For months now, US Federal Reserve officials have been fretting publicly about the possibility of a wage-price spiral, something I thought died a quiet death with the demise of the labour movement.
Alas, the wage-price spiral is alive and well and living in policy circles.
At its most basic, the term describes a situation where prices rise, employees demand a higher wage to maintain their purchasing power in the face of higher inflation, businesses raise prices (again) to cover higher labour costs, and so on, and so on.
There are a few fallacies with the theory, not to mention its applicability in the current environment.
For starters, the idea that businesses blithely accept labour’s wage demands and mark up their prices accordingly is outdated in a global marketplace. Cheap labour and the ability to outsource production have made that model moot.
Workers, for their part, have come to realize that their success is aligned with that of their company. Anything that makes a company less profitable can mean a loss of job and benefits.
Then there’s the misplaced notion that businesses wait around for costs to rise and raise their prices accordingly. Businesses always want to raise their prices. The reason they don’t is an inability to do so without sacrificing sales and market share.
A businessman hiring someone and paying him more than his marginal revenue product, or the additional revenue earned, is tantamount to paying someone to reduce his profits.
The idea of a wage-price spiral in today’s economy is even more far-fetched than the theory. Richard Fisher, president of the Dallas Fed, has been a leading proponent, warning that a rise in inflation expectations could ignite a wage-price spiral.
“Even if you have inflation expectations, how do you turn it into inflation if your employer doesn’t cooperate?” says Neal Soss, chief economist at Credit Suisse.
Soss says that rising inflation expectations are being met by a collapse in consumer expectations about their own financial well-being, as reported in the Reuters/University of Michigan surveys of consumers.
“They’re saying, inflation is going to immiserate me,” he says. Without a raise in nominal wages, “they can’t inflate away the debt burden.”
According to a 1 August The New York Times story, Fisher “argued in an interview that wages are rising for others around the world, particularly in Asia, and ‘American workers will react’ by demanding higher pay for themselves.”
Huh? A Chinese urban worker gets a raise from an average of 84 yuan ($12.25) a day in 2006 to 99.3 yuan ($14.50) in 2007, and that’s supposed to get a rise out of American workers earning an average of $18.06 an hour, or $144 a day?
Fisher dissented at Tuesday’s meeting for the fifth time this year, preferring an increase in the overnight rate. The Federal Open Market Committee, or FOMC, left its benchmark rate unchanged at 2%, emphasizing both “downside risks to growth” and “upside risks to inflation” in its statement. Fisher was joined in his March and April dissents by Philadelphia Fed president Charles Plosser, a proponent of real business cycle theory. The theory’s advocates believe the business cycle is driven solely by technology shocks and their effect on productivity, not by the actions of the central bank. All monetary policy can do—in the long run and in the short run—is influence inflation.
Doubter as policymaker
“Plosser is fundamentally wrong about how monetary policy works,” says Bob Barbera, chief economist at ITG Inc., a New York brokerage. “Fed policy affects real variables—spending, employment, income—in the short run.”
Putting a real-business cycle theorist on the FOMC “is akin to having a Christian Scientist on your surgical team”, Barbera says. If Plosser thinks the Fed can’t do anything to offset the stresses in the financial system and credit constraints being imposed by the private sector, no wonder he’s been arguing for a rate increase “sooner rather than later”.
Plosser didn’t dissent Tuesday, but in speeches both he and Fisher have warned of the possibility of a wage-price spiral. We’ve already dismissed the logic. Where’s the evidence this is happening?
Average hourly earnings rose 3.4% in the year ended July. That’s down from 4.3% in December 2006, the peak of the current cycle.
Inflation, meanwhile, has doubled in that time frame, from 2.5% to 5%. The unemployment rate rose from a cycle low of 4.4% to 5.7%. As long as there’s a “reserve army of unemployed”—a Marxian concept dusted off and transformed into a “pool of available workers” by no less an objectivist theoretician than Alan Greenspan—it’s easy for companies to just say no to labour.
“Relax, President Plosser,” Barbera writes in his latest research. “The leap in joblessness is keeping wage increases in check.”
How can he relax when the wage/price spiral is giving him vertigo?
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