American capitalism isn't broken after all

One of the best-loved stories about the squeeze on middle-class incomes in the U.S. concerns the long-term divergence between wages and productivity. This goes as follows: Wages have stagnated for decades even as output and profits kept going up. Owners of capital grabbed all the gains.

For those who tell this story, the issue is justice not growth. What's the point of striving for efficiency if the benefits don't flow to the living standards of everyday Americans? Instead, they argue, capital needs reining in. The U.S. should restore the bargaining power of labor -- with stronger unions, higher minimum wages, import barriers, taxes on profits, and so forth.

The narrative is so appealing that to remain popular it probably doesn't need to be true. That's just as well, because it turns out to be wrong.

The evidence suggests that greater productivity makes a decisive contribution to living standards. Earlier this year, President Barack Obama's Council of Economic Advisers illustrated the point by comparing hypothetical scenarios. One asked what would have happened to living standards if everything had been the same except that inequality hadn't increased after 1973; another, if productivity growth had remained as strong in the 40 years after 1973 as it had been in the 25 years before. Unchanged inequality would have added $9,000 to the typical family's annual income, which is a lot. Sustained productivity growth would have added $30,000, which is a lot more.

The Wall Street Journal's Greg Ip adds that wages rose faster during administrations that presided over good growth in productivity (for instance, Bill Clinton's second term) than during administrations when productivity grew slowly (for instance, Clinton’s first).

Yet there's a puzzle: Despite the correlation between wages and productivity, standard measures of wage growth have shown disappointing results for years.

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