Towards a High-Wage, High-Productivity Economy

Question 1: Which of the following statements most closely reflects your understanding of the relationship between productivity and wages.

Question 2: What is your evaluation of the following statement: “A well-designed government-stipulated wage increase can lead to higher productivity”?

Summary

The CfM panel of experts on the UK economy is nearly unanimous that the main path to sustainably higher wages is through long-term productivity growth. More than half of the panel believes that there are some scenarios in which higher wages lead to higher productivity and a minority thinks that government intervention in wages could lead to higher productivity. However, even this minority argues that policies supporting higher wages should be complemented with investments in skills and other productivity-enhancing measures.

Background

The November 2021 CfM survey asked the members of its UK panel to evaluate claims that wage-supporting policies could lead to higher productivity.

Wages and Productivity

The UK government has begun setting out its plans for a post-Covid economy. During his October speech at the Conservative Party Conference, Prime Minister Boris Johnson vowed to “move [away from] the same old broken model with low wages, low growth, low skills and low productivity”, stressing that increases in wages were allowing the UK to “embark on a change of direction long overdue in the UK economy: […] a move towards a high wage, high skill, high productivity, and low tax economy.” The Chancellor’s Fall budget also reflects this ambition, calling for higher investments in infrastructure and skills to spur productivity growth. He has also followed recommendations of the Low Pay Commission to “increase the National Living Wage next year by 6.6%, to £9.50 an hour”.

 

The correlation between productivity and real wages in the data is unquestionable. Textbook economic theory attributes this correlation as reflecting the effects of productivity on wages. In this view, wages are determined by supply and demand and workers’ pay will ultimately reflect their productivity. Productivity growth is then the only sustainable way to obtain higher wages. Teichgräber and Van Reenen (2021) have shown that real wages have indeed tracked productivity in the UK over the past 40 years. However, Ngai and Sevinc (2021) have shown that productivity growth in a specific sector may not lead to wage growth in that sector and economy-wide productivity growth is necessary to guarantee wage growth for all. (See Vox Talks video explainer on the subject.)

The Prime Minister and Chancellor have been cautious in making causal connections between wage growth and productivity. However, many commentators have understood the government’s “high wage high productivity” model as suggesting that wage increases due to lower immigration and labour shortages will themselves lead to innovation and higher productivity. (See Oulton 2019 on the relationship between the growth in the labour force, productivity, and wages.) This view has received a mixed response from economists and journalists. Most journalistic responses have reflected the conventional wisdom that wage increases cannot in and of themselves cause productivity growth. Writing in the Independent, Sean O’Grady uses wage increases for lorry drivers as an example: “Lorry drivers, and others, can demand higher pay packets and better conditions because there’s a shortage of them. They all work very hard – and deserve better working conditions – but they’ll be working no harder tomorrow than they do today. Their trucks will be no more efficient, nor their logistics improved, nor working practices transformed.”

Writing the Times, David Smith agrees that “pay rises without an accompanying rise in productivity will push up unit wage costs. Stagnant productivity explains why real wages did so badly in the 2010s.”  These higher labour costs will decrease employment and employers will merely pass them on to consumers. Jill Treanor, writing in the same publication, warns that recent wage increases are no cause for celebration claiming that “higher wages might force some companies to collapse.” She points to “the problems in the supply chain—from importing timber to finding enough lorry drivers” as the main cause for wage hikes and a driver of high inflation. Smith concurs, predicting that “a shortage of HGV drivers may result in higher wages for them, and indeed is doing so. But the more such shortages there are, because of a supply shock, the more costs will rise and, particularly following a huge monetary stimulus, the more inflation will become a problem, squeezing the real wages of everybody else”.

A contrasting view suggests that workers can be motivated through higher wages. In its modern incarnation, this view goes back the “efficiency wages” theory of Shapiro and Stiglitz (1984), with a macroeconomic stipulation put forth by Yellen (1984) that states that firms will be willing to pay workers’ wages above their market rate to encourage greater work effort. This view has antecedents going at least as far back as Alfred Marshall’s stipulation that “any change in the distribution of wealth which gives more to the wage receivers and less to the capitalists is likely, other things being equal, to hasten the increase of material production” (Alfred Marshall, cited in Wolfers and Zilinsky 2015).

A survey by Wolfers and Zilinsky (2015) summarizes the evidence in support of the high wage to high productivity hypothesis. They cite evidence that wages lead to higher job performance, higher customer service quality, lower turnover rates, and higher quality of hires due to higher wages. Critics of this view have questioned why government intervention is required: firms should benefit from these outcomes and be willing to offer higher wages themselves. Martin Sandbu, writing in the FT, makes a separate argument that higher wages will encourage investment in machinery that allows workers to be more productive. However, Acemoglu and Restrepo (2020) have shown that such mechanisation has led to job losses in the US, bringing instead lower wages for the average worker.

This month’s CfM survey asks the panel whether higher wages could lead to higher productivity. The panel was asked to focus on real wages and long-run productivity growth.

Question 1: Which of the following statements most closely reflects your understanding of the relationship between productivity and wages.

Twenty-three panel members answered this question. 91% of panel members support the proposition that wage increases generally do not increase productivity on the long run. The consensus is that productivity drives wage increases. However, a majority (51%) of the panel agrees that wage increases can contribute to long-term productivity. The remaining 40% believe that wage increases cannot increase productivity in and of themselves.

Many respondents argue that there is no causal relationship through which higher wages augment productivity in the long run. Roger Farmer (university of Warwick) writes that while wage increases could yield a one-off boost to workers’ effort, “[there is] no plausible causal chain that would lead… to continual improvements on an ongoing basis—as would be needed to explain continual productivity growth.” Michael Wickens supports Farmer’s stipulation and further highlights that governmental measures to artificially increase wages may cut in to firms’ profits. In his words, this would lead to “a fall in the demand for labour and increased unemployment”. In a similar vein, Martin Ellison (University of Oxford) states that while there are “models in which low wages discourage effort”, arguing the reverse would “look like falling into the fallacy of reverse causality”, adding that “history is unlikely to look kindly on such initiatives”.

51% of respondents nevertheless believe that wage increases may, in some cases, lead to improved productivity. According to David Miles (Imperial College London), “effort and morale may might rise with remuneration”. While conceding that “productivity developments are the major source of sustained increases in real wages”, James Smith (Resolution Foundation) points to evidence (Dustman et al 2021) that “setting a floor on wages can incentivise firms to adopt productivity-increasing changes in technology.” To Morton Ravn (University College London), supporting labour productivity through higher wages can only be effective when accompanied by investment in workers’ skills and new technologies: “increasing real wages by themselves may not do much apart from exporting jobs and motivating firms to invest in labour saving technologies. A high wage economy without investment in skills will force individuals with lower skills out of the workforce. There might be shorter run motivating factors of higher wages but they cannot sustain longer run productivity enhancements, Britain's main problem.”

Question 2: What is your evaluation of the following statement: “A well-designed government-stipulated wage increase can lead to higher productivity”?

Twenty- five panel members answered this question. 56% of panellists either “strongly disagree” or “disagree” with the proposition that the UK government can raise productivity through a wage increase. Ricardo Reis (London School of Economics) and Martin Ellison  argue that the state of our knowledge on the causal effect of wages on productivity would lead to poor design of government policy attempting to exploit this relationship. Ellison writes that “it is uncertain whether any government-stipulated wage increase can lead to higher productivity, however well designed, and it’s certain that any attempt to exploit such a possibility will be badly designed. We simply do not understand enough about how a government-mandated wage increase affects productivity to start exploiting that relationship.” Moreover, Gino Gancia (Queen Mary University) warns that “higher wages will lead to more automation with adverse re-distributional implications.”

James Smith arguing for the minority view that the government could boost productivity through wage regulation writes that “in some circumstances, there is evidence that Government policies which increase wages can prompt behavioural changes which are associated with higher measured productivity.” But like most panel members espousing this opinion he adds the proviso that “longer-term increases in wages will need to be driven by sustained improvement increases in productivity.” Similarly, Paul Mortimer-Lee (National Institute of Economic and Social Research), although agreeing that government wage supports could be effective, posits that “average productivity will increase because workers whose real productivity falls below the new real wage level… will cease to be workers. Low productivity jobs will go, to be replaced by unemployed workers with a productivity of zero.”

Finally, few panellists wholeheartedly supported the notion that wage increases could support productivity growth. Nicholas Oulton (London School of Economics) concurs with the stipulation that restricting migration flows towards the UK might further aggregate productivity levels. Arguing that “[the UK’s] higher growth rate of labour explains [its] poor productivity performance relative to countries which by one means or another control immigration”, he writes that “reducing immigration can raise both the level and growth rate of productivity, and so raise the level and growth rate of wages.”

References and Further Readings

Acemoglu, Daron and Pascual Restrepo (2020) “Robots and Jobs: Evidence from US Labor Markets,” Journal of Political Economy (2020) 128:6, 2188-2244.

Dustmann, Christian, Attila Lindner, Uta Schönberg, Matthias Umkehrer, Philipp vom Berge, (2021) “Reallocation Effects of the Minimum Wage”, The Quarterly Journal of Economics.

Ngai, Rachel and Orhun Sevinc (2021) “A Multisector Perspective on Wage Stagnation,” mimeo, London School of Economics

Oulton, Nicolas (2019) “The UK and Western productivity puzzle: does Arthur Lewis hold the key?” International Productivity Monitor, Number 36, Spring 2019, pp. 110-141.

Shapiro, C.; Stiglitz, J.E. (1984). “Equilibrium Unemployment as a Worker Discipline Device”. American Economic Review. 74 (3): 433–444.

Andreas Teichgräber and Van Reenen, John, “Have productivity and pay decoupled in the UK?” POID Working Paper No. 21

Wolfers, J. and J. Zilinsky (2015), “Higher Wages for Low-Income Workers Lead to Higher Productivity”, Peterson Institute for International Economics.

Yellen, Janet L. (1984), “Efficiency Wage Models of Unemployment,” American Economic Review 74, no. 2: 200–205.

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How the experts responded

Question 1

Participant Answer Confidence level Comment
Michael McMahon's picture Michael McMahon University of Oxford Wage increases can in some cases increase long-run productivity Confident
Martin Ellison's picture Martin Ellison University of Oxford Wage increases cannot increase productivity in and of themselves Very confident
It is difficult to see a compelling causal mechanism running from higher aggregate wages to higher productivity in the UK, when the converse is so obviously attractive. There are clever models in which low wages discourage effort (e.g. the effort of workers in their jobs or the efforts of employers to automate or invest in their workforce) but at the aggregate level these feel like exercises in “rationalising apparently puzzling behaviour” that economists are attracted to. Remember the largely now debunked “expansionary fiscal contractions”? Raising wages to improve productivity looks like falling into the fallacy of reverse causality. History is unlikely to look kindly on such initiatives.
Jagjit Chadha's picture Jagjit Chadha National Institute of Economic and Social Research Wage increases can in some cases increase long-run productivity Confident
Wage increases are very much a function of labour productivity but that in itself depends on the level of worker skills, capital employed, capacity utilisation, the quality of management as well as other factors. If wages are raised and there is an accompanying improvement in the management of the firm then it might support in increase long run productivity by, for example, encouraging investment in skills. It has to be part of a strategy.
Nicholas Oulton's picture Nicholas Oulton London School of Economics No opinion or other Very confident
It all depends on the cause of the wage increase. If the wage increase is just by government decree and is not accompanied by any other policy intervention, then this is highly unlikely to raise productivity.
Paul Mortimer-Lee National Institute of Economic and Social Research Wage increases can in some cases increase long-run productivity Very confident
David Cobham's picture David Cobham Heriot Watt University Wage increases can in some cases increase long-run productivity Confident
If but only if they lead to greater investment in machinery and equipment, and are accompanied by rises in skills. But note that UK government efforts of different kinds to increase economic growth - which go back at least to the 1960s - have not typically been very effective: what really matters is total factor productivity growth, and that's the bit of growth which we really do not understand well. Good access to a large market would also help (and there’s some evidence of higher growth in the UK when it was in the Common Market/EU).
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Wage increases cannot increase productivity in and of themselves Confident
Simon Wren-Lewis's picture Simon Wren-Lewis University of Oxford Wage increases can in some cases increase long-run productivity Confident
With all price changes we have to ask why are prices higher before giving a good answer. If real wages are higher in some sectors because stricter immigration controls lead to supply shortages, the higher wages might produce productivity improvements in those sectors, but productivity is likely to decline in other sectors. More seriously disruption to supply chains may cause worse outcomes.
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Wage increases can in some cases increase long-run productivity Not confident
In the long run, wages are driven by productivity, not the other way around. I cannot dismiss the possibility that there are some industrial policies that would raise workers' bargaining power and wellbeing and therefore their productivity, certainly in the short run. But these are minor in the long run relative to the opposite direction of causation.
James Smith's picture James Smith Head of Macroeconomic Policy, Resolution Foundation Wage increases can in some cases increase long-run productivity Confident
Obviously productivity developments are the major source of sustained increases in real wages but there is some evidence that setting a floor on wages can incentivise firms to adopt productivity-increasing changes in technology. A good example is the literature on the impact of changes to the minimum wage. (See, for a recent example: Christian Dustmann, Attila Lindner, Uta Schönberg, Matthias Umkehrer, Philipp vom Berge, Reallocation Effects of the Minimum Wage, The Quarterly Journal of Economics, 2021.)
Costas Milas's picture Costas Milas University of Liverpool No opinion or other Confident
Productivity is the main driver of wage increases and then there is some subsequent feedback from higher wages on productivity.
Wouter Den Haan's picture Wouter Den Haan London School of Economics Wage increases cannot increase productivity in and of themselves Not confident
I chose this answer because improved productivity due to increased motivation is not permanent and any increase in productivity because of a substitution out of labour into capital means that it isn't just a wage increase anymore.
Paul De Grauwe's picture Paul De Grauwe London School of Economics Wage increases can in some cases increase long-run productivity Confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Wage increases cannot increase productivity in and of themselves Very confident
Roger Farmer's picture Roger Farmer University of Warwick Wage increases cannot increase productivity in and of themselves Extremely confident
Measured labour productivity is a non-stationary process. The same is true of total factor productivity (TFP). The Shapiro-Stiglitz hypothesis might (and I stress might) account for a one-off increase in unmeasured effort that would be measured as a productivity advance. I see no plausible causal chain that would lead this channel to lead to continual improvements on an ongoing basis — as would be needed to explain continual productivity growth.
Morten Ravn's picture Morten Ravn University College London Wage increases can in some cases increase long-run productivity Very confident
Wage increases - for example through high(er) minimum wages - may spur sustained productivitiy growth but only to the extent that they spur investment in skills and in technology which, in most cases, go hand in hand. Investment in skills requires government investment in education of the population from an early age throughout to apprentices, university graduates, and further adult education. This requires aboloshing the UKs dual education market which caters for those who can invest in private education mainly. It requires providing families with child care to prevent skill loss during times out of the labor market and social safety nets for those whose investments do not pay off. It requires a flexible labor market. These are all policies seen in Scandinavia which also rely on low levels of government debt, efficient pension systems, and this takes time. Just increasing real wages by themselves may not do much apart from exporting jobs and motivating firms to invest in labor saving technologies. A high wage economy without investment in skills will force individuals with lower skills out of the workforce. There might be shorter run motivating factors of higher wages but they cannot sustain longer run productivity enhancements, Britain's main problem.
Sir Charles Bean's picture Sir Charles Bean London School of Economics Wage increases can in some cases increase long-run productivity Confident
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Wage increases cannot increase productivity in and of themselves Very confident
The relation between real wages and productivity is an equilibrium condition. It does not imply causality one way or the other. However, it is difficult to see how real wages can be higher than productivity for long without profits suffering. This would induce a fall in the demand for labour and increased unemployment in the transition back to equilibrium. The fall in employment would cause the required increase in productivity. In equilibrium a rise in nominal wages can be passed on to prices without altering real wages or requiring a productivity increase.
David Miles's picture David Miles Imperial College Wage increases can in some cases increase long-run productivity Not confident
There are a few channels by which a link from higher wages to higher productivity might work - the obvious one is a switch in the capital labour ratio to align labour productivity with real wages but effort and morale may might rise with remuneration.
Ricardo Reis's picture Ricardo Reis London School of Economics Wage increases can in some cases increase long-run productivity Very confident
It depends on how you interpret productivity. If labor productivity, as measured by output per hour or worker, then a clear yes: the labor share of income is approximately constant in the long run, so higher wage is one-to-one correlated with higher average product of labor. If total factor productivity, then no, as most economic mechanisms for an association would not survive free entry in the long run.
Lucio Sarno's picture Lucio Sarno Cambridge University Wage increases cannot increase productivity in and of themselves Extremely confident
Natalie Chen's picture Natalie Chen University of Warwick Wage increases cannot increase productivity in and of themselves Not confident
Linda Yueh's picture Linda Yueh London Business School Wage increases can in some cases increase long-run productivity Confident

Question 2

Participant Answer Confidence level Comment
Michael McMahon's picture Michael McMahon University of Oxford Neither agree nor disagree Confident
In general I disagree - aggregate wage increases would not typically raise aggregate productivity. And the best lever to raise take-home wages are income tax cuts which have been used but I think most studies emphasise the link between top tax rates, which would only affect take-home pay of the richest, and productivity. But the openness of the statement means that perhaps one could design some instances where, eg, higher wages entice people back into the labour market bringing skills and experience that raise productivity at some local (regional or industrial) level.
Martin Ellison's picture Martin Ellison University of Oxford Strongly disagree Very confident
“Well-designed” is doing a lot of heavy lifting in the statement. It’s uncertain whether any government-stipulated wage increase can lead to higher productivity, however well designed, and it’s certain that any attempt to exploit such a possibility will be badly designed. We simply do not understand enough about how a government-mandated wage increase affects productivity to start exploiting that relationship.
Jagjit Chadha's picture Jagjit Chadha National Institute of Economic and Social Research Neither agree nor disagree Confident
If it is well-designed then policy will meet its objective. But I wonder if the objective of government set wages is productivity? It is not: it is to offset the monopsony of employers and ensure a more equal distribution of income.
Nicholas Oulton's picture Nicholas Oulton London School of Economics Strongly agree Very confident
Restricting immigration, particularly of the low skilled, is one way to raise both wages and productivity. Firstly, economic theory (the Solow model) suggests that the level of wages will be higher, the slower the growth rate of the labour force. Reducing immigration will lower the growth rate of the labour force. The reason is that slower growth of labour increases the long run capital-labour ratio, leading to higher wages and productivity. Secondly, as a matter of fact since 2007 faster growth of labour has been associated with slower growth of productivity in the Western world. Though this cannot be expected to be true at all times and places (the Solow model predicts no association in the long run), I have argued that since the global financial crisis foreign demand for exports from countries like the UK has been constrained. So our higher growth rate of labour explains our poor productivity performance, relative to countries which by one means or another control immigration. In other words, reducing immigration can raise both the level and growth rate of productivity, and so raise the level and growth rate of wages.
Paul Mortimer-Lee National Institute of Economic and Social Research Agree Very confident
Productivity - average productivity that is - will inrease because workers whose real productivity falls below the new real wage level (adding on taxes, NI etc) will cease to be workers. Low productivity jobs will go, to be replaced by unemployed workers with a productivity of ...zero. Additionally, facing higher wages, firms may invest more to raiseproductivity.
David Cobham's picture David Cobham Heriot Watt University Neither agree nor disagree Confident
The design would have to cover infrastructure and training, and that’s not straightforward. But if the government really wanted to reduce poverty and inequality, it could require wage increases at the lower end of the scale which - because most such workers are in the non-tradables sector – would lead mainly to higher prices paid by the better off, and those higher prices could be sold politically as the quid pro quo for living in a more civilised society with less poverty and less inequality.
John VanReenen's picture John VanReenen London School of Economics Disagree Confident
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Disagree Confident
Simon Wren-Lewis's picture Simon Wren-Lewis University of Oxford Neither agree nor disagree Confident
See above. Impossible to say without specifying how specifying how that 'well-designed government-stipulated wage increase' has been achieved.
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Disagree Not confident
James Smith's picture James Smith Head of Macroeconomic Policy, Resolution Foundation Agree Confident
As discussed above, *in some circumstances*, there is evidence that Government policies which increase wages can prompt behavioural changes which are associated with higher measured productivity. At the macroeconomic level, however, longer-term increases in wages will need to be driven by sustained improvement increases in productivity. A key priority, therefore, for government policy should be finding ways to increase productivity. My view is that such improvements will be much more likely if overall macroeconomic performance can also be improved. The latter is a task for macroeconomic policy.
Costas Milas's picture Costas Milas University of Liverpool Disagree Confident
As (joint) work of mine (https://blogs.lse.ac.uk/politicsandpolicy/brexit-and-the-productivity-puzzle/) discusses, productivity and (real) wage increases take place through lower business investment uncertainty.
Wouter Den Haan's picture Wouter Den Haan London School of Economics Strongly disagree Very confident
Although, there may very well be sectors in which workers are not treated fairly and some regulatory protection would be warranted, a generic strategy to increase wages across the board seems like madness to me.
Paul De Grauwe's picture Paul De Grauwe London School of Economics Neither agree nor disagree Confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Disagree Very confident
Higher wages will lead to more automation with adverse redistributional implications.
Roger Farmer's picture Roger Farmer University of Warwick Strongly disagree Extremely confident
I would be surprised if there is much disagreement from the panel on this question. If there IS disagreement, I would be keen to understand the reasoning from dissenters that leads from government mandated wage increases to persistent increases in the quantity and/or quality of the goods and services produced by the UK economy on an ongoing basis — my preferred definition of productivity. A one-off increase in measured productivity — as a result of additional effort — is a possibility but not a possibility that I give much credence to. And to those arguing otherwise I would add — I have a bridge to sell you.
Morten Ravn's picture Morten Ravn University College London Disagree Very confident
I answered this in the previous question. Such policies need to be accompanied by other policies and this will take time.
Sir Charles Bean's picture Sir Charles Bean London School of Economics Agree Not confident
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Neither agree nor disagree Confident
As my first answer makes clear, this could be at the expense of lower employment. To be well-designed the policy would therefore have to be accompanied by a demand stimulus to avoid generating unemployment. To be sustainable such a stimulus should follow from government investment and not by raising current expenditures.
David Miles's picture David Miles Imperial College Agree Not confident
see answer to first question
Ricardo Reis's picture Ricardo Reis London School of Economics Disagree Very confident
Depends on what you mean by "well-designed". In the UK context, and given current debates on the topic, the design that would emerge is most likely to not significantly increase productivity.
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme Agree Not confident
Lucio Sarno's picture Lucio Sarno Cambridge University Strongly disagree Very confident
Natalie Chen's picture Natalie Chen University of Warwick Disagree Not confident
Linda Yueh's picture Linda Yueh London Business School No opinion Not confident