If you’ve ever gotten completely lost — no GPS, off the map, which-way-is-up lost — you know how disorienting it can be. All of a sudden, nothing looks familiar and every available path seems like the right one. It can take a while to find your bearings and get back on track.
In its own way, the economy has been off the map over the past three years. The standard measures look pretty good. Inflation has been a concern, but production is solid and the job market has been white hot. The unemployment rate fell below 5 percent in September 2021 and never looked back.
But public opinion is another matter entirely. Pollsters regularly ask Americans how they think the economy is doing, and whether it is getting better or worse. Both measures have drifted downward since late 2020 and cratered this past year. Everything’s amazing, almost — and nobody’s happy.
This is new. Public opinion had historically followed the business cycle, declining in recessions and improving in expansions like the one we’re experiencing now. For observers of the economy, this divergence was akin to being lost in the woods. They trotted out all sorts of explanations for our unexpected pessimism. It’s the media! It’s gas prices! It’s politics and partisanship!
But what’s going on isn’t vibes. There is a simple explanation, once you really look into it: people’s pay hasn’t been keeping pace with inflation. People’s dissatisfaction with the economy reflects this decline in purchasing power. What’s causing that is the real mystery.
The troubling thing about all of these explanations is that they basically claim the American public has lost its collective mind. It’s as if, after decades of sensible responses to surveys about the economy, everyone suddenly decided “Nope! Not doing that anymore!” It’s one thing to shrug off a single poll that misses an election result by a few points, and another thing entirely to wave off years of surveys across multiple pollsters as a mistake or an illusion.
By tradition and training, economists and financial journalists focus their attention on three fundamentals — unemployment, inflation, and total production — shunting all other economic factors off to the side. But these are not ends in themselves; they’re a conduit for what really matters to households: purchasing power. Since most of us pay our bills by working, this means a comparison of wages with prices.
For a long time, the illusion that these fundamentals adequately represented the economy persisted because it worked. Reductions in unemployment reliably raised wages relative to prices; increases in unemployment went the other way. So we continue to gaze at these fundamentals, even though this relationship has now broken down.
Workers are in notably worse shape than they were two years ago, despite low unemployment. Measuring this accurately — and most people don’t — is tricky. You can’t just look at wages in dollars. You must account for inflation, which erodes the purchasing power of pay, and also for worker skill. A pay rate of $25 per hour is great for busboys in high school but not for engineers 20 years out of college.
“Real wages” are the hourly rate of pay adjusted for both of these factors. Households have more purchasing power when they rise and less when they fall. For most of 2021 and 2022, they fell. In the second half of 2022, real wages were about 3 percent lower than they were two years earlier, which for the average worker amounts to a loss of nearly $1,800 per year. It is hardly surprising that people’s opinion of the economy has been affected. It would be shocking if it wasn’t.
In recent months this trend has reversed — real wages are up in 2023 compared to 2022. The experience of the last couple of years isn’t going to be washed away with a few months of data, but the trend is promising.
Economists seem to cling to the illusion that low unemployment automatically makes a strong labor market for another reason too: It’s what makes the most sense. After all, low unemployment doesn’t just make it easy for people to find work — it also makes it hard for businesses to find workers. To compete for those workers, they raise pay.
There are just two ways around this logic. One is a lack of competition. But as a social scientist who’s spent way too much time studying the economy, I don’t think this can be to blame. While the labor market has indeed been getting less competitive, just like many goods and services markets, this is a gradual process, far too slow to cause recent changes in real wages.
That leaves the other option: a breakdown in wage setting. Though tight labor markets make it hard to find workers, firms are slow to provide the pay increase needed to get them.
A better way to put it is that wages aren’t as fluid as, say, gas prices, which seem to jump up or down in an instant. There are reasons for this. Gas prices are easily observed and easily changed, and people will happily switch stations to save a few cents per gallon. Labor markets aren’t like this at all. Switching jobs takes time and effort, and many workers are reluctant to give up the devil they know for the devil they don’t. Employers capitalize on this situation by adjusting wages slowly, if at all.
Here’s what this looks like in practice. A friend of mine is a traveling nurse, who is contracted out to hospitals that are short on staff. These contracts sometimes last months on end, which is plenty of time for the hospital to hire more nurses. It could get those nurses by raising pay, but it would have to do this for everyone or face a backlash. That’s expensive, so it uses the staffing agency instead, staving off any pay increase as long as possible.
Sluggish wage adjustment has always been the rule in the US — a very broad rule. It holds for wage decreases as well as increases, and in response to inflation as well as unemployment. In the last 15 years, in fact, every notable change in real wage growth has been associated with prices moving the other way. For example, during the Great Recession in 2008 and 2009, real wages increased a lot as prices unexpectedly fell, raising everyone’s purchasing power by accident. Three years later, prices unexpectedly rose and real wages fell. In both cases, it took a while for things to return to normal.
In that sense, what we have been experiencing lately is simply an extreme version of business as unusual: High inflation, combined with slow wage adjustment, drives purchasing power down. And this is true not just for the US. Canada’s post-Covid pay has followed the same trajectory as ours, and it is not alone.
To climb out of this hole, real wages will have to start growing again. The good news is that they already have. Annual real wage changes turned positive in February; month-on-month changes turned positive late last year. In this respect, we are doing well. Most European economies still haven’t seen real wage growth.
Furthermore, this hole is shallower than it may seem. Since late 2020, real wage reductions have cost households a little less than $1 trillion. That is a lot, without a doubt, but it is less than half of what households received in Covid-related transfers — stimulus payments, expanded unemployment insurance, child care credits, and the like — which amounted to $2 trillion. That puts them well ahead of where they were in March 2020, which is why people report that their own finances are doing just fine, even while they trash the state of the economy.
The prospects for continued wage growth are good. Delayed pressure does not mean no pressure, and low unemployment and reduced purchasing power should both continue to exert upward pressure on pay. The public has picked up on this. Sentiment indexes began inching upward late last year, about the same time real wages did.
What we need to free ourselves from is the preconception that low unemployment alone makes a good labor market. Where we actually are is simple to understand. Dollar wages adjust slowly to price increases. Inflation has raised prices a lot, reducing purchasing power. As a result, the public is not happy about the economy. This is nothing new — not for this country, not for others — and it too shall pass.
Darren Grant earned his PhD in economics in 1995. He is currently an economics professor at Sam Houston State University in Texas, where he researches topics as varied as the cesarean section, drunk driving, the design of election ballots, and the movement of wages over the business cycle. He is an avid cyclist who bikes for transportation and for travel. Learn more about his professional activities and bike tours here.