Inflation for Merit

Economists have long known that worker compensation is “compressed.” Firms overpay their worst workers, and underpay their best workers. The problem is especially severe in the public sector, free of a hard budget constraint. But compression is everywhere. Compression is the fundamental reason why firms prefer abler workers. If all workers were exactly paid their personal productivity, subpar employees would be just as profitable as stars.

Part of the reason for compression is that nominal pay cuts are bad for morale. As long as inflation is very low, the 0% nominal floor binds for many workers. As a result, the worst workers often get the same raise as their mediocre colleagues.

Now that inflation has hit 9.1%, however, employers suddenly have extraordinary flexibility. You can now give your worst workers a real pay cut of almost 9% by holding the line.* How should business respond?

Compensation specialists carefully strategized about this during the last Great Inflation of the late 70s and early 80s. What did the specialists conclude? Akerlof, Dickens, Perry, Bewley, and Blinder’s 2000 BPEA piece provides a succinct summary:

In fact, textbooks for compensation professionals warn against using the formal procedure that economists would imagine to be standard. For example, George Milkovich and Jerry Newman discourage their readers from granting automatic wage and salary increases, including increases for the cost of living. Such automatic grants, these authors say, reduce the funds available to reward employees for performance. Similar thoughts are expressed in the handbook of the influential Hay Group of compensation consultants, in which managers are advised to "avoid linking salary movement to changes in the cost of living, because this creates entitlement and reduces the amount of money available to differentiate for performance."

Thus, while employers could respond to high inflation with high across-the-board raises, this is probably a huge mistake. (Which hasn’t stopped Virginia from handing out a 5% across-the-board raise to state employees!) Instead, our high-inflation era is a rare - perhaps once in a lifetime - opportunity to realign pay and performance.

Managers, think about all of your workers who don’t pull their weight. Why should you give them raises if you’d like them to quit? Just offer a 0% raise after a year of 9.1% inflation and see what happens. If they stay, at least they bleed you less; if they leave, better yet!

Next, use some of the savings to raise pay for high achievers. Why bother? To retain the employees who more than pull their weight.

Finally, use the rest of the savings to poach high achievers from competitors who don’t read Bet On It.

Would this work? You could argue that fairness norms evolve during eras of high inflation. A minimum raise of 0% may be necessary to maintain worker morale when inflation is 2%. When inflation is 9.1%, however, the minimum raise necessary to maintain worker morale could rise to 5% or 7%.

In the long-run, this is probably right. But given how poorly most people understand inflation (and percentages!), it’s hard to believe the norm fully updates in the matter of a year or two. There is no time like the present for firms to strike a blow for meritocracy - and their future. If you employ others, why not give it a try? And if you’re a meritorious worker, why not whisper these heresies in your employers’ ear?

*With inflation at 9.1%, giving a 0% nominal raise multiplies their real salary by 1/1.091=.917, a real pay cut of 8.3%.