How Fast are Wages Rising?

Greg Ip of the Wall Street Journal illuminates an important point - how to interpret the increase in labor income observed in recent data. It turns out that much of the increase is likely due to the way profits from the exercise of options are counted in the Commerce Department's calculation of compensation changes. Because of this, the rate of increase in typical wages may be much slower than these data imply, something also noted by Dean Baker, among others:

How Stock Options Muddle the Relationship Among Wages, Corporate Profits and Inflation, by Greg Ip, Wall Street Journal [Free]: Scorekeepers at the Commerce Department last month discovered that American workers were earning far more than previously estimated -- and that created an economic puzzle.

The new data were out of step with other measures showing sluggish wage growth, a factor in widespread worker dissatisfaction turning up in the polls. And the increased income wasn't matched by more production -- that is, in gross domestic product -- as it should have been.

Solving this puzzle is important for understanding how well American workers and companies are doing and whether rising wages pose an inflation threat. The answer appears to be stock options, a growing part of compensation for top-end workers. ...

The Commerce Department's Bureau of Economic Analysis, which keeps the nation's GDP books, treats profits from the exercise of options as labor income. But options aren't counted in most other measures of wages. So the BEA reports ... may be overstating the extent of wage pressure, and, for related reasons, at least temporarily understating overstating (see note below) profits.

Here is what's going on:

Last month, the BEA declared that labor income for all Americans in the first half was ... 1.3% more than it had estimated just a month earlier. This suggested Americans were flush with cash, welcome news for those worried about a slowing economy, but it also raised inflation alarm bells. ... The new data ... showed that business compensation per employee-hour soared almost 8% in the year through June. Adjusted for higher productivity, labor costs jumped 5%, a near six-year high.

But something didn't seem right. That jump in labor costs should have squeezed profit margins, yet margins are at a 40-year high. Plus, the 8% rise in hourly compensation far outstripped better-known measures of labor costs. The Labor Department's employment-cost index -- which includes hourly wages, benefits and bonuses -- rose just 3% in the same period. The weekly wage of workers at the statistical middle rose only 2.5%.

Adding to the mystery was the economic-textbook fact that Americans' income -- wages, benefits, profits, etc. -- is supposed to equal the value of what they produce. But after the revisions, gross domestic income was rising much faster than GDP. The two seldom match perfectly, but the divergence was striking.

The likely explanation: stock options. The income earned when employees cash in stock options is counted in both gross domestic income and the Labor Department's productivity-adjusted labor-cost measures, but not in most of the other wage measures. ... Because higher-paid employees are more likely to have stock options, this helps explain why the advance in labor income doesn't reflect the average worker's experience... The bottom line: Wage increases, while accelerating, aren't flashing a warning sign.

This will get sorted out as more data arrive, but as the article details (it's free), that will be a slow process. For now, it looks like the reversal in widening income inequality - the change Ed Lazear and others keep saying is just around the corner - is still just around the corner.

Update: Just received an email from Greg Ip with a correction:

Mark: Thanks for linking to my article on your blog this morning. There's an error in the original version of the story which I'd appreciate you correcting on your blog;

In this paragraph:

The Commerce Department's Bureau of Economic Analysis, which keeps the nation's GDP books, treats profits from the exercise of options as labor income. But options aren't counted in most other measures of wages. So the BEA reports ... may be overstating the extent of wage pressure, and, for related reasons, at least temporarily understating profits.

It should say "temporarily overstating profits," not understating profits.

The story on wsj.com today will have the corrected version of the article.

Thanks Greg - appreciate receiving the correction.