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In testimony to the House Financial Services Committee yesterday and to a Senate committee last week, Fed Chairman Alan Greenspan attributed the growing income inequality in the United States to a growing demand for skills in the workforce. Until the education and skills of most U.S. workers improve, there is little we can do to reduce income inequality, in his view.

Of course, Greenspan's analysis is at least partly correct. The pay premiums associated with education and other measures of skills in the labor force have all risen over the past three decades. New technologies have dramatically changed how we produce goods and services in our economy, and higher levels of skills are now needed to achieve higher-paying jobs. Too many workers in our economy have not had the opportunity to develop these skills.

At the same time, the story Greenspan tells is quite incomplete. Over the past few decades, the earnings of less-educated Americans have also been hurt by the weakening of laws and institutions that traditionally have protected them from the harshest effects of market forces. For example, minimum wages have failed to keep up with inflation over time; and union membership has plummeted, especially in the private sector. These trends have contributed importantly to growing earnings inequality as well.

A story that focuses only on skills also explains little of what has happened in the labor market over the past three years. In that time period, productivity has soared at a rate of about 4 percent per year. But the inflation-adjusted earnings of non-supervisory workers have barely budged. In the past year, while the economy is recovering and jobs are once again being created in significant numbers, productivity has soared by about 5 percent while average weekly pay has fallen by over 1 percent. Measures of changes in real hourly compensation in that time period, which include rising benefit costs as well as supervisor salaries, look somewhat better but not greatly so. So, while the economic "pie" is growing rapidly, the slices going to most Americans are actually getting smaller.

What's going on here? Part of the story reflects a recent uptick in inflation, driven by sectors such as energy and food; and a very small piece of it might reflect some net shifts in the economy towards lower-paying sectors of work. But the major culprit is probably the continuing weakness of the overall labor market. Though jobs are once again growing in number, they are not doing so rapidly enough to eliminate labor market slack. Employers can meet their demands for goods and services primarily through rising productivity; increases in hiring activity remain modest. The unemployment and employment rates for the labor force and population have barely budged, even while modest job growth has returned. So employers feel little pressure to pay their workers more, since they have little trouble attracting and retaining workers at current wage levels.

Over the longer term, higher productivity is almost always a positive development, which helps raise the incomes of all workers. But, while the labor market remains so weak, employers have little incentive to share the gains of productivity with their employees. So profit margins rise handsomely while worker wages and salaries stagnate. This situation contrasts sharply with what we observed in the late 1990s, when productivity growth and a strong labor market generated earnings gains that were widely shared among all workers. And the growing income inequalities generated by recent trends in wages, salaries and profits have all been compounded by tax cuts that have generated huge windfalls for those at the very top of the income ladder and modest gains for everyone else.

What is to be done about all of this? In the next few years, a tightening labor market will no doubt help, though it is anyone's guess how quickly this will occur. Over the longer term, Greenspan is right that educational improvements would help. But disagreements remain very sharp over exactly how this ought to be accomplished – as we have seen in the bitter debates over school vouchers and implementation of the "No Child Left Behind" legislation.

Improving worker skills can also be attained through various kinds of job training – including occupational skills training and apprenticeships for in-school youth, "second-chance" programs for those out of school, enhanced training for "incumbent workers," and better access to post-secondary education for displaced workers and the poor. But federal funding for many kinds of training has been cut in the past few years, and the huge budget deficits that have been created (largely because of tax cuts that Greenspan has supported) make major new expenditures in these areas unlikely anytime soon. Efforts to expand early childhood education and improve teacher quality are unlikely to occur as well, without first restoring some fiscal balance at the federal level.

In addition, we could still do a lot more to "make work pay" better for less-educated Americans. Moderates increases in the minimum wage would help those at the bottom of the pay scale, without generating much employment loss for these workers. Extensions of the earned income tax credit would help, as would expanding access to health insurance for lower-paid workers.

Thus a stronger labor market recovery over time, coupled with a return to fiscal sanity and sensible federal priorities, would finally enable us to address the growing income gaps between Americans that plague us today.

Harry J. Holzer is professor in the Georgetown Public Policy Institute at Georgetown University, and a senior affiliate of the Northwestern University-University of Chicago Joint Center for Poverty Research, a national fellow of the Program on Inequality and Social Policy at Harvard University, and a research affiliate of the Institute for Research on Poverty at the University of Wisconsin at Madison. He served as chief economist in the Department of Labor prior to joining Georgetown University in 2000.

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