Putting cost-of-living cart before the productivity horse

The English economist E. J. Mishan wrote a book 10 years ago about 21 stubborn economic fallacies. Since then, another fallacy has spread like an epidemic -- the view that wages should rise at least as fast as the cost of living. It is the notion back of the cost-of-living-adjustment clause in collective-bargaining agreements: COLA, for short.

A letter to the Sun City, Arizona, News-Sun: "When will the working men and women of this country get increased wages to keep up with at least the level of six years ago?" The writer is preaching the notion of COLA. But it puts the cart before the horse. The real linkage is between productivity, first, and wages, second. Money wages are just a claim on actual goods and services. We can consume only what we produce. Wages don't come out of thin air. A person's wage has to be paid out of what he produces.

American workers enjoy high wages because they belong to a highly productive team. The country has grown rich in land, capital, and a skilled labor force; in enterprising businessmen; in governments that have maintained a climate favorable to economic growth; in managerial and technological know-how. Since George Washington's day wages have risen steeply because productivity -- output per man-hour -- has climbed. In our private economy, including the farms, gains in productivity used to run about 3 percent a year. From 1947 to 1967 productivity rose an average 3.2 percent a year. From 1968 to 1972 the rate was 2.2 percent. And from 1973 to 1978, it was 1.2 percent. For 1979, productivity may actually have dropped -- as much as 3 percent.

In private business outside the farms, between 1967 and 1978 output per man-hour rose about 20 percent. Wages and benefits per hour increased about 133 percent. Labor cost per unit of output nearly doubled: It climbed about 94 percent. Wages higher each year by 6, 7, and now 8 percent could not be paid out of gains in productivity.

Could these higher wages have been paid out of profits? Most people think profits are higher, and a good deal higher, than they are.Last year the Gallup Organization asked American teen-agers how much corporations make after taxes on a dollar of sales. Some had no idea, but those who did put the figure on the average at 36 cents. A nickel would be nearer right.

Teen-agers have a special stake in business profits, for the jobs they can find and the environment they will live in depend largely on profits. Business profits supply a large part of the new investment the country needs. The United States is falling behind other countries in saving and investment.We need more investment to modernize our plant and compete more effectively with foreign producers; to maintain a healthy environment; and to promote our economic goals generally, including the creation of well-paid jobs. The late Walter Reuther, when he was president of the United Auto Workers, said, "Wages are limited by [ corporate] ability to pay and our ability to produce. This is nothing new. It's an old idea. It's just common horse sense."

When government agencies, like the Postal Service or a municipal water system , sell a service, the linkage is basically the same as in business: wage-cost-price, plus any subsidy. In 1978, the postal workers won a pay increase of 21.3 percent over three years, with an escalator clause to take effect if the cost of living increased more than 6.5 percent. Say that translates into an annual increase of 10 percent. Unless the productivity of postal workers gains at the same rate, either postal rates will go up or the government will have to raise its contribution.

Generally governments don't sell their services. The linkage then is wage-cost-taxes or governmental subsidies. Sometimes escalator clauses are tied to gains in productivity. The simplest way to raise productivity is to cut staff. If so, pay increases may come -- in the schools, for instance -- at the expense of larger classes (and presumably poorer teaching) and fewer jobs for young teachers.

Unless private employers take lower profits, or public employers cut services , pay raises higher than a percentage point or so each year can be paid only out of higher prices or higher taxes.

Wage increases are not the only cause of inflation. Big deficits in the federal budget are another. Any increase in the money supply not justified by what we produce fuels inflation. Governmental paper work and regulations raise costs without increasing salable product. OPEC oil price increases give inflation another prod. But the Joint Economic Committee of Congress said flatly this year, "The most important determinant of the overall price level is the level of unit labor cost." In a comment on COLA, the committee said, "The lack of productivity gains meant that most of the nominal wage increases were simply passed on to consumers in the form of higher prices, stimulating another round of higher wage demands."

Some economists have argued that escalator clauses may be preferable to big settlements at fixed percentages that allow for estimated increases in living costs. That could be true under particular facts. But the Pay Advisory Committee on new wage standards reports that under the current guidelines workers sheltered by escalator clauses have received substantially bigger increases -- 10 to 11 percent -- than workers without escalator clauses -- a little over 7 percent.

Escalator clauses are virtually dangerous for another reason. With an occasional exception, they explicitly deny the link between productivity and real wages. Suppose productivity had continued to gain at 3 percent a year. By one estimate, real output would now be $400 billion higher -- about $4,000 for each worker. That's the route to higher real wages.