Besides justifying labor-hostile monetary policy, unit labor costs are often trotted out to blame unreasonable wage expectations for troubled economies’ “lack of competitiveness”. For example, here’s a chart published last year by Paul Mason (ht Paul Krugman):

It is a common trope that labor costs in the European periphery have grown to unsustainable levels, while in the prudent and virtuous North, costs have been contained.

But the chart is misleading. Let’s take a look at the same information presented a bit differently, from a wonderful Levy Institute working paper by Jesus Felipe and Utsav Kumar, “Unit Labor Costs in the Eurozone: The Competitiveness Debate Again”:

Rather than lazy Mediterraneans demanding high pay for little output, what has happened since 1980 is a convergence to prudent German norms. Workers in Southern europe are now paid roughly the same amount per unit of goods produced as their counterparts in Mitteleuropa. This is macroeconomics, so the meaning of a “unit of goods produced” is a fuzzy and contestable. But to the degree that unit labor cost statistics capture what they claim to capture, what they tell us is that European workers, North and South, have come to earn roughly equal pay for equal product.

Southern European workers do earn less overall, simply because they produce fewer or lower-value goods and services than their Northern neighbors. Unit labor costs are not the problem at all: it is the scale of aggregate output. And what determines the scale of aggregate output? Is it the laziness of workers? No, of course not. We all know that when residents of poor countries emigrate to rich ones, the same weak bodies and flawed characters that produce very little at home suddenly explode into economic vigor. The difference is “capital depth”, broadly construed to include all the physical equipment, business organization, public infrastructure, and governance that collude to enable two small hands and a broken mind to accomplish outsize things. Workers’ pay level is not the problem in Southern Europe. It is deficiencies in the arrangement of capital, again broadly construed, that have left Greece and Spain unable to produce value in sufficient quantity to compete with their neighbors.

One might argue that since “capital” is in some sense a scarcer factor in Southern Europe than in Northern Europe, unit labor costs “should” be lower in the South, as a “marginal unit of capital” adds more value than another hour of labor. I have to use the scare quotes though, because there really is no such things as a marginal unit of good institutions, and to the degree that’s even coherent as an idea, it has no relationship at all to financial returns on invested cash. If governance fairies came to Greece and demanded workers surrender some fraction of their per-unit wages in exchange for the institutional capital that enables German levels of productivity, that might be a good deal. (Perhaps Angela Merkel thinks of herself as just such a governance fairy. I don’t think a disinterested observer of her priorities and demands would agree.) In the real world, there is little consensus, with respect either to institutional development or deployment of physical capital, on how, in the context of a tradables glut from its neighbors, Southern Europe could increase its output of tradable goods and services. Looking backwards, with a converging European price level, restraint in unit labor costs relative to the European norm would have meant increased returns to financial capital, and financial capital was emphatically not a scarce factor in Southern Europe prior to the crisis. On the contrary, financial capital was abundant and enthusiastically misdeployed. That misdeployment, the tsunami of bank-mediated money that found its way into real estate and consumer loans rather than the production of competitive tradables, was the primary and proximate cause of Southern Europe’s diminished competitiveness.

In their role as borrowers, some Southern Europeans were complicit in this process. But, as always, it is creditors rather than borrowers who we must hold accountable for bad lending, if we want incentives consistent with good aggregate outcomes.

In their role as workers, Southern Europeans were victims rather than beneficiaries of the wave of malinvestment. Recall that unit labor costs can be decomposed into two factors, the price level and labor’s share of output. Let’s take a look at some more graphs, again from Jesus Felipe and Utsav Kumar:

In all countries other than Greece (including the rest of the “PIIGS”), labor’s share of output has been declining. Rather than winning unreasonable victories, workers have been receiving an ever smaller fraction of the output that they help to produce. The rise of unit labor costs in Portugal, Italy, Ireland and Spain have only partially compensated for the steeply rising prices that have attended European convergence.

Felipe and Kumar also estimate “unit capital costs” along the lines I described in the previous post. (See Table 1 of the paper.) For all countries other than Greece, payments to capital providers per unit output have been growing faster than payments to workers.

So what’s does all this mean? Two things:

1. There’s a common narrative of the European crisis that pins the blame on workers. It is said that during the “good times”, when rivers of money flowed from Northern Europe to the Mediterranean, workers in Southern Europe were able to extract exorbitant wage hikes, forcing prices up and rendering their products uncompetitive in global markets. To put it gently, there is no evidence to support this narrative except perhaps in Greece. In the other PIIGS, unit labor costs failed even to keep up with the rising price level. Workers received a smaller share of the value they helped produce in 2007 than they took in 1980. Southern Europe’s unit labor costs converged with Northern Europe’s because the price levels of the two regions converged, not because Mediterranean workers took a greater share. If Southern Europe lacks competitiveness, the part of the cost structure that needs to be reformed has to do with rents paid to capital rather than the sticky wages of workers.

2. We should beware reductionist accounts that put the blame for the periphery’s misery on inflated relative prices. Though one can tell an alarmist story looking at relative rates of change of unit labor costs, in terms of levels, the periphery’s labor structure looks competitive. Nor can we blame the problems in the periphery on a mere absence of capital. Prior to the crisis, there was plenty of capital available. The European periphery was rendered uncompetitive by toxic patterns of capital allocation, for which both Northern Europe’s financial institutions and Southern Europe’s regulators ought to be held accountable. Altering the relative price of labor between Northern and Southern Europe would not fix these problems. Real devaluation might provide temporary relief in terms of domestic employment, and that might provide breathing room for developing better policy ideas than accepting capricious capital flows and hoping they sustain asset bubbles. But breathing room is all that devaluation can provide. It cannot substitute for better policy. Mediterranean Europe already had much lower relative labor costs than the European “core” prior to the recent convergence. Look how that worked out. The PIIGS should work to avoid falling into a kind of macroeconomic “Groundhog’s day”, cycling between low relative costs, convergence, and crisis.

   Even though devaluation is no panacea, the nations of peripheral Europe might still wish to consider dropping the Euro. But the case for that is not, ultimately, about relative prices, but about sovereignty and bargaining power. As the MMTers correctly emphasize, control over money is essential to the sovereign power of a state. For now, the nations of the Eurozone have ceded a significant part of their sovereignty to European institutions. That would be fine, if those institutions could be trusted to look out for, or at least give fair weight to, the interests of the states which have surrendered sovereign powers. If I were a citizen of Portugal or Greece, Spain, Ireland, or Italy, I would conclude that European institutions have unduly little concern for my interests and unduly much concern for a transnational financial system and Northern European taxpayers. If that continues, I’d want my government to retract the sovereignty it had ceded, so that it has the freedom to maximize the forward-looking welfare and growth of my nation without hobbling itself in the interests of claimants to past loans that ought never have been made.

An obvious corollary to all this is that “internal devaluation” is absolutely idiotic. It’s one thing to accept chemotherapy when the disease is cancer and the pain might do some good. But if the disease is not cancer, chemotherapy is just eating poison. Peripheral Europe’s problem is an incapacity to produce tradable goods and services in sufficient quantity to pay for its import bill. That is a structural deficiency. The wages workers are paid for the goods and services they do produce are in line with the rest of Europe’s. Lower wages might help create incentives for new investment to resolve the structural deficiency. But that hasn’t worked in the past when the periphery’s labor has been unusually cheap. The clear and present miseries of “internal devaluation” should not be allowed to rest on so slim a reed.

In an otherwise excellent post, Matt Yglesias commits one of the deadly sins of monetary policy:

[M]y favorite indicator of inflation is “unit labor costs”… Unit labor costs are basically wages divided [by] productivity. It’s not the price of labor, in other words, but the price of labor output. If productivity is rising faster than wages, then even if wages themselves are rising unit labor costs are falling. Conversely, if wages rise faster than prodictivity than unit labor costs are going up. Clearly there’s nothing wrong with a little increase in unit labor costs here or there. But over the long term, growth in unit labor costs needs to be constrained or else it becomes impossible to employ anyone. And you can see that in the seventies it’s not just that gasoline got more expensive, we had an anomalous spate of high unit labor cost growth. That was inflation and it’s what led to the regime change that’s governed for the past thirty years.

That all sounds reasonable. But Yglesias has fallen into a trap. Unit labor costs are not “basically wages divided [by] productivity”. That’s not the right definition at all. [See update below.] Unit labor costs are nominal wages per unit of output. With a little bit of math [1], it’s easy to show that

An increase in unit labor costs can mean one of two things. It can reflect an increase in the price level — inflation — or it can reflect an increase in labor’s share of output. The Federal Reserve is properly in the business of restraining the price level. It has no business whatsoever tilting the scales in the division of income between labor and capital.

Yet throughout the Great Moderation, increases in unit labor costs were the standard alarm bell cited by Fed policy makers as an event that would call for more restrictive policy. And all through the Great Moderation, except for a brief surge during the tech boom, labor’s share of output was in secular decline. (More recently, the Great Recession has been accompanied by a stunning collapse in labor share. Record corporate profits!)

Correlation is not causation, and undoubtedly much of the decline in labor share can be attributed to factors unrelated to monetary policy, such as the integration of China into global labor markets. But even if the Fed didn’t “cause” the decline in labor’s share, Great Moderation monetary policy made it very difficult for labor’s share to grow. Consider a simple rearrangement of the equation above:

For labor’s share to expand, either the price level must fall, or unit labor costs must rise faster than the price level. But the Fed responds aggressively to rising unit labor costs, and is committed to preventing any decrease in the price level. Under this policy regime, expansions in labor’s share are pretty difficult to come by! There was that late 1990s surge in labor’s share. But that is the exception that proves the rule: The Fed, to its credit, tolerated an expansion in unit labor costs from 1997 through 1999 without raising interest rates.

In addition to its direct suppression of labor’s share of output, the Fed’s hawkish rhetorical hawkishness on unit labor costs had debilitating indirect effects. Politicians view contractionary monetary policy as a threat to reelection. George H.W. Bush famously blamed the Greenspan Fed for not easing sufficiently prior to his failed reelection bid. Bill Clinton famously chose Rubinomics over, say, Reichonomics, and he cultivated a cordial detente with the Fed. Far too much attention is given to keeping central banks independent of politicians, and far too little is given to keeping politicians independent of central banks.

Since the early 1990s, all actors in the US political system have understood that policies that increase unit labor costs risk a response by the “inflation fighting” central bank, whose “credibility” was swaggeringly defined as a willingness to provoke recession rather than risk inflation. In this environment, the decline of labor unions and their shift in focus from wage growth to working conditions was understandable. If workers won on wages, they would lose when the recession put them out of work. As long as wages were contained, monetary policy was “accommodative”, and workers could supplement their purchasing power with borrowings and asset appreciation. During the Great Moderation, wage growth was rendered obsolete. A superior means of middle class prosperity had been invented. Or so it seemed, until we experienced the toxic after-effects in 2008. Now we have grown skeptical of debt-fueled pseudoprosperity. But the covert hostility to wage growth that underpinned Great Moderation monetary policy remains unchallenged.

I imagine some readers saying to themselves, “But still. If the labor cost of ‘stuff’ is allowed to grow, how can that not be inflationary? It’s common sense.” And that’s true, as far as it goes. But if the capital cost of stuff grows, that must also be inflationary. Suppose we define the complement to unit labor costs, unit capital costs. Unit capital costs might be defined as “business profits per unit of output”. Would it be politically tolerable in the United States to have a central bank that prevented expansions of business profit per unit sold? Is restraining profitability of investment a proper role for a central bank? If suppressing returns to capital would be improper, why on Earth do we tolerate a central bank that opposes returns to labor?

There is an orthodox answer to this question. Wages, it is said, are sticky, while returns to capital are highly flexible. Elevated wage levels distort the economy, or force us to tolerate inflation in order to reduce real wages. Capital prices respond to market forces and find their efficient level. That might all be true at a micro level, but at a macro level our experience is opposite. The fraction of expenditures we pay into corporate profits has ratcheted upward pretty continuously since the mid-1980s, with a brief lull in the late 1990s and an even briefer one during the Great Recession. The share we pay as wages has fallen precipitously. In aggregate, labor has proven very flexible in its demands while the rentier class has been quite rigid. Economists like to be microfounded and all, but this is macroeconomics, and actual macroeconomic evidence has to count for something.

All of this is one more reason to prefer the NGDP path target promoted by Scott Sumner and his merry Market Monetarists. It might prove difficult in practice to target inflation without paying some especial attention to wage growth. But a central bank can target the path of aggregate expenditure without playing favorites about who pays what to whom. Simple neutrality by the central bank in the contest between capital and labor would be a huge improvement over the status quo.

Many thanks to Nick Rowe, who probably doesn’t agree with any of this, but helped me think these issues out in the comments here.

Update: It is easy to show that unit labor costs are not equal to total wages divided by labor productivity. But Nick Rowe points out in the comments that unit labor costs are equal to the average hourly wage divided by labor productivity. So, depending on how you want to interpret “wages”, I was too quick in tweaking Matt Yglesias for a misstatement. Sorry!

Thanks to Rowe, Dan Kervick, and JKH who work this out carefully in the (excellent) comment thread.

So, here’s a thing I think we should do.

The Federal government should offer inflation-protected savings accounts to individual citizens, but with a strict size limit of, say, $200,000. These accounts would work like bank savings accounts, and might even be administered by banks. But deposits would be advanced directly to the government (reducing borrowing by the Treasury), and the government would be responsible for repayment. The accounts would promise a tax-free real interest rate of 0% on balances up to the limit. Each month, accounts would be credited with interest based on the most recent increase in the Consumer Price Index (adjusted for any revisions to estimates for previous months).

The purpose of this plan would be to offer a no-frills, low risk savings vehicle for middle-class workers. Ordinary bank savings accounts no longer do the job. They already pay negative real interest rates, and those rates might well get worse if we experience more inflation. TIPS don’t do the job. They expose savers to interest rate risk and liquidity risk. Small savers must compete with large savers for the same very limited pool of securities, resulting in negative yields. The option implicit in the floor on principal isn’t easy to price. It takes a degree of risk-tolerance and sophistication to manage a portfolio of TIPS that we ought not demand of waitresses and schoolteachers. They should be able to just open an inflation-protected savings account at their local bank.

Republicans should love this proposal. It would reward “virtuous” savers who are currently punished by negative real rates, and the benefit would be tilted upwards towards the relatively prudent and productive. People with substantial savings gain more from the tax and interest rate subsidy than people putting just a few dollars away. Democrats should love it too, as rewarding savers is a bipartisan trope, and the $200,000 limit keeps it a middle-class program, preventing a huge giveaway to the top 1%.

These “starter savings accounts” would be a popular vehicle for ordinary people who want convenience and safety with as little entanglement as possible in casino finance.

But the real benefit would be macroeconomic. “Market monetarists”, MMTers, and old-fashioned Keynesians love to squabble with one another, but they have a great deal in common. By whatever combination of monetary and fiscal policy, in a depression, all these groups agree that some manner of expansionary intervention should be pursued to maintain spending and effective demand. But any such policy increases the risk of inflation, and so is opposed by people holding debt or fixed-income securities. The people with the most to lose from inflation are the very wealthy, who hold a disproportionate share of financial claims. But middle-class savers value their small nest eggs just as dearly, and make common cause with multibillionaires to oppose inflation. By providing means for small savers to protect themselves from inflation when intervention is called for, we can stop the very wealthy from using middle-class retirees as human shields, and thereby create political space to adopt expansionary policy.

The existence of these accounts would be mildly contractionary, as smaller savers could no longer be scared into spending by the threat of inflation. But while pushing small savers to spend their way into precarity might contribute to short-term GDP, the overall costs of that approach probably exceed the benefits. Expansionary policy should encourage consumption and investment by people with the means to bear risk rather than threaten the savings of people who cannot afford to spend.

The limited size of “starter savings accounts” would leave the wealth of large savers at risk, and with fewer places to hide. That is as it should be. The risk of the aggregate investment must be borne by someone. Patterns of aggregate investment are determined by the behaviors of savers, or the people to whom they directly or indirectly delegate investment decisions. If we want a high quality of investment, we have to ensure that these investors bear the cost when aggregate investment disappoints. All savers would enjoy protection of their “starter savings”, but people trying to push large sums of wealth into the future would have to take responsibility for directing the use of their capital, and for monitoring the quality of the institutions through which capital is allocated generally. When the process fails, when capital allocation goes badly awry, large savers would bear the costs directly via writedowns or indirectly via inflation. It will be hard to push for bail-outs when middle-class nest eggs are insulated from the vagaries of capital markets and banks. It will be hard to push for austerity when middle-class nest eggs are immune from inflation. Wealthier savers would still be protected from penury, if they wisely max out their starter savings accounts before piling into CDOs and auction-rate securities.

The program proposed would, for now, be a subsidy to small savers, since real risk-free interest rates are negative. In better times, the program would impose a small “tax”, because the government would pay less to depositors than the positive real rates it pays on other borrowings when the economy is growing. But this would not actually be a tax, because participation would be optional. When times are good, banks and brokers will relentlessly encourage savers to migrate into higher yielding assets. Savers may choose to buy whatever Wall Street is selling, or to stick with what is simple and safe. Even in good times, a guaranteed, perfectly liquid, inflation-protected savings vehicle would be popular with many savers. Starter savings accounts would be a useful and voluntary program with a negative fiscal cost.

Some practical considerations:

• Limiting the size of the accounts is absolutely crucial. Failing to do so could put the finances of the state into dangerous jeopardy. A currency-issuing government’s nominal “debt” is best classified as equity. Inflation-protected debt is much more debt-like, and can put the solvency of the state into question. Nominal debts can always be repayed in extremis by printing money. But that is not true of inflation-protected debt, on which a government may be forced to default, overtly or tacitly (by corrupting the inflation indices). The US government, very wisely, keeps its TIPS issuance very small. It should keep the aggregate size of the starter savings program small as well. At $200,000 per person, the program could succeed catastrophically if the relatively well-off take to it en masse. To manage this, the government might set a ceiling on the aggregate size of the program (perhaps 25% of GDP), and adjust the limit of inflation protection as necessary to remain beneath the ceiling. (The government would announce periodic adjustments, up or down, to the limit. The government would pay the ordinary 30-day Treasury bill rate on balances above the inflation protection ceiling.)

  Alternatively, the government could discourage overuse by publishing a diminishing real-interest rate schedule, so that the first few thousand dollars in an account would accrue interest at a sharply positive real rate while “late” dollars are punished with ever more negative real rates.

• The accounts would have to be nonhypothecable. To put that in English, loans and other contracts that pledge the contents of these accounts as security should be prohibited and unenforceable. Otherwise, when real interest rates are negative, financial engineers will bundle loans secured against many poorer individuals’ accounts into unlimited sized accounts for rich people. This sort of indirect use of the accounts is impractical if the loans are unsecured and their repayment is at the discretion of the borrower. (Every sort of contractual encumbrance or automatic withdrawal should be prohibited, to prevent schemes where administering banks enforce security arrangements that the law would not.)

Often my proposals are pie-in-the-sky, after-the-revolution sort of affairs. But this one strikes me as practical, achievable within the present political context. “Starter savings accounts” would represent a form of middle class social insurance that I think a lot of people are thirsting for. They would have a small near-term fiscal cost, and would likely pay for themselves over the long-term. Since the program would be structured as personal savings, it flatters the American policy establishment’s devotion to “bourgeois virtues“. I think the existence of these accounts would open up a great deal of political space for better macroeconomic policy. They would reduce resistance to expansionary monetary/fiscal intervention. They would reduce the press for bailouts and corrupt reflations when the stock market swoons or some megabank coughs blood. Shouldn’t we do this?