[Extensions of Remarks]
[Pages E340-E342]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]

THE FED'S UNNECESSARY ASSAULT ON WAGES

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HON. BARNEY FRANK

of Massachusetts

in the house of representatives

Thursday, March 16, 2000

Mr. FRANK of Massachusetts. Mr. Speaker, I have become increasingly
concerned that the relentless drive of the Federal Reserve to cut back
on economic growth will lead to serious economic problems later this
year. Federal Reserve officials have heretofore stressed that there is
a time lag of many months between their decisions to raise interest
rates and the effect those increases will have on the economy. We have
recently had four Federal Reserve increases in interest rates, and by
the Fed's own previous standards, only one of those could possibly have
begun to have any economic impact, and that, barely so. For the Federal
Reserve despite this to continue to raise interest rates threatens us
with serious economic problems later in the year. I do not at this
point believe that this will lead to a recession, although if the Fed
continues to raise interest rates on a regular basis that will be the
result. But what their actions will guarantee is a significant slow
down in the growth of our economy. That is not only bad in itself, it
will deprive our economy of the one factor that has served in recent
years to alleviate the increasing trend towards exacerbating inequality
that has accompanied overall prosperity for much of the past decade.
The justification for the Federal Reserve's action is of course that
it is necessary to stave off inflation. This is a justification the Fed
offers, despite what might appear to be the inconvenient fact that no
inflation is in prospect. In a recent analysis, Jeff Faux of the
Economic Policy Institute analyzes the Federal Reserve's argument, and
delves into American economic history to show the fallacy of the Fed's
approach.
Because of the importance of this topic to both the economic and
social health of our country, and because of the cogency of Mr. Faux's
analysis, I ask that it be printed here.

The Fed's Unnecessary Assault on Wages

(By Jeff Faux)

The Federal Reserve Board has raised its key interest rate
a full percentage point since June 1999, and it has indicated
that it will continue to raise rates until economic growth
slows down.
It takes a while for interest rate changes to work their
way through the economy. But sometime this year, the nation
can expect to begin paying the costs. These costs will
include: An increase in joblessness and a weakening of the
bargaining power of low- and middle-income families, whose
wages--after being stagnant for most of the 1990s--have been
rising in the last several years because of tight labor
markets. Higher housing, consumer credit, and general
borrowing costs. a worsening of the trade deficit, because
raising interest rates will increase the near-term value of
the dollar.
According to Fed Chairman Alan Greenspan, these costs are
justified by the benefits of slower growth, which will: (1)
prevent the current boom from ``overheating,'' i.e.,
generating politically unacceptable levels of inflation that
must then be brought down by engineering a deep recession,
and (2) deflate the overpriced stock market, thereby
preventing a future crash.
But the slowing of the economy is unnecessary. As Greenspan
himself admitted in his February 17 semi-annual report to
Congress, ``inflation has remained largely contained.''
Moreover, the historical evidence for Greenspan's
inflationary scenario is weak. As for an overpriced stock
market, the Fed has other policy options with which to
deflate it. These realities suggest that the Fed's
intervention has been aimed more at preventing wage increases
than at preventing inflation.
If anything, lowering, rather than raising, interest rates
is a more appropriate monetary policy for the current
condition of the economy.

NO INFLATION SIGNALS

There are no signs that the economy is approaching close
enough to capacity to represent a serious inflationary
threat. The latest data show that the January ``core''
inflation rate--consumer prices other than volatile energy
and food prices--rose only 1.9% above the year before,
compared with a 2.3% annual increase a year earlier.
Nor is there any evidence that production is threatening to
outstrip capacity. The Federal Reserve's own numbers show the
capacity utilization rate at 81.6%, substantially below the
85.4% reached in 1988-89, at the peak of the last business
cycle.
The employment cost index--the statistic said to be most
watched by the Fed economists--in the fourth quarter of 1999
was rising at an annual rate of 4.5%. But productivity was
rising even faster--by 5%--leaving room in the economy for
more noninflationary wage increases.

THE DISAPPEARING NAIRU

It is of course plausible that at some point spending could
outgrow the economy's capacity to produce, causing prices to
accelerate to unacceptable levels. Economists have labeled
the unemployment rate below which this inflationary spiral
would theoretically ignite as the NAIRU, or the non-
accelerating-inflation rate of unemployment.
In the early 1990s, the conventional wisdom among
economists, including most at the Federal Reserve, was that
the unemployment rate could not go below 6% without
triggering an accelerating rate of inflation. The few
economists who pointed out that there was little empirical
evidence to support this theory and that the economy could
achieve noninflationary unemployment rates of 4% or even
lower were derided by the profession and ignored by the
business media. (The late William Vickery of Columbia
University, a Nobel Prize winner, said in 1994 that a 2%
unemployment rate was feasible.)
The unemployment rate has now been below 6% since September
1994, below 5% since June 1997, and below 4.5% since April
1998. As we have seen, core inflation has not only not
accelerated, it remains dormant.
The experience has taught us that no one, not even Dr.
Greenspan, can calculate the

[[Page E341]]

NAIRU beforehand. Moreover, it has discredited the notion
that low levels of unemployment will cause wages and prices
to accelerate out of control. The NAIRU is revealed as
useless as a guide to economic policy.

the wrong history lesson

Still, the threat of the kind of runaway inflation that
caused such economic and political havoc in the 1970s has
been enough to stifle objections to the Fed's current
strategy, even in an election year.
The inflationary terror with which Greenspan threatens us
is a scenario in which rising demand in a peacetime economy
bursts through the limits of capacity to set off a wage price
spiral that feeds on itself, becomes politically
unacceptable, and compels the government to bring it down by
engineering a recession (reducing demand by reducing
incomes). But, in fact, since 1914, when the U.S. began to
measure consumer prices with a comprehensive index, a demand-
driven peacetime economic boom has never generated the kind
of inflation with which Greenspan frightens policy makers and
the public.
A reasonable definition of ``politically unacceptable''
inflation is a condition in which rising consumer prices are
used by the political opposition to successfully affect the
outcome of elections. In this sense, price inflation was a
significant national political issue on several 20th century
occasions. One was the aftermath of World War I, when war-
time inflation continued to increase through 1920. Prices
rose 15% that year, and Republican Warren Harding, along with
a GOP Congress, was elected on a platform of a ``return to
normalcy.''
The next was 1946, when the end of World War II's price
controls saw prices rise at a rate of 8.3% between 1945 and
1946. Rising meat prices were a particular sore spot with the
voters, who elected a Republican Congress that November.
Interestingly, prices rose at an annual rate of 11.3% over
the next two years, but Democrat Harry Truman was still re-
elected in 1948.
The next time that rising prices were a significant
political issue was in the early 1970s. World oil prices were
driven up by an oil-producing cartel, and a series of bad
harvests in Russia and elsewhere caused global grain prices
to rise as well. Price increases in these sectors then
rippled through the U.S. economy. Between 1972 and 1980,
consumer prices rose at an annual rate of 8.9%, and for three
of those years the increases were in double digits. Political
victims included Republican members of Congress decimated in
the off-year election in 1974, President Gerald Ford in 1976,
and President Jimmy Carter in 1980.
Thus, the general price increases that have reached
politically troublesome levels have all involved several
years of sustained inflation at rates that at some point
reached double digits.
If we take a 5% increase in the consumer price index (CPI)
as the point in which prices are moving toward this
``politically unacceptable'' range, we find that in no case
since 1914 did price inflation reach even that level as a
result of a peacetime economy growing beyond its capacity to
produce. Every time the growth in the consumer price index
reached 5%, the cause was exogenous to the domestic economy,
i.e., war-related or energy and food price shocks emanating
from outside U.S. borders.
Figure 4 shows the history of consumer price changes year-
by-year since 1914. Working backward, the brief price spike
in 1990 that put the CPI slightly over 5% was a result of a
sharp, short run-up in oil prices during the Gulf War. As
indicated above, the inflation of the 1970s was not a result
of an overheated economy but was generated by world oil and
grain price shocks. Nor was the previous bout of inflation in
the late 1960s ignited by an insufficiently vigilant Fed; the
culprit was Lyndon Johnson's refusal to raise taxes to pay
for the Vietnam War. The inflation episode before that was
fueled by the Korean War. And, as indicated, the other two
bouts of inflation were the products of the 20th century's
world wars.
In other words, the memories of inflation that give
political support to Greenspan's policy of raising interest
rates reflect past experiences that are irrelevant to the
present condition of the American economy. In fact, one
cannot find in modern history the inflationary scenario from
which Greenspan is presumably protecting us.

Dampening stock market exuberance

Recently, the stock market has been deflating on its own.
Still, given the widespread casino mentality that pervades
the markets, it is not unreasonable to attempt to bring down
values more in line with economic fundamentals, i.e., the
growth of employment, incomes, and production.
But it is not reasonable to undercut those economic
fundamentals in order to bring down a speculative bubble in
the stock market. Instead, the Fed should be trying to
achieve balance by contracting the stock market and letting
the productive part of the economy expand, gradually
substituting real for speculative value in share prices.
Much of the recent overvaluation of U.S. stock markets has
been fueled by excessive credit. The share of ``margin debt''
to the capitalization of the stock market is now at or above
the heights reached just before the 1987 market crash. The
ratio of margin debt to the gross domestic product (GDP) is
now double what it was at that time.
A number of market observers, including financier George
Soros and Stanley Fischer, deputy director at the
International Monetary Fund, have recently advocated that the
Fed let air out of this credit boom by raising margin
requirements. But Asian Greenspan has consistently refused.
When asked about this at his confirmation hearing before the
U.S. Senate Banking Committee. Greenspan said that he did not
want to discriminate against individuals who were not wealthy
enough to have other assets against which to borrow in order
to play the stock market. Given that people who use margin
leverage to buy stock are typically wealthy by any reasonable
standard, this is a rather weak rationale for favoring higher
interest rate policies whose costs will largely be felt by
lower-and middle-income working people.
To the extent that Greenspan is concerned about irrational
exuberance in the stock market, raising margin requirements
should certainly be the weapon of choice.

Wages--the Fed's real target

Given the absence of inflationary signals, the lack of
historical precedent, and the Fed's disinclination to target
the stock market bubble directly, it does not appear that
preventing an outbreak of inflation--at least as most
Americans
The Fed's defenders would of course argue that that is
exactly how one prevents ``wage-price'' spirals from taking
off. But as economist Jamie Galbraith has pointed out, every
episode of accelerating inflation since 1960, with the
exception of the lifting of Vietnam-era price controls after
Richard Nixon's re-election, were led by prices, not by
wages.
The current effort to slow down the economy, therefore,
appears to be targeted at weakening the bargaining position
of labor vis-a-vis capital. Indeed, throughout this economic
expansion of the 1990, we have seen a shift of market incomes
from wages to profits. This shift has been so pronounced that
economist Jared Bernstein has calculated that, even if labor
costs were to accelerate to rising 1% faster than
productivity (as opposed to their current slower growth
rate), it would take four years before wages and profits went
back to their respective shares in the decade of the 1980s.
It is reasonable to ask the following: if the expansion of
profits and the subsequent reallocation of income from labor
to capital that occurred throughout the 1990s did not by
itself raise inflationary concerns, why should a potential
swing back to labor's favor?
The Fed is unlikely to enlighten us. But it is obvious that
Federal Reserve Boards have historically considered
themselves defenders of the interests of those who invest for
a living as opposed to those who work for wages. This one is
no exception.
Greenspan deserves some credit for not having cut off this
current expansion when the unemployment rate reached what the
conventional wisdom assumed were NAIRU limits. On the other
hand, he has responded much faster to problems in financial
markets than to problems in labor markets. Thus, he was quick
to intervene in the economy in the case of the stock market
crash of 1987, the Asia financial crisis of 1997, and the
Long Term Capital Management debacle of 1998. But he was so
slow to react to a rising unemployment rate in the early
1990s that he allowed the economy to fall into a recession.
Greenspan himself has said on several occasions that job
insecurity has been a significant factor in limiting labor's
earnings during the expansion and thus adding to profits and
the profit expectations that have fueled the stock market.
From this perspective, raising interest rates to raise the
unemployment rate, as opposed to targeting margin
requirements, insures that labor's share remains depressed
even as the financial markets are forced to undergo a
correction.

Keeping the Expansion going

The economic policy task now facing the United States is
how to keep the current expansion alive by keeping it in
balance, e.g., avoiding speculative markets, excessive debt,
and high interest rates. This will require careful management
by both the Federal Reserve and the administration.
First, at the very least, the Fed should not raise interest
rates any further. In fact, the Fed should gradually begin
lowering rates to keep probing the economy's limits and to
allow the dollar to fall and to make U.S. goods more
internationally competitive. If and when signs appear that
the domestic economy is overheating and price inflation
threatens, there will be plenty of time to raise interest
rates (or taxes) to reduce the growth rate.
Second, at the same time, the Fed should use its authority
to raise margin requirements. In addition, both the Fed and
the Clinton Administration should move to reduce excessive
stock market and consumer credit use. Bank regulators should
discourage the growing issuance of unsound mortgage lending
and home equity loans and impose stricter regulation of
credit care companies.
Tightening credit in speculative markets while allowing the
rest of the economy to grow will bring more balance to the
economy. In particular, it would help to raise real incomes
and at the same time help reduce consumer debt, providing
more stability and staying power for the household sector
that has been the sustaining force for growth over the past
decade.
Third, neither the Fed nor the Administration should
attempt to slow economic

[[Page E342]]

growth if energy prices continue to rise. The lesson from the
1970s is that oil price cartels do not last. It helps that
the U.S. economy is less energy intensive than it was in the
1970s and less vulnerable to energy price increases. The
president's decision to increase subsidies to help low-income
families to cope with temporarily higher heating oil prices
was wise. If necessary, the Administration should use
national oil reserves to counter any extraordinary short-term
surge in prices that threatens to cut off economic growth.
This longest economic expansion in modern history has in
the last few years finally begun to bring real income growth
to low- and middle-income Americans. Maintaining that growth
is essential for America's private sector to remain
competitive and its public sector to have the revenues it
needs to finance social investment.
The risk of jeopardizing these goals far outweighs any
small risk of a sudden and historically unprecedented
outbreak of demand-driven inflation.

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