A long spell of very low unemployment would raise wages—even in the face of employers’ monopsony power

Probably the most-asked question about the U.S. economy in recent months has been “why aren’t wages growing faster?” For years during the slow recovery from the Great Recession of 2008–09, the reason why wages weren’t growing fast enough was pretty clear: the labor market had too much “slack”, represented by the millions of potential workers sidelined by the crisis who were queuing up to take any available job. The big bargaining chip workers have when negotiating for higher wages is the threat to quit and find another job. This threat isn’t very credible when alternative work is hard to find and there are multiple workers who would jump at the chance to take your current job.

But because unemployment has dropped below pre-Great Recession levels, many have decided that labor slack can’t be the cause of subdued wage growth anymore. So, the search for causes of sluggish wage growth that are not labor slack has begun. Two (potentially related) suspects accused in recent months have been an erosion of workers’ labor market leverage (sometimes referred to as growing monopsony power on the part of employers) and rising monopolization. This post will discuss the first one, one tomorrow will tackle monopoly.

Two punchlines to this discussion are simple enough to highlight:

First, the definition of labor market slack is wage growth too weak to put upward pressure on the Fed’s price inflation target. If this wage growth is not happening, there is labor market slack. So, simply looking at some quantity-side measure of the labor market (say the unemployment rate) and thinking “hmm, that’s low, we must be at full employment” is substituting gut feeling for economic reasoning.

Second, the fact that workers’ leverage and bargaining power have been imploded by policy in recent decades does not mean that labor market tightening will fail to raise wages. It just means that a greater degree of labor market tightening is needed to engage the wage growth flywheel.

On the first point, the entire reason why we care at all about what unemployment rate constitutes “full employment” is because we worry that pushing unemployment below this rate will spark accelerating inflation. This worry is way overblown by policymakers, and the idea that even a few months of “above-full” employment will lead to damaging inflation spirals has always been a specter that made for terrible policymaking decisions. But this theory that there is an unemployment rate floor that leads to spiraling inflation if you go beneath does crystallize an obvious question to those who want to declare we’ve achieved full employment without any wage or price pressure: why should we ever stop trying to push unemployment ever-lower if this did not lead to wage growth that pushed inflation above the Fed’s comfort zone? This sounds like all gain (very low unemployment) with no pain (accelerating inflation).

And this logic is not changed at all if labor markets are monopsonistic. The only reason for macroeconomic policymakers to ever target an unemployment rate higher than zero is that they’re worried about too-rapid wage growth leading to above-target price inflation. If monopsony-like labor markets keep wage growth tame even as we get to zero unemployment (I know we actually won’t get to zero—it’s a thought experiment), what’s the problem with pursuing a low-unemployment macroeconomic strategy?

One potential objection to this reasoning is that wage growth follows falling unemployment with a lag, and if policymakers get too far ahead of themselves in pushing unemployment down, they can find themselves facing a sudden tsunami of wage and price pressure. But this argument has essentially guided policy since 1979, and the tsunami of inflation has never happened—but a crisis in hourly pay for the vast majority has. Surely it’s time to reweight what we think the real risks are facing macroeconomic policymakers, and start erring on the side of pushing unemployment too low, rather than keeping it too high.

On the second point, it is clearly true that declining leverage and bargaining power of low and middle-wage workers (call it rising monopsony power of employers if you like, though we think that’s a bit imprecise) is a key ingredient for why hourly pay for this group has lagged economy-wide productivity growth in recent decades. But this really doesn’t change the fact that macroeconomic policymakers should continue trying to push unemployment low enough to spark wage growth that begins pushing up price inflation. The only thing that the decline in workers’ leverage and bargaining power changes in this regard is how low this unemployment needs to go before the wage-price growth flywheel begins to engage.

Can it really be the case that running a high-pressure labor market can push wage growth up even in the face of the long-run policy assault on workers’ leverage and rights? Yes, it definitely is the case.

One piece of evidence on this is simply the fact that the policy assault on workers’ leverage began long ago (the mid-to-late 1970s is where I date it), yet even after more than a decade of this assault, a period of low sustained unemployment in the late 1990s led to strong across-the-board wage growth. Further, emerging new research shows that the ability of employers to “mark down” wages they pay relative to workers’ productivity is eroded as labor markets tighten. If the (correct) story is that this wage “markdown” has risen in recent decades as workers’ economic leverage and bargaining power has been attacked by policy, then this just means that even tighter labor markets will be needed to chip away this “markdown” and boost wages. Other research shows that as workers’ bargaining power is reduced, estimates of how low unemployment can go without sparking accelerating inflation are reduced.

This assault on typical workers’ bargaining power in recent decades has indeed made it harder to spark wage growth. But this doesn’t mean that you give up—it means you try harder!