NCPA - National Center for Policy Analysis

Greenspan Wrong: Wages Don't Push Inflation

October 13, 1997

Last Wednesday, Federal Reserve Chairman Alan Greenspan again rocked financial markets. In testimony before the House Budget Committee, Greenspan implied that inflation was making a comeback. This led investors to believe that the Federal Reserve might soon raise interest rates. The Dow Jones Industrial Average immediately dropped 83 points.

In his testimony, Greenspan was particularly concerned about tightness in labor markets. "The imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity," he warned.

What Greenspan is saying is that as the unemployment rate falls and the supply of labor dries up, workers will demand higher wages, and higher wages will cause inflation. In short, he has endorsed what economists call the Phillips Curve, which shows that there is always a trade-off between inflation and unemployment: low inflation is associated with high unemployment and high inflation is associated with low unemployment. (This relationship was first put forward by British economist A.W. Phillips in a 1958 article.)

The only problem with the Phillips Curve is that there is precious little evidence supporting it. In fact, the latest research shows the opposite relationship. As a recent study from the Federal Reserve Bank of San Francisco put it, "tests that allow for a long-run relationship between wages and prices tend to find that price changes predict future wages, while wage changes do not have much effect on prices."

In any case, there is still plenty of unutilized and underutilized labor in the economy. The current 4.9 percent unemployment rate, while low by recent standards, is still more than a percentage point above the level achieved without inflation in the late 1960s. Although the overall labor force participation rate is at a historical high, this is due entirely to the increase in working women. The participation rate for men is actually at an all-time low.

The main reason for the fall in male labor force participation is the extraordinary decline in work by men over age 65 (see figure). In 1949, almost 47 percent of men this age still worked. Today, the figure is less than 17 percent. This is an incredible waste of a scarce and valuable economic resource. A recent study by Hudson Institute economist Alan Reynolds, "Restoring Work Incentives for Older Americans," lays much of the blame on tax and pension laws that actively discourage older Americans from working. If Greenspan really thinks we are facing a shortage of trained workers, this may be where to find them.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, October 13, 1997.


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