Stagnant services and the gradual disinflation of advanced economies

Abstract

In advanced economies, nominal wage growth and inflation have been falling in secular terms since the early 1980s. Drawing on debates on industrial composition and industrial dualism, I argue that a key driver of falling wage growth and inflation has been the growing share of employment in “stagnant services”: those with limited productivity growth, competitive product markets, and thin profit margins. In these services, it is difficult to raise wages and prices. I use these insights to revisit Baumol's cost disease theory, arguing that weak wage growth in stagnant services has spilled over to other sectors with more room for wage growth, resulting in the gradual disinflation observed in recent decades. Using graphical plots and error correction models of nominal wage growth and inflation in 21 advanced economies from 1972-2009, the analysis shows that employment growth in stagnant services over this period was associated with a reduction of nominal wage growth and inflation by more than half. Without deep changes in stagnant services, slow wage and price growth are here to stay.