The Relation between Productivity and Compensation in Europe

One of the classical problems of political economy has been to understand the relation between labour compensation and labour productivity; in more recent years, then, wage growth has become a key concern for the conduct of monetary policy by major central banks. This paper studies to what extent increases in productivity translate into increases in compensations. While previous studies had investigated this relation in the case of the US, this work enlarges the scope of the analysis to a set of 34 advanced economies over the past half century. The results show on average a significant link between growth in productivity and growth in compensation, however there is no one-to-one relation, there is instead a significant gap. Cyclical conditions as well as labour market structures greatly affect this relation. These findings imply that policies aiming at increasing productivity are a necessary but not sufficient condition to achieve also appropriate pay growth, because other factors intervene to weaken the link between the two. Although this topic has gained more prominence in the US, the analysis shows that these findings apply to the EU and to other advanced economies as well. Finally, to the extent that the gap between productivity and compensation affects aggregate demand, understanding it is crucial for the conduct of macroeconomic policies.