The Crusade That's Killing Prosperity

The great untold story of the American economy in the 1990s is the disguised
high rate of unemployment and its direct impact on stagnating living standards.
Properly calculated, our rate of joblessness is well into double digits. No
wonder workers have no bargaining power to get their share of an increasingly
productive economy.

Among economists, a debate rages on why earnings inequalities began to rise
rapidly and real median wages started to fall a quarter century ago. Some blame
a technological shift that cut demand for uneducated labor while boosting the
demand for those with greater education and skills. Others identify global
"factor price equalization"--in an open global economy overseas workers with
comparable skills but lower wages are forcing the wages of Americans down.

What's left out of this lengthy, if inconclusive, debate is the role played
by the slack economic environment in which these two forces have been
operating. While each is real, their impacts would have been very different if
they had operated in an environment of labor shortages rather than one of vast
labor surplus. The U.S. economy has been celebrated for creating tens of
millions of jobs during the past two decades. But properly counted, our true
unemployment rate is no better than Europe's. And nothing keeps wages from
rising like a large pool of idle or underemployed workers.

Today's slack labor markets were produced by the war against
inflation--declared in the early 1970s and still underway 25 years later.
Inflation began with the mis-financing of the Vietnam War in the late 1960s,
accelerated with the OPEC oil shock and food shocks of the early 1970s,
expanded across the economy in the mid-1970s because of the widespread use of
cost-of-living indexes in both labor and supplier contracts, and was rekindled
by the second OPEC oil shock at the end of the 1970s.

While other remedies such as wage and price controls were initially
tried, none seemed to work. Eventually all of the world's major governments
came to the conclusion that the only cure for inflation was to use higher
interest rates and tighter fiscal policies (higher taxes or lower expenditures)
to restrain prices by deliberately slowing growth to push unemployment up and
to force real wages down. Excess capacity and surplus labor became the key
players in the anti-inflationary game.

In the end the strategy for braking the world economy worked. The world's real
economic growth rate slid from 5 percent per year in the 1960s to 3.6 percent
per year in the 1970s. The double-digit inflation of the early 1980s led to
another round of monetary tightening, and growth further decelerated to 2.8
percent per year in the 1980s. Actions such as Federal Reserve Chairman Alan
Greenspan's seven interest rate hikes between early 1994 and early 1995 and the
Bundesbank's very restrictive policies in Germany slowed the world's growth
rate even further, and in the first half of the 1990s world growth has averaged
just 2 percent per year. Today the Federal Reserve Board designs policies to
limit American economic growth to a maximum of 2.5 percent or less. Anything
more is believed to be inflationary. In its annual policy recommendations, the
Organization for Economic Cooperation and Development (OECD) subscribed to the
view that America's maximum noninflationary growth rate was 2.5 percent.

Like a real war that has gone on far too long, all of the original
reasons for the war--the mis-financing of the Vietnam War, OPEC oil shocks,
food shocks, indexed wage and supply contracts, inflationary ex pecta
tions--are long gone. As the war continues year after year, the negative side
effects of the war, falling real wages and rising inequalities, have become far
more corrosive than the original reasons for joining the battle. The battle
continues even though the war against inflation has been won. The combatants
have gotten so used to "fighting on" that they cannot even recognize that they
have won.

Slow growth cured inflation because it directly pushed real wages
down--creating very slack labor markets. Indirectly, it created an environment
where factor price equalization, a skill-intensive technological shift, and
other factors could generate enormous downward pressures on real wages.

Restrictive monetary and fiscal policies have produced unemployment rates not
seen since the Great Depression. Today, more than 10 percent of the European
workforce is officially unemployed and in three countries (Spain, Ireland, and
Finland) unemployment has been above 20 percent at some point in the first half
of the 1990s. Spain and Italy have youth unemployment rates of over 60 percent.
While it is very fashionable to blame Europe's high unemployment rates on
"rigid labor markets," which is to say unions and welfare state protections,
the real culprit is macroeconomic austerity. Most of the same protections
existed before 1973, and coexisted nicely with high growth, full employment,
and rising wages. Japan's official unemployment rate is near 3 percent, but
Japan essentially has a system of private unemployment insurance where workers
who would be fired in the United States remain on private payrolls. Even the
Japanese admit that if their firms acted as American firms do, their
unemployment rate would be over 10 percent.


In the fall of 1995, America's official unemployment rate was hovering
around 5.7 percent. But like an iceberg that is mostly invisible below the
waterline, officially unemployed workers are just a small part of the total
number of workers looking for more work.

If we combine the 7.5 to 8 million officially unemployed workers, the 5 to 6
million people who are not working but who do not meet any of the tests for
being active in the workforce and are therefore not considered unemployed, and
the 4.5 million part-time workers who would like full-time work, there are 17
to 18.5 million Americans looking for more work. This brings the real
unemployment rate to almost 14 percent.

Slow growth has also generated an enormous contingent workforce of
underemployed people. There are 8.1 million American workers in temporary jobs,
2 million who work "on call," and 8.3 million self-employed "independent
contractors" (many of whom are downsized professionals who have very few
clients but call themselves self-employed consultants because they are too
proud to admit that they are unemployed). Most of these more than 18 million
people are also looking for more work and better jobs. Together these
contingent workers account for another 14 percent of the workforce. In the
words of Fortune magazine, "Upward pressure on wages is nil because so
many of the employed are these `contingent' workers who have no bargaining
power with employers, and payroll workers realize they must swim in the same
Darwinian ocean." Like the unemployed, these contingent workers generate
downward wage pressures.

In addition there are 5.8 million missing males (another 4 percent of the
workforce) 25 to 60 years of age. They exist in our census statistics but not
in our labor statistics. They have no obvious means of economic support. They
are the right age to be in the workforce, were once in the workforce, are not
in school, and are not old enough to have retired. They show up in neither
employment nor unemployment statistics. They have either been dropped from, or
have dropped out of, the normal working economy. Some we know as the homeless;
others have disappeared into the underground illegal economy.

Put these three groups together and in the aggregate about one-third of the
American workforce is potentially looking for more work than they now have. Add
in another 11 million immigrants (legal and illegal) who entered the United
States from 1980 to 1993 to search for more work and higher wages, and one has
a sea of unemployed workers, underemployed workers, and newcomers looking for

These millions of job-hunters lead to a more human-scale result that everyone
can understand. At 5 p.m. a midsized metal-ceramic firm posts job openings for
10 entry-level jobs on its bulletin board. By 5 a.m. 2,000 people are waiting
in line to apply for those 10 jobs.

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While the economy has been generating about 2 million jobs per year
since the end of the 1990-1991 recession, these gains are just barely large
enough to hold even with migration and the normal internal rate of growth of
the working-age population. However rapid, job growth cannot lead to wage
increase, unless it is faster than the growth rate of those looking for work.

If one believes even marginally in the power of supply and demand, surplus
labor of these magnitudes has to lead to falling real wages. Wages rise roughly
with productivity growth only if there are labor shortages. Since slow growth
throws the bottom 60 percent of the workforce into unemployment far more than
it does the top 20 percent, the earnings of the bottom 60 percent should be
expected to fall sharply relative to the top 20 percent in a period of high
unemployment--as they have.

These direct negative effects on wages were compounded by several indirect
effects. American economists used to talk about something called "efficiency
wages." One of the mysteries of the post-World War II era was wages that rose
even when there were unemployed qualified American workers who would have been
glad to do those jobs for less. This anomaly was explained by arguing that
firms deliberately paid incumbent workers above-market wages to secure a high
degree of cooperation, commitment, and effort that they could not have gotten
if their workforces could have quit and easily gotten equal wages elsewhere.

But in a world where there are always millions of unemployed and underemployed
workers, firms do not have to pay efficiency wages. The same degree of
cooperation, commitment, and effort can be achieved by using the motivation
factor called "fear"--the fear of being thrown into this enormous sea of
unemployment and underemployment. In the last five years examples abound of
profitable firms that simply marched in and dramatically lowered the wages of
their existing workforces by 20 to 40 percent. Workers complain but they don't

Similarly, two decades of surplus labor have broken the linkage between
productivity gains and wage increases. The early 1990s demonstrated that no
government would come running to the rescue with large fiscal and monetary
packages designed to stimulate demand during recessions. Instead, recessions
would be allowed to run their course and governments would simply wait for a
recovery--or as happened in 1994 in the United States, adopt monetary policies
to actually slow what was already by historical standards a very weak recovery.

Knowledge that governments won't shorten recessions radically changes
expectations. If downturns are sharper and longer, business firms have to
reduce prices if they wish to survive. As a result, in the 1990s more of
America's productivity gains are showing up as falling prices and fewer are
showing up as rising wages. Higher labor productivity doesn't lead to higher
labor wages as it used to. Wages can fall while productivity rises--as has
happened in the last 20 years.

The best example is the computer industry--an industry that pays very low wages
for its production workers. Productivity is growing very rapidly, but all of
that productivity gain shows up in lower prices or higher profits for
chip-makers or software firms. None shows up as higher wages as used to occur
in industries such as automobiles or steel. This sea of excess labor
accentuates the downward pressures of a skill-intensive technology shift and
global factor price equalization. Tight labor markets would offset much if not
all of the impact on the bottom 60 percent of the wage distribution, but they
don't exist.

A skill-intensive technological shift should raise the wages of the skilled and
lower the wages of the unskilled, but in the context of vast supplies of excess
labor the expected higher wages even for skilled workers don't appear. The
upward wage pressures that should be seen are more than offset by the downward
pressures from surplus unemployed skilled laborers. For males, real wages are
now falling at all education levels, even for those with graduate degrees. For
the unskilled the downward wage pressures that flow from this technological
shift are magnified because of the surplus labor that already exists.

The war on inflation has also intensified the downward wage pressures
coming from a number of other sources. Some capitalists certainly plotted to
kill America's labor unions. President Reagan's firing of all of America's
unionized air traffic controllers legitimized a deliberate strategy of
de-unionization. In the private sector, consultants were hired who specialized
in getting rid of unions, decertification elections were forced, and legal
requirements to respect union rights were simply ignored--firms simply paid the
small fines that labor law violations brought and continued to violate the law.
The strategy succeeded in shrinking union membership to slightly more than 10
percent of the private workforce (15 percent of the total workforce). And even
where unions still existed they lost much of their power to influence wages or
negotiate working conditions. Combined with corporate compensation committees
who in the past 25 years have escalated CEO salaries from 35 to 157 times that
of entry-level workers, one could argue that the capitalists had declared class
warfare on labor--and were winning.

While the economics literature is inconclusive as to whether unions affect
average wages (equally productive companies with and without unions tended to
pay the same wages in the past), there is no doubt that unions affect the
distribution of wages. Wage distributions are much more equal where unions
exist. High school-college wage differentials, for example, have always been
smaller in the union sector than in the nonunion sector. As a result, with the
demise of unions as a force in the American economy, wage differentials should
be expected to rise. In addition, as company worries about unionization have
waned, the gap between union and nonunion wages has doubled. Higher wages no
longer need to be paid in nonunion firms to keep unions out.

The attack on unions could not have succeeded in an environment of tight labor
markets. But in this sea of surplus labor, unions have little negotiating power
to offer prospective members.

Deregulation has also led to some wage reductions. In regulated industries such
as trucking and airlines, workers collected some of the excess profits--what
economists call "rents"--that accrued from regulation. Truck driver wages and
the wages of some airline employees fell dramatically with deregulation. In the
case of truck drivers, wages fell three times as fast as elsewhere. The rents
that had been built into their wages were transferred back to the consumer or
to corporate profits. But in a world of tight labor markets more of those rents
would have stayed with workers.

Since wages in the many advanced industrial countries are now above those in
the U.S., most of the factor price equalization flowing from other First World
countries is behind us. But ahead lies the integration of the Second World into
the First World and a very different Third World. The communist countries did
not run effective civilian economies but they ran excellent education systems.
The Soviet Union was a high-science society with more engineers and scientists
than anyone other than the United States. China is capable of quickly
generating hundreds of millions of medium-skill workers. The end of communism
and the success of the "little tiger" countries on the Pacific Rim have led the
Third World to junk import substitution as a route to economic development, and
to become export oriented. Where countries with only a few million workers used
to be export oriented (Singapore, Hong Kong, Taiwan, and South Korea), Third
World countries containing billions of people now want to be export oriented
(Indonesia, India, Pakistan, Mexico). As a result, exports from low-wage Third
World countries are apt to be much larger in the years ahead. Whatever one
believes about how much of real wage declines and increases in wage dispersion
can be blamed on globalization in the past, the forces of factor price
equalization are going to grow enormously. If they continue to operate in a
world of slack labor markets inside the United States, the rate of decline in
real wages will accelerate.


Inflation itself has already ended. But as long as the policymakers are
convinced that the ghost of inflation will at any minute reappear, they will
operate their policies as if inflation were a real threat.

It is possible, in fact, that inflation is even lower than its low official
rate. The broadest measure of inflation, the implicit price deflator for the
gross domestic product, fell from 2.2 percent in 1993 to 2.1 percent in 1994,
and in the third quarter of 1995 inflation was running at the rate of

Having fallen during the previous recession, the producer's price index for
finished consumer goods in December 1994 was below where it had been in April
1993 and annual rates of increase decelerated from 1.2 percent in 1993 to 0.6
percent in 1994. In 1994 and 1995 labor costs rose at the slowest rate since
records had been kept and the core rate of inflation (the rate of inflation
leaving out volatile energy and food prices) was the lowest rate recorded since

Officially the rate of inflation in the consumer price index (CPI) fell from 3
percent in 1993 to 2.6 percent in 1994, and to 2.5 percent in 1995, but
Chairman Greenspan had himself testified to Congress that the CPI exaggerated
inflation by as much as 1.5 percentage points since it underestimated quality
improvements in goods (in computers, for example, it has performance rising at
only 7 percent per year) and since it gives no credit at all for quality
improvements in services. The Boskin Commission, appointed by the Senate
Finance Committee, has estimated the upward bias in the CPI at between 1 and
2.4 percentage points. If one is willing to assume that the sectors where
quality improvements are hard to measure are in fact improving quality at the
same pace as those sectors where quality is easy to measure, the
over-measurement of inflation may be closer to 3 percentage points.

Health care is a sector whose inflationary dynamics have little to do with
macroeconomic pressures. Since health care accounts for 15 percent of GDP and
health care prices were rising at a 5 percent annual rate in 1994,
mathematically another 0.75 percentage points of inflation can be traced to
health care (more than one-third of 1994's total inflation).

Put all of these factors together and it is clear that the rate of inflation in
the sectors where inflation is controllable with slower growth is certainly
very low and probably actually negative. While some economists argue that the
CPI does not in fact overstate inflation [see Dean Baker, "The Inflated Case
Against the CPI," TAP, Winter 1996] it is bizarre that Alan Greenspan is
among those who think that inflation is significantly below its officially
measured rate since it undercuts his arguments for contractionary monetary

Left to their own devices, those who operate central banks are never
going to declare a permanent victory over inflation. The reasons are simple. If
the battle against inflation is primary, central bankers will be described as,
and actually be, the most important economic players in the game. Without
inflation, they run rather unimportant institutions.

It is important to remember that in 1931 and 1932 as the United States was
plunging into the Great Depression, economic advisers such as Secretary of the
Treasury Andrew Mellon were arguing that nothing could be done without risking
an outbreak of inflation--despite the fact that prices had fallen 23 percent
from 1929 to 1932 and would fall another 4 percent in 1933. The fear of
inflation was used as a club to stop the actions that should have been taken.
Central banks are prone to see inflationary ghosts since they love to be
ghostbusters. While it is true that no human has ever been hurt by a real
ghost, it is equally true that ghostbusters have often created a lot of real
human havoc.

Central bankers will of course tell us that when they gain "anti-inflationary
credibility," rapid noninflationary growth will resume. But this is a mirage
shimmering in the hot desert air. If any central bank has anti-inflationary
credibility, it should be the German Bundesbank, yet Germany has one of the
industrial world's lowest real growth rates. If the Bundesbank has not yet
achieved anti-inflationary credibility, no central bank ever will obtain this
exalted status.

As a result, if policies are to change it will require a change in political
perceptions. Rising inequalities and falling real wages have to come to be seen
as more important problems than the ghost of inflation when it comes to getting
elected or reelected. Social welfare programs for the poor are not politically
viable as long as the poor do not vote for the politicians who support the
programs that benefit them. Tight labor markets are equally politically
unviable unless voters reward the politicians who are willing to reverse the
macroeconomic policies that have been in place for the past 25 years.

The long-run answer to falling wages is a much better-skilled bottom
three-quarters of the American workforce, but without a reversal in our
macroeconomic policies no set of human-capital investment policies can hope to

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