Where’s the labor shortage? Behind the Numbers, December 2017

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While businesses bemoan the labor shortage, economists appear unconcerned. Is there really a talent crunch, or is it just that talent professionals need to learn what a “normal” labor market is like?

Introduction

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Many businesses are feeling the pinch. They just can’t find the workers they need—top newspapers are documenting the pain of business executives.1 Think tanks are assembling panel programs on the “skills shortage". And Deloitte economists are hearing from several clients that they don’t seem to be able to find the right talent.

And yet . . . many economists are surprisingly blasé about the problem.

In fact, many economists’ social media feeds erupted with applause a few months ago, when Minneapolis Fed President Neel Kashkari responded to a question about the labor shortage by saying, “If you’re not raising wages, then it just sounds like whining."

What’s the difference? Why are economists so dismissive of business concerns?

Understanding the price of labor

Remember the third week of introductory microeconomics? The professor was showing you how the supply/demand framework worked, explaining that a shortage is the point where demand is greater than supply. The professor told the story of how the shortage leads to rising prices . . . until the amount demanded falls, the amount supplied rises, and the market reaches equilibrium. So to an economist, "shortage" is almost synonymous with "rising prices."

The problem is, the price of labor in the United States isn’t rising. Figure 1 shows two measures of wages.

The first measure is the Employment Cost Index (ECI). The ECI is a broad measure of compensation (including money wages and most benefits). During the 2002–2007 recovery, the ECI grew at an average annual rate of 3.4 percent.2 During the current recovery, from 2009 to the most recent available data, the ECI has grown just 2.0 percent. Compensation growth has been slightly faster in the past couple of years, but at 2.3 percent is still substantially below the growth rate of the previous recovery—even though the inflation rate has been about the same.

The second measure is the cost of one unit (hour, if you like) of labor. The unit labor cost measure adjusts compensation costs for the growth of labor productivity. If labor is scarce, then the cost of a unit of labor should be rising, even when adjusted for slower productivity growth. In fact, unit labor costs have been falling in the past few quarters! In the previous recovery, unit labor costs rose 1.1 percent. During the current recovery, unit labor costs have risen at an annual average rate of just 0.7 percent per year.

The evidence is clear: Compensation is, at best, stagnant. It’s hard to argue that there’s a shortage when prices aren’t rising. It’s a pretty fundamental economic insight, which is why we teach the relationship to first-year students early in their introductory course.

Labor costs

One response to this is that, while overall wages aren’t going up, they may be going up in certain sectors. And that may be true—but it’s not actually relevant. It’s not relevant because, in a dynamic economy, some wages will be rising as some are falling. Those signals are necessary to convince workers to change jobs and careers. As long as overall wages are stagnant, there is no general labor market shortage, even if shortages and surpluses in specific occupations require appropriate wage adjustment. And, yes, it may require some additional compensation to get workers to change occupations or industries. But that’s how markets work. The higher cost of labor in some markets (and the pain of business leaders in those markets) is a feature, not a bug, of a healthy market economy.

Now, we economists may enjoy hearing a Fed president speak plainly about the problem. But there is a reason why business executives see a problem, and not just the normal operations of the market economy. For most people, the definition of "normal" is based on our past experience—and that can be misleading in this case. Because the labor market has not been "normal" for most of the recent past.

What’s "normal"? To an economist, "normal" would imply that the market is in equilibrium—that demand and supply are roughly balanced. When that happens, the price (in the labor market, that’s the wage) is stable. To create a measure of "normal," economists find the unemployment rate at which the real wages are stable. This unemployment rate is sometimes called the "natural" unemployment rate or the non-accelerating inflation rate of unemployment (NAIRU). (Trust economists to come up with a snappy name.) It’s not zero because some people are unemployed in equilibrium—because they don’t have necessary skills, because they live in locations that don’t have high labor demand, or because they quit without immediately finding new jobs (perhaps to move to a new location or change occupations).

Figure 2 shows a well-regarded estimate of the market equilibrium rate compared to the actual unemployment rate. For the past 20 years, the actual unemployment rate has been at or below the equilibrium unemployment rate only 35 percent of the time. For almost two-thirds of this period—whenever the actual unemployment rate is above the market equilibrium rate—the labor market has been out of equilibrium. The supply of labor has been greater than the amount demanded.

That sounds abstract. In the real job market, it means that for much of the past 20 years, businesses have become used to a buyers’ market for labor. HR departments received hundreds of resumes for job openings. Potential workers got used to applying for jobs for which they are "overqualified" and hiring executives became used to having an abundance of qualified candidates to choose from. Further, many businesses have needed to use arbitrary methods to sort the overabundance of candidates. These range from computer screens to unnecessary qualifications.3 So what if a few qualified applicants don’t understand how to create job applications that will get through the computer screen? Plenty will make it through. That’s been a reasonable hiring strategy for much of the past 20 years.

Unemployment rate and labor market equilibrium rate

But it’s not an effective strategy when the job market is in equilibrium. An equilibrium job market means that businesses won’t always find the perfect candidate (just as the candidate may not find the perfect job). It means that successful businesses will become more flexible about job qualifications.4 It means that many successful businesses will consider additional training and other methods to widen the pool of applicants. And it means that talent executives who are serious about finding good applicants are revisiting job requirements such as location and flexibility in working hours to be sure that their organizations have access to a wide talent pool.

What does it mean for businesses?

The good news is that many US businesses are doing these things. We know that because those businesses have found an average of 170,000 additional workers to hire each month in 2016 and 2017—when the growth of the population of labor force age (16 to 64 years) has been just 50,000. And they are doing so without needing to raise wages. That’s not the sign of a labor shortage; it’s the sign of a healthy labor market that is creating the jobs that US workers want and need.

There can be a very important lesson for hiring companies here. Successful companies typically aren’t "whining." They are figuring out how to operate in a competitive labor market. They are doing so without letting labor costs go up, by simply being smarter about how they pursue and keep talent. Companies that aren’t competitive in the labor market will likely increasingly fall behind, the same way that companies that aren’t competitive in their product space will typically lose market share. Blaming the state of the labor market for a company’s flawed personnel strategy is about as productive as blaming consumers for disliking the latest tech gadget.