How Labor Was Left Behind: An (Incomplete) Story

The major trends in labor income in the US over the last 50 years are wage stagnation and a yawning gap between workers with and without a college degree.  Both these developments are not just topics of mere economic interest.  They have serious social and political repercussions.  Here I give a partial explanation of how it happened. 

First the data.  Until the early 1970s, the US economy (GDP) and wages grew pretty close together and labor got its fair share.  Things changed after the seventies.  Thus, from 1979 to 2018 productivity rose by 70% but real wages only by 12%.  In the period after 1970, the ratio of wages to profits in the formation of the GDP declined from 67% to 60%.  By the 2000s, automation and outsourcing had robbed non-college workers of well-paying jobs, especially in manufacturing.  The economy created lots of jobs but most were for skilled educated workers.  As a result, wages for low-skill jobs fell and these workers were left behind with respect to: income, social status and integration, and healthcare.  Very tellingly, these disparities were unique to the US among advanced market economies.

There are several factors that drove these negative developments.  For one, the demise of labor unions and unfavorable labor laws and rulings cut down the bargaining power of labor.  But another place to look is changes in the financial objective of the firm which were played out in the corporate boardrooms and the financial markets.

We can say that from the fifties to the seventies American business was ruled by managerial capitalism.  Shareholders held nominal power but they were mostly considered another class of capital suppliers, like bondholders and banks.  Executives governed with little oversight from shareholders whom they tried to appease with just adequate returns.  Executives were mainly compensated by salary and modest, by today’s standards, bonuses.  Whether they held views of social fairness toward labor or they aimed at maintaining labor peace with unions and an assertive working force, they were willing to split the gains in productivity (and profits) quite fairly between shareholders and workers.  Being compensated mostly by salaries, executives also had an incentive to seek higher wage increases which would justify commensurate salary raises for themselves.

But closer inspection of corporate performance by academics revealed that this style of corporate governance had left too much shareholder money on the table.  That is, excesses either in the form of generous labor contracts, managerial perks, or for the building of corporate empires were pursued at the expense of the shareholders.  (Just for the sake of illustration, think of the purchase of a jet to fly the CEO around; it adds to the CEO’s prestige and ego but its cost comes out of the shareholders’ profits.)  To rein in such managerial waste, a new theory, called “agency theory,” proposed that shareholders had to monitor managers more diligently and, even better, make managers behave like shareholders.  The theory argued that treating executives as agents of the shareholders and compensating them at fixed salaries did not incentivize them to create maximum value.  If, however, they were granted shares and/or options to buy shares in their firms, then they would behave as principals (i.e., shareholders) and think twice before they wasted shareholder value.   

Although the goal was to foster better management of resources, turning executives to shareholders created new unintended effects.   In order to increase the value of their stock, executives now had an incentive to squeeze expenses, including labor costs.  That gave us more part-time and temp jobs with little or no fringe benefits, all the way to gig jobs a la Uber.  No longer the interests of executives were aligned with those of labor as in the early era. 

The second harmful possibility came from the incentive to inflate the stock prices even by unethical means.  This reached scandalous and eventually criminal levels around 2000.  Mighty corporations, like Adelphia, Enron, Worldcom, and Arthur Andersen (the renegade auditing firm) were prosecuted for using misinformation and accounting irregularities for the purpose of inflating stock prices.  And adding insult to injury executive compensation packages blew through the roof to levels unseen in the US or other market economies.  To this day, even failing executives are rewarded stratospheric severance pay packages to relieve a firm of their incompetent presence.  Whereas thousands of workers are laid off with minimal notice and severance pay, top executives are sent to retirement with millions of dollars to presumably ease the pain of their aborted tenures.  

The most fertile ground to pursue shareholder value maximization, with significant consequences for labor nonetheless, is corporate restructurings, that is, the sale and purchase of corporate assets, divisions and whole firms.  This is exactly the arena where Schumpeter’s “creative destruction” takes place.  Very soon, the new term “takeover premium” was coined to mean the additional value a firm had as a potential takeover target.  New laws and regulations were passed with the objective to loosen up the grip of various stakeholders on firms and make them easier targets for corporate raiders. 

This newly minted market for corporate control, as it was named, got a big boost when private equity funds and hedge funds entered the market in earnest in the nineties.  The tax loophole of treating carried income as capital gains turbo-charged these funds.  Consistent with the relentless emphasis on shareholder value maximization, an academic study found that between 1952 and 1988 stock prices grew in sync with the GDP; from 1989 to 2017, GDP growth accounted for only 24%.  The rest came from “reallocated rents to shareholders and away from labor compensation.”

The thing is that corporate restructurings and takeovers help cleanse the economy of losing projects and incompetent managers and thus improve efficiency.  However, when academics and consultants measure the positive value creation of such activities, they do it from the perspective of shareholders under the financial objective of shareholder value maximization.  What they leave out is the costs from worker displacement, the unraveling of local economies, and negative social effects.  The neoclassical economic view is that workers and capital holders smoothly navigate the upheaval caused by “creative destruction” until everybody lands on a better place.  After all, it is the government’s job to pick up the cost of smoothing the transition.

But that’s not what happened.  The stories of blue color workers in the American Midwest tells a more dire story.  Their story had a lot to do with who entered the White House in 2016.