Productivity is as productivity does
One of my students recently wrote a paper on international labor standards. The primary foundation of his claim that they are not only unnecessary but actually harmful was that there is a very tight relationship between productivity and wages (or more broadly, labor compensation). Thus labor standards will only drive up wages higher than productivity levels will allow, forcing capital to abandon this now higher-cost labor and harm workers' interests overall. In short, there's just no escaping the laws handed down by productivity -- either by labor or capital.
Our measurement of the relationship between productivity and compensation is heavily influenced by the price indexes we use. While poking around the web, I found this on the blog of the esteemed Greg Mankiw (you remember him, don't you? Greg "Former Chair of Dubya's Council of Economic Advisors" Mankiw? Greg "Outsourcing is just a new way of doing international trade" Mankiw? Ah, now you remember . . .):
The price index is important. Productivity is calculated from output data. From the standpoint of testing basic theory, the right deflator to use to calculate real wages is the price deflator for output. Sometimes, however, real wages are deflated using a consumption deflator, rather than an output deflator. To see why this matters, suppose (hypothetically) the price of an imported good such as oil were to rise significantly. A consumption price index would rise relative to an output price index. Real wages computed with a consumption price index would fall compared with productivity. But this does not disprove the theory: It just means the wrong price index has been used in evaluating the theory.And hence the broad claim from the right that there is not a compensation-productivity gap in the US (or anywhere else for that matter) because those claiming to find it are using the wrong price index -- the CPI -- when they should be using "an output deflator". Douglas "Disciple of Jagdish Bhagwati" Irwin uses the PPI in his book Free Trade Under Fire to show that there is no compensation-productivity gap at all in the US -- something my student seized upon with glee.
But hold on a minute. Productivity is defined as output per hour. So what's the price index for output? A fine question indeed.
It took some digging, but here is what the Bureau of Labor Statistics itself said back in 1999. The "deflation method" is used to calculate 93.3% of real business output (almost all the rest is by "extrapolation"). And what is the business output deflator, you ask? Well, it's a hodge-podge of several price indexes, but the largest component -- 55.9% -- is the Consumer Price Index! Yes, over half of the "output deflator" used to calculate business output per hour (which you can find right here) is actually a "consumption deflator". Well, according to Greg Mankiw that's just a great big no-no! This is despite the fact that, if we search down to little 'ol footnote 12 in the BLS document, we find out that "Based on 1997 current-dollar data, personal consumption expenditures account for about . . . 73 percent of business sector output". Only 15.1% of the business sector output price index is made up by the Producer Price Index -- you remember, the one which Douglas Irwin used to impress my student and "prove" that labor compensation closely and faithfully tracks productivity levels. Another 10.6% is made up of "BEA input-based indexes" -- which sounds like another Mankiw-banned procedure. Then we've got export and import price indexes as well as a slew of other bits and pieces to round out the family.
So what's the upshot? When Mankiw says "the right deflator to use to calculate real wages is the price deflator for output" he's talking past how output data itself is actually measured -- a majority of it using price deflators for consumption.
And the upshot of the upshot? Since 1973 there has been a significant divergence in the US between productivity growth and compensation growth when real compensation growth is deflated even by the PCE index (which understates inflation notably in comparison to the CPI). The only exceptions have been a couple of years in the late 1990s, and 2006. Don't get fooled by the likes of Mankiw, Irwin and the other apologists for capital who want to tell you otherwise.