Forty Centuries of Wage and Price Controls

17

Coping With Inflation

Before jumping to conclusions about the cure for inflation, it is important to understand its cause. The lack of such an understanding explains why price and wage controls have had such a painful and ineffective history.

There is growing support for the hypothesis that inflation is always and everywhere a monetary phenomenon, caused principally by an expansion of the supply of money in circulation over and above the level of output. The mechanism by which such an expansion produces inflation is really quite simple.

If an expansion in the total supply of money which is in people’s pockets and bank accounts happens to occur, but there is no corresponding expansion in industrial output, then it is natural that people will tend to spend a bit more. They might become less price conscious; they might tend to buy more expensive or better quality commodities; they might expand the number of goods and services which they buy. In any case, the effect will be the same: shopkeepers will find their prices being bid up—people will be prepared to pay more and to keep supply in line with demand; shops will raise their prices slightly. Wholesalers, many of whom sell their wares by auction, will find the same effects although they are powerless to stop them—prices will simply be bid higher. An expansion of the supply of money in circulation, without a corresponding expansion of the commodities in circulation will, therefore, produce a general rise in prices throughout the economy.

WHY GOVERNMENTS CAUSE INFLATION

Inflation can be caused in many ways. Perhaps the most obvious way occurs when the government spends in excess of the tax revenue it takes in. The money to pay for public programs has to come from somewhere and governments have a number of ways of getting new money into circulation.

One way would be to buy stocks from commercial customers or even to sell short-term stocks and bonds at high rates of interest. Another way is simply to take on more government employees and make sure that they are paid. In any of these circumstances, the new money gets into the economy because of government action—the government has to print new banknotes, mint new coin, and extend new credit.

There are, of course, many pressures on the government to inflate the money stock. It may be that the pressures from public employees for higher wages are irresistible. It might be that the government believes it is “fine-tuning” the economy and that prices will not really be raised by a modest inflation. It might be that the government wishes to stimulate the economy, believing that higher prices will produce more output (remember Say’s law that supply produces its own demand; this is the exact reverse). It might be that industries find their margins tight because of union pressure for wage and working condition improvements, and so they sell stock, which the government buys, to compensate. There may be an infinite number of reasons. Ultimately, however, the government and its agencies are the root cause.

Some self-interested motives of the government should not be overlooked. An inflationary situation brings about more wage bargaining and higher average wages, so people find themselves moving into higher tax brackets. The government draws in more revenue and the people are powerless to prevent the erosion of their real earnings.

Furthermore, ending an inflation with strict monetary policy is not easy, because the “tight” monetary situation will undoubtedly mean that some firms will find that they can no longer exist in the market and will have to close down. Unemployment will be a result, at least in the shorter term.

THE PROBLEMS OF INFLATION

In fact, of course, inflation produces more unemployment the longer it continues. As the rate of inflation rises, more and more industries find themselves squeezed by a tight money situation and more workers are laid off.

But inflation itself produces a kind of unemployment—an underemployment of resources. This is because under inflation, it is very hard for people to predict the future: What price will stocks be a year from now? Will consumer preferences still be the same or will they have moved to cheaper varieties of goods? What will the labor unions bargain for at the next round of pay talks? These things produce uncertainty, and uncertainty produces an unwillingness to invest and doubt produces a misinvestment in unprofitable and underproductive industries.

Now we see why the traditional policy of wage and price controls cannot contain inflation. It is not a question of people deliberately raising their prices; it is a question of people being unable to accommodate a monetary situation which is not of their own making.

Take the owner of a grocery store. You might go in and find that the price of bread has risen by ten percent over the last month. You will chastise the owner of the store because of the price rise. But he will not accept any criticism; he will undoubtedly say that he is merely passing on a price rise from the wholesaler. Ask the wholesaler why his prices have risen; he will probably blame it on the baker; and the baker, on the miller. The miller will explain that the price rise is not of his own making, but comes directly from the farmer. The farmer will say that he cannot help but raise his prices, because this present inflation is making his farmhands less well off and they have pressed him for higher wage settlements.

None of them accepts the blame because none of them is blameworthy. They are merely trying to maintain their positions in an inflationary economy. Controls upon one part of the chain—say the retail price of bread—will jeopardize the welfare of the grocer because he will find his costs increasing all the time. Controls upon the whole cycle will leave everyone disgruntled, thinking that they are “behind the general trend.” As we have seen over the history of the past fifty centuries, these problems are insuperable.

The ultimate cure, then, must be at the source of the inflation: a contraction in the supply of money per unit of output. But this is very painful; how can it best be cushioned?

INDEXATION

Perhaps the first priority is a major, if gradual, cut in public expenditures; government spending and administration must be brought in line with taxes if monetary equilibrium is to be restored to the inflationary economy. To a very minor degree, wage controls might have a short-term, “cosmetic” importance in reducing the expectations of price rises, lowering the marginal propensity of individuals to consume, and preparing the country for cuts in government services.

A proposal deserving serious consideration is comprehensive indexation. In this process, all contracts would be adjusted to make allowance for the prevailing rate of inflation, so that everyone knows where they actually are and nobody tends to “overbid” for inflation—which just forces the government to produce more inflation. (For example, in wage bargaining in the inflationary economy, unions bargain not only for the money which they have lost through inflation, but also for an amount that they expect to lose in the next contract period. This can only squeeze firms harder and thus pressure the government to come to their assistance with more expansionary measures.) As Milton Friedman says1 of this proposal, one of the first things it would do is “temper some of the hardships and distortions that now follow from . . . inflation. Employers will not be stuck with excessively high wage increases. . . . Borrowers will not be stuck with excessively high interest costs, for the rates on outstanding loans will moderate as inflation recedes . . . . Businesses will be able to borrow funds or enter into construction contracts knowing that interest rates and contract prices will be adjusted later in accord with indexes of prices.”

The mechanism of this indexation is simple. Cost-of-living agreements built into all wage bargains would insure the unions against future inflation and would lead to a real lowering of present settlement standards. This is so because “Without escalator clauses, a proportion of negotiated wage increases are simply a compensation for expected increases in the price level. However, once negotiated, they must be paid, regardless of what actually happens to prices.”2 By getting rid of the over-expectation, indexed cost-of-living agreements reduce the pressure on the government to continue the inflation.

There is a strong case for a government guarantee that bonds—particularly bonds issued to small savers (who suffer more than most from inflation)—should have a built-in escalator clause. If this were the case, more certainty would be possible in investment and the productive capacity of industry would be increased. More output would help absorb the inflation.

Such an approach would make coping with inflation less painful, although a certain amount of painful reallocation is always necessary after a period in which investment has been low or has been uncertain and inefficient. But one thing is certain: unless backed up with a policy of this nature, no amount of wage and price control will stem the tide of inflation.

FOOTNOTES

1. Milton Friedman, “Monetary Correction,” Essays on Inflation and Indexation (Washington, D.C.: American Enterprise Institute, 1974) p. 43.

2. David Laidler, “An Alternative to Price Controls,” The Illusion of Wage and Price Control (Vancouver: The Fraser Institute, 1976) p. 207.