The wage inflation problem

At its best, politics gives coarse expression to subtle drifts of the popular mood. It happened on the issue of trade last week in the U.S., to the possible detriment of long term economic growth and demand for energy. Makers of macroeconomic policy should heed the message, which argues for change in the standard view of the economy.

Organized labor, long counted as down and out in American politics, has reasserted its influence. In concert with environmental interests, it last week denied President Bill Clinton fast-track trade negotiating authority. Every U.S. president since 1974 has enjoyed fast-track authority, which forces Congress to vote up or down on trade agreements negotiated by the executive branch. Yet Clinton's fellow Democrats, pressed by labor leaders, wouldn't deliver the relatively few votes needed from their camp to assure passage of a Republican-backed measure for fast-track renewal.

Flaw of analysis

How did organized labor rise from its own political wreckage and so solidly rebuke a Democratic president on an issue he recognized as crucial to long-term health of the U.S. economy? The answer lies in a clash between one of those subtle drifts of the popular mood and a flaw of economic analysis as currently enunciated and applied, especially in monetary policy.

The flaw is the concept of wage inflation. According to economic orthodoxy, such inflation occurs when an economy grows so much that the supply of labor can't keep up with demand. Employers then must bid for workers, which lifts wage and salary costs.

Wage pressures surely build as the unemployment rate falls in an expansion. But that's not necessarily inflation. As Federal Reserve Chairman Alan Greenspan has emphasized recently, inflation is a monetary phenomenon-an increase in prices of everything caused by an increase in supply of, relative to demand for, money.

Wages are the price of labor, which isn't everything in an economy. Labor is one of three factors of production; the others are land and capital. When caused by growth in demand relative to supply, an increase in the price of labor is not inherently inflationary unless money supply expands to paper over the cost. Otherwise, values of other factors of production simply adjust.

Yes, that means companies pay more for the workers they need. The higher costs reduce profits and dividends-a price of capital. A falling price of one factor of production thus offsets the rising price of another. When profitable companies increase payouts to shareholders, economists and policy makers do not fret about dividend inflation. They should not be fretting about wage inflation now.

The market can handle any labor squeeze occasioned by 2%/year economic growth. Employment isn't as low everywhere else as it is in the U.S. Rising wages will attract workers to jobs if policy makers stay out of the way. If the costs become a problem, growth will slow and demand for labor will ease-if organized labor stays out of the way.

Of course, politics doesn't trouble itself with economic peculiarities such as these. It does, however, take direction from the popular mood, which correctly senses that economic returns for several years have favored capital over labor. The popular mood also correctly senses that overreaction to the wage inflation bogey threatens to keep the market from cycling as it should.

Political revival

When policy denies economic labor (the factor of production) the rewards it is due in the market, organized labor (the factor of politics) gains the popular support it needs to demand even more. Hence organized labor's political revival. First, the United Postal Service strike. Now, the fast-track fiasco.

The standard macroeconomic model in use today has begun to incite political mischief with more destructive potential than the wage increases it so mightily resists. It's time to adjust the model, beginning with its notions about wage inflation.