Forty Centuries of Wage and Price Controls

16

On the Causes of Inflation

Before a policymaker jumps to the conclusion that wage and price controls can actually cure an inflation, he should make an attempt to understand the true causes of that phenomenon. The absence of such understanding is one of the reasons that wage and price controls have had such a long and painful history of failure and ineffectiveness; controls may be able to suppress the symptoms of inflation, but the evidence shows that they are not a cure for the disease itself.

The underlying conditions necessary for inflation to occur are not really in dispute by economists and can therefore be thought of as the fundamental causes of inflation. Other economic factors contribute to an inflation, however, not only by putting a pressure on governments to continue inflationary expansions, but by spreading the inflation through the economy. Hence, some economists believe that these supplemental factors are just as important as the underlying conditions.

The underlying conditions can be described as follows:

(1) When aggregate expenditures expand faster than the increase in the supply of goods and services, the expansion allows and encourages a rising price level. Prices are, if you like, bid up to absorb the increase in aggregate expenditures.

(2) The expansion in aggregate demand can be generated by increased government spending or by a cyclical upswing in private demand. Again, where this expansion is greater than the expansion in commodity supply, a rising price level will be supported.

(3) These increases in demand and expenditure can occur only when the supply of money in the economy is larger than the demand for money balances. When this is so, the excess money will go into producing excess aggregate demand, assuming that the supply of commodities does not expand in step with the monetary increase. The necessity of this condition of monetary expansion to inflation is one of the reasons that has led the distinguished Nobel Prize-winning economist Milton Friedman to say that “Inflation is always and everywhere a monetary phenomenon.”

Friedman himself cites an impressive correlation between the excess of money supply over output and inflation.1 He has made the same point in numerous books and articles, but an analysis of the empirical testing of this theory is beyond the scope of the present work.

OTHER INFLATIONARY PRESSURES

Although monetary expansion is the ultimate necessary condition that allows an inflation to occur, it is, as has been said, not the only factor that constitutes a pressure toward inflation. Other economic factors, prompting increases in demand and excess money supply, contribute to inflation and allow it to spread quickly through the economy, making inflation politically difficult to deal with.

These other economic factors can be broadly summarized as follows:

(1) Failure of prices to adjust in recession

According to Phillip Cagan, who has extensively studied the movement of prices during boom and recession over the course of this century, “The distinctive feature of the postwar inflations has not been that prices rose faster in periods of cyclical expansion—many previous expansions had much higher rates—but that they declined hardly at all, or even rose, in recessions.”2 As an example of this in one industry, he cites the familiar example of the steel industry, in which from 1955 to 1960 the wholesale price index of iron and steel rose 21 percent while the index of all wholesale prices rose 8 percent. Over the same period, steel output fell 22 percent and capacity utilization was down to about 80 percent after 1955 and even lower during the subsequent strikes and recessions.

Such failure of prices to fall during a recession has been typical of the postwar economy, although the steel industry is a particularly emphatic example. Nevertheless, the coexistence of high rates of inflation with high rates of unemployment and recession has caused the public to be more and more aware of the phenomena of “stagflation” and “slumpflation. “

(2) Causes of the failure to adjust

This effect—the failure of prices to adjust downward in a recession—has many causes. The first would be the downward inflexibility of wages and (to some extent) prices. A recession rarely comes suddenly, but is a slow process, occurring over a period of months or even years. Often the recession will be accompanied by government assurances that the recession is only temporary, or does not exist at all. Workers are, therefore, tempted to believe that the economic situation does not warrant a cut in salaries or a reduction in employment and will militate against any such suggestion. Furthermore, since recession is typified by an initial cutback in demand rather than falling prices, workers will object that they are being asked to accept cuts even though prices have not fallen. Their failure to take wage cuts will itself (since prices are fixed largely upon production costs, which include the price of labor) tend to prevent prices from falling.

Furthermore, industries tend to build up inventories during recession, rather than lay off men and underutilize equipment, both of which are painful decisions to make. This has the effect of drawing some part of supply off the market, thus keeping up prices, even though large stockpiles may be accumulated. Short-run shifts in demand can be absorbed and price fluctuations are, therefore, smaller.

As has been said, some industries find that it is costly to change their prices. The preparation of new price lists, new labelling and the administrative costs associated with these are one source of such costs. Price-cutting wars are another cost that large firms wish to avoid; hence the fact that the most concentrated industries (in which the first few firms have large percentages of the total industry sales) display a lower amplitude of cyclical price changes.3 The further assumption by firms that the recession will soon be over (an assumption probably encouraged by optimistic government officials) will also discourage them from lowering their prices for what they perceive as a short period.

Although prices in the long run may adjust to meet changes in demand, there is no guarantee that short-run price changes will adjust. Wage rates are slow to adjust in a deceleration of inflation, as are service prices (which are closely related to wage rates), so there is little opportunity for prices to be diminished because of the importance of these costs in determining selling price. Firms may trim costs, use space and workers more efficiently, or cut out unprofitable products in favor of more profitable ones. In addition to these adjustments, the fact that most plants are designed to work most efficiently at a certain level of output means that average unit costs rise when production is cut back in the face of falling demand. This is yet another factor that tends to keep prices up during a depression, since prices are largely determined by costs.

(3) Economic rigidities

Inflation is perpetuated and spread through the reluctance of governments to change the existing economic institutions. Consequently, inflation is often allowed to continue, even though a small change in the existing economic structure would dissipate it. For instance, the major gold discoveries of 1849 served to expand the money supplies of the gold-standard countries, so that prices were pulled up in the 1850s and 1860s. The same phenomenon has been seen with respect to other currency metals at other times throughout history. If countries had merely abandoned their gold convertibility into gold and allowed their currencies to float in value against others, this inflationary effect could have been avoided. The fixed exchange rate, in conjunction with an expansion in specie reserves, actually serves to engender inflation in those countries subject to the fixed-rate agreement.

Another example is afforded by the common postwar policy of interest rate manipulation, particularly the attempts by the governments on both sides of the Atlantic to keep the interest rate down so that small borrowers would be able to afford loans. This policy, however, made it impossible for monetary restraint to be exercised through the usual device of selling low-price (and therefore high rate) Treasury securities on the open market. On the contrary, the interest rate policy required the Federal Reserve to buy securities in order to keep buying prices high and, therefore, interest rates low.

Still another policy objective that conflicts with anti-inflation policy is that of employment. It has long been thought that there is an approximate trade-off between inflation and unemployment; the larger the dose of inflation permitted in an economy, the smaller the rate of unemployment. Postwar policy has laid such emphasis on full employment that high rates of inflation have been accepted, but it seems to be an unfortunate fact (which will be examined in the next chapter) that larger and larger doses of inflation are needed to sustain a given employment level.

(4) Expansions caused by war

In the United States there have been four major economic expansions associated with high rates of inflation. Of these, all except the 1950s, “investment boom” years followed wars. There was a strong expansion of aggregate demand in World War II, although the inflationary effect of this was partly submerged in wage and price controls. Upon their removal in 1946, prices rose significantly and continued to rise until the end of 1948. The outbreak of the Korean War also had a severe inflationary effect, since a great deal of “scare buying” (partly due to fear of the reimposition of economic controls!) constituted a rise in aggregate demand in addition to the demands of the war itself. Prices in 1950 once again increased significantly. The escalation of the Vietnam War is also associated with a steady rise in the rate of inflation, although the rate did not fall to zero as the demand pressure eased; the phenomenon of the downward inflexibility of prices and of the now familiar “slumpflation” had begun to be noticeable.

The inflationary aspect of wartime expansions seems to suggest that this, and presumably more modest political policies, can have a marked effect on inflation. The goodwill of governments has not been sufficient to administer the monetary correction needed following these expansionary events, partly because of the rigidities in prices and wages that have been referred to. Noneconomic objectives, then, can interfere with our economic targets.

(5) The advantage to governments

Governments find many advantages in a mild inflation. Inflation is, in Friedman’s words, “irresistibly attractive to sovereigns because it is a hidden tax that at first appears painless or even pleasant, and above all because it is a tax that can be imposed without specific legislation.”4 According to the same author (in Essays on Inflation and Indexation) government directly “profits” from inflation in three ways.

First, the additional government-created money will pay debts and finance expenditures over and above what the government collects in revenue.

Secondly, government-induced inflation pushes taxpayers into higher income brackets and thus leads to taxpayers paying unlegislated tax increases. According to the congressional Joint Committee on Internal Revenue Taxation, the real income tax increase in 1974 caused by inflation totaled $7,122,000,000—a percentage increase of 5.9 for the average taxpayer. Since these statistics were compiled, the situation has become even worse. In 1953, the average family income was $5,000 and 11.8 percent of that was paid in direct taxes of all kinds—federal, state and local; according to the Advisory Commission on Intergovernmental Relations, the average family income in 1975 had risen to $14,000, but that family was paying 22.7 percent of its income in taxes—almost twice the amount paid two decades earlier. If we assume an annual inflation rate of six percent (a conservative assumption in a year when inflation is approaching the double-digit level), inflation-induced tax increases could net the federal government an additional unlegislated bonanza of $50 billion by 1980.5

Thirdly, the real amount of the national debt is reduced since the money had been borrowed at a time when the inflation rate was lower and money was worth more. Taking all these factors into account, Friedman estimates that the federal government’s revenue from inflation came to more than $25 billion in 1973 alone.

Given these facts and figures, it will come as no surprise if the enthusiasm of at least many government officials for fighting inflation is less than all-consuming.6

Some other advantages of inflation should not be overlooked. The first is that an inflationary situation offers an opportunity for wages to be adjusted down in real terms even though no apparent decrease occurs. Given the downward inflexibility of wages, some economists thought that a mild inflation would actually benefit particular industries in their economic adjustment following reductions in demand. The second is that an inflationary expansion does call forth an increased supply in the short-term at least; employment is stimulated, and commerce prospers. Ending the inflation would mean a decline in employment, or wages, and the capitulation of firms that are only marginally profitable and can exist only under inflationary conditions. For governments, this prospect has not been appealing politically.

The phenomenon of inflation is therefore seen to have one major cause, but is associated with a large number of economic conditions, institutional rigidities and so on, which make simple solutions like wage and price controls inadequate as a cure.

FOOTNOTES

1. Newsweek, June 24, 1974.

2. Phillip Cagan, The Hydra-Headed Monster (Washington, D.C.: American Enterprise Institute, 1974) p. 3.

3. See James Tobin, “Inflation and Unemployment,” Presidential Address to the American Economic Association, American Economic Review, Vol. 62, March 1972. See also Phillip Cagan, “Changes in the Recession Behavior of Wholesale Prices in the 1920s and Post World War II,” Explorations in Economic Research (New York: N.B.E.R., Winter 1975). See also W. F. Mueller, “Industrial Concentration: An Important Inflationary Force?”, Paper presented at Columbia Law School Conference, March 1974, on Industrial Concentration: The Economic Issues.

4. Milton Friedman, “Using Escalators to Help Fight Inflation,” Fortune, July 1974, p. 94.

5. For more information, see Donald J. Senese, Indexing the Inflationary Impact of Taxes (Washington, D.C.: The Heritage Foundation, 1978).

6. It must be remembered that inflation does have a constituency; while it clearly hurts certain groups in society (especially those living on fixed incomes) it benefits (at least in the short run) certain other groups, especially those who can use their economic or political power to “stay ahead” of inflation.