Wage increases generally comprise two main parts—an increase to compensate labor for inflation and an increase in real income to reflect productivity gains. Because there is no reliable way to forecast either component, wage negotiators tend to base their assumptions on past levels of both inflation and productivity. This has profound implications for the relation between productivity and inflation.

Suppose, for example, that the inflation and productivity assumptions incorporated in wage bargains each equal three per cent per annum, so that wage increases equal six per cent. If actual productivity falls from three to 1½ per cent, the result is a rise in inflation from three to 4½ per cent; this, of course, becomes the new inflation for the next period’s wage bargaining. If productivity growth remains at the new 1½ per cent level, while expectations remain at three per cent, inflation will spiral in the next period from 4½ to six per cent. If actual growth in productivity consistently falls short of anticipations, inflation will accelerate over time.

Although, relative to the rest of the world, the level of U.S. productivity is still high, our lead is being rapidly eroded by an anemic rate of productivity growth; for the period 1973–79, only Italy ranked lower than the U.S. Yet U.S. companies still tend to use an outdated three per cent productivity growth standard. The discrepancy goes a long way toward explaining our stubborn inflation problem.

To the layman, productivity growth means faster assembly lines and greater human exertion. But modernization of plant and equipment and more efficient production processes account for most gains. The key to licking inflation is productivity, and the key to improving productivity is capital investment.