is some validity to this theory as automation was a growing force in the economy in the post-war years that have accelerated as time went on. There are some flaws to the theory. First, automation did not come onto the scene from nowhere in the early 1970s, it had been an ever-growing force in the economy since the industrial revolution. Had this been the primary driving cause of the Great Decoupling you would not see a sharp line of demarcation where wages and productivity diverged, rather you would see a slow departure as wages gradually fell behind productivity growth. In other words, as automation grew steadily since the 1880’s wages and productivity would never have been coupled in the first place. Second, the growth in automation would have only impacted a few sectors of the economy, primarily manufacturing and farming. Over the period of the Great Decoupling those 2 sectors represented a shrinking portion of the overall economy and as a result, there were plenty of jobs for the workers impacted by automation to go to in other sectors of the economy to find work leaving them with plenty of bargaining power to increase wages.
Ultimately this theory is used to back either an Organized Labor narrative or to support dire predictions of a coming singularity where automation renders huge percentages of the workforce obsolete and while that may or may not have some validity going forward it is a very poor fit to describe what actually happened to the economy between 72 and 74. The best you can say is that Automation was one factor among many that helped keep wage growth decoupled from productivity growth, it could not have been the causal factor which initiated the decoupling.
Theory 2: Deregulation and tax cuts for the wealthy transferred ever-growing wealth from workers to capitalists
This is your standard Progressive/Neo-Marxist talking point. Basically, the greedy rich people convinced the government to change the rules so that they can seize ever more money from the proletariat. Often by having government itself redistribute the income/wealth upwards through cuts in services to the poor being funneled into tax cuts for the rich. Unlike with Theory 1 however, there is pretty much no validity to this claim whatsoever.
As the graph shows, the deviation between real wages (real wages have been adjusted for inflation) and productivity are clearly indicated to have occurred suddenly between 1972 and 1974. For government regulation or tax changes to be the driving force, there would by necessity have had to have been some major new legislation on taxes or regulations that drove the change within a handful of years immediately prior to the time period in question. What we instead see in the years immediately prior to the decoupling event is a period of massive increases in regulation with the government going so far as to impose wage and price controls as well as the creation of 2 of the largest and most powerful regulatory bodies in our government, OSHA and the EPA. On Taxes the only significant changes being the imposition of entirely new payroll taxes and while those taxes were not progressive in nature, they were small and offset by massive increases in welfare spending transferring income to the poor. You do not see significant tax cuts or pushes for deregulation going into effect until 1982 a full decade after the decoupling event.
The best factual case that progressives and left-wing economists can make is that the decoupling was initiated by something else and then reinforced by the tax and regulatory changes of the Reagan administration and even that is a weakly supported claim based on the evidence.
What really happened
Admittedly not being a trained economist or having access to all of the data to back this theory up or prove it this is just a theory but what I can say about what is to follow is that it is a far more complete vision of what happened and is totally consistent with all of the evidence which I took into account.
Before we can really understand what drove the decoupling we must understand when and how it happened. If you look very closely at the graph in the image you will see that in 1972 productivity and wages remained in synch, in 1973 they had begun to diverge however the divergence was within what was expected based on how the 2 metrics had moved in the past and by 1974 the 2 metrics were moving along completely different curves. This is a very sharp line of demarcation it can be placed to somewhere in an 18-month period from the start of 1972 through mid-1973 that a 24-year-old trend suddenly changed. Since it was not some kind of a gradual event there must have been a specific change that drove it and it had to have occurred no earlier than 1970 and no later than 1973. When we look at history there happens to be just 1 significant political-economic event that matches this time period, the end of the Bretton Woods system.
What was the Breton Woods System? Following World War 2 the major nations of the world agreed to a system of international currency valuations with other currencies being marked to the dollar and the dollar being directly convertible into gold. The system worked well enough for a while, but it was originally based on the political and economic realities of 1944 where most of the economies of the world had been smashed to rubble and the only significant industrial economy remaining was the US. By the 1960s that was no longer true, England and France had resumed their prewar positions as major economic players, Germany was not far behind and Japan was an up and comer hot on their heels. Compounding this was the fact that the global economy was growing so much faster than the US economy that the US lacked the gold reserves to sufficiently guarantee the currency.
In 1971 the G10 held a summit to try and rescue the Bretton Woods system devaluing the dollar from $35 to $38 per oz of gold and in August of that year the US stopped the practice of allowing dollars to be directly exchanged for gold by closing the “Gold Window”. These steps did not help, and the dollar reached $44 per oz of gold in 1972. The end came in 1973 when the US and the rest of the world abandoned the Bretton Woods system and the gold standard altogether for a system of fiat currency backed by nothing where exchange rates would be determined by market forces. Under this system, a country can manipulate its currency by just creating new money as needed without the need to worry about whether they have the gold reserves to back that new money. Basically, the end of Breton Woods was the birth of the Inflationary monetary regime.
So now we have a candidate that at least could, in theory, cause the decoupling and fits the timeline, but this is still not a complete enough explanation as a move from fixed to floating currency can merely cause inflation, there is no real mechanism for it to suppress wages in relation to productivity changes, or at all for that matter. While wages generally trail inflation, they do rise with it. So, If the end of Breton Woods were the sole cause of the decoupling event then what we not have seen a decoupling between real wages and productivity as there would have been nothing to prevent workers from continuing to capture the same portion of productivity growth as they had in the past
Now we have a temporal event that acted as a trigger in the decoupling but that event is not in and of itself capable of producing the result we have seen so there must also be other forces at play here, we have to come up with a reason why wages are not only not rising with productivity but also not rising with inflation as they always have in the past and economic theory says they should. We need to come up with some kind of economic force or combination of forces that are capable of completely counteracting inflation and productivity growth which are working to pull wages up and results in wages that have essentially flatlined for 45 years.
The link between wages and prices
Before we can get into what is driving the wage stagnation there is an important relationship we need to understand, the link between prices and wages. Economists argue over whether wages drive prices or prices drive wages, but they all agree that prices and wages are intimately linked. The actual evidence seems to say that the link is bi-directional, that is, an increase in wages in an economy will drive a corresponding increase in prices and an increase in prices will drive a corresponding increase in wages. There is good reason to believe in this bi-directional link between the two as it fits in with much we know about human motivations.
When a worker accepts a wage, he is not really agreeing to the absolute magnitude of the wage he is evaluating that wage in relation to what it costs him to live and the lifestyle that the wage will afford him. If prices are rising, then he will eventually decide that the current wage no longer satisfies his needs and seek a higher one. On the reverse side when a company offers a wage for a position, they are taking the same factors into account and if prices are falling they may not be able to get their current workers to accept lowered wages but they certainly will offer new workers lower wages in response and in extreme cases will replace current higher paid workers with new workers at lower wages. So, this is how wages respond to changes in price levels within an economy.
Prices also respond to changes in wages. If a worker’s wages are increasing, he will be more willing to spend increasing amounts on goods and services that he was in the past with the lower wage, companies seeking to maximize profit will note this increased financial flexibility within the market and adjust their prices higher accordingly. Additionally, if a company finds itself having to pay higher wages for workers that represents an increase in costs and therefore they have a strong incentive to raise prices to compensate for the increase In cost.
So as you can see there are multiple forces on each side of the wage-price equation that work to keep the two in close correlation and when one looks at real wages (that is wages adjusted for price inflation) over this time period one does indeed see that both wages AND prices have been flat.
We find ourselves in a world driven by inflationary fiat currencies which according to pretty much all economic theories should be producing increasing prices and wages, but we find that neither are really increasing at all and so the questions that must be answered are why neither is increasing because if either was increasing then the other would be.
What has been keeping wages down?
In addition to there not having been any upward pressure on wages from increasing prices it boils down to supply and demand. Coming out of World War 2 the US had a rapidly growing labor force as productivity increases in farm work freed up large numbers of workers to go to work in more valuable endeavors and the number of women in the workforce began to grow steadily. This trend was then reinforced by improvements in public health driving up the median age as well as the age to which one was healthy enough to work and eventually the Baby Boomer generation entering the workforce. This was not a problem in the immediate postwar years as the US had a massive export economy and virtually no import economy to compete with thanks to the US being the sole remaining industrial power in the world. Even in the face of this rapidly growing workforce, there was still plenty of work to go around.
By the mid 1960s this began to change, even though the growth in the US workforce was not slowing countries had largely rebuilt from the war and not only could satisfy many of their material needs themselves they were beginning to export large quantities of goods into the US so while there was still plenty of work to go around companies and consumers began to have alternatives to just paying higher prices for US labor.
As time has gone by this trend has only continued to accelerate as more and more countries became first major export players and eventually economic powers in their own right. At the same time technology has been expanding to make the world a more global place. Yes, the US is still the leading economic power, but it is no longer the only economic power so that workers in the US are no longer just competing with their neighbors but with people across the globe who often can work for a tiny fraction of what a US worker needs to earn and still survive. The result of this is massive downward pressure on wages, there is plenty of work and we do not see widescale unemployment but there is little flexibility for workers to place upward pressure on wages because if US workers ask for too much the work will just go overseas.
What is keeping prices low?
The first thing to recognize is that a fiat currency regime need not be inherently inflationary. It is only inflationary to the extent that the money supply grows faster than the growth in goods and services produced within the economy which means that new money created up to the level of the gains in productivity + population growth would simply have the impact of counteracting the natural deflationary tendency of productivity and population growth and work to hold prices steady. It is only money creation beyond this level which could cause actual inflation in prices.
That said with the monetary policies created following the end of Bretton Woods were significantly beyond this point and so a common refrain you hear to challenge economists opposed to the monetary policies of the Fed and US Government is “Where is the inflation”? Prices have been essentially flat for decades even though the monetary base has been increasing near exponentially, so those theories are falsified, right?
Not so fast. The first thing that needs to be realized is that both increases in productivity and population exert deflationary pressure on prices.
Given that an increase in population represents more workers producing goods and services however while this represents a deflationary pressure on prices as there are fewer dollars available for each unit of production in the economy so the monetary supply had to grow by the same proportion as population growth (more specifically workforce growth but they are interchangeable if we assume a steady portion of the population in the workforce) before you would see any price inflation.
Additionally, an increase in productivity means a decrease in production cost. Growing productivity will by necessity produce some combination of a decrease in price, an increase in wages, or an increase in profits the question becomes what proportion of each. That is, who claims the benefit from the growing productivity, the workers, the owners, or the consumers?
All other things being equal standard economic theory says that competition in the market place will result in the companies benefiting from productivity growth trying to realize the increased profits but over time being forced to cut prices to stave off competition and in the end the consumer receiving the benefit in the form of lower prices for goods and services. Workers will also try to claim a portion of this windfall from increased productivity by demanding increased wages. Historically this could be seen by the link between productivity gains and wages. Workers claimed a constant portion of the productivity gains, the company’s owners received a short-term benefit and over time prices would fall so that in the long term the remaining benefit would flow to consumers in the form of a decrease in prices.
Over the period of the Great Decoupling, we have seen quite large gains in both productivity and population which in the absence of an inflationary monetary policy would have served to drive prices down, these trends have been in effect canceling out some of the price inflation that you would have expected to see.
Finally just as workers began to find themselves in competition with other workers all over the globe companies also began to find themselves in the same position. You no longer had to contend with one or two competitors inside your own country you also had to deal with foreign competition both in the form of a foreign entity beginning to import products that compete directly with yours as well as competitors cutting costs and prices by outsourcing their work to foreign workers. This increased environment between companies acted to make it harder for those companies to raise prices to stay in line with inflation and so in order to maintain their bottom line they began to actively find ways to cut production costs which both drove some of the gains in productivity and worked to place yet more downward pressure on wages.
Putting the pieces together
Now we can tell a complete story of how the Great Decoupling came to be.
As a result of a growing workforce and globalization, there has been persistent downward pressure on wages starting in the mid to late 1960s. Due to technological growth and the aforementioned globalization economic productivity began to grow at never before seen rates. The end of the Bretton Woods system and a switch from hard currency to fiat currency accompanied by an inflationary monetary policy acted as the trigger event that allowed those two forces to cause both wages and consumer prices to stagnate in real terms. As productivity continued to grow and the gains from the productivity growth are no longer being divided between workers (in the form of higher wages) and consumers (in the form of lower prices) but are rather being counteracted by inflation. The net impact has been growing productivity with stagnant wages and low consumer price inflation.
Now I cannot prove this theory is true, not being a professional economist, I do not have easy access to the data which could do that but what I can say is that this theory is both more complete and fits the actual historical data better than any other theory as to what is behind this economic event. To the extent that what I have laid out here is true, it shatters the progressive claim that the Great Decoupling is an inevitable result of “unfettered capitalism and proof that we live in an era of unbridled greed.”
Up next, looking into how these factors are the key drivers of income and wealth inequality.