Forty Centuries of Wage and Price Controls

18

The Cures For Inflation

So far it has been shown that throughout history, wage and price controls have been ineffective as cures for inflation. Occasionally, they have relieved the symptoms of inflation for a while; sometimes, they have reduced expectations of inflation and therefore contributed to a reduction in the public pressure on the government to stimulate monetary growth. Always, however, they have been short-lived and they have never been fully effective in their nominated ends. Indeed, as has been pointed out, wage and price controls often have such a perverse effect on the economy that they worsen the inflationary situation. If wage and price controls are ineffective as cures, what measures are left? This chapter will review a few possibilities.

Earlier postwar economic theory recognized a phenomenon associated with the name of the economist, A. W. Phillips. This phenomenon was a negative correlation between the level of unemployment and the rate of change of money wages. According to this theory, wages would increase at a faster rate when unemployment was low and would increase at a slower rate (or even fall) when unemployment increased. If the assumption were made (and it is a reasonable assumption) that prices are linked to wages, then the “Phillips Curve” would suggest a stable negative correlation between the rate of change of prices and the level of unemployment.

At the time when the Phillips Curve analysis was being formulated, the rate of change of wages was small, despite some rather large short-term fluctuations. The relationship between unemployment and inflation seemed sufficiently stable under these conditions that it suggested a policy trade-off, perhaps inevitable, between unemployment and inflation. Policymakers could choose either a high level of employment, conjoined with a high level of inflation or they could cut down on their policies of economic stimulation and enjoy lower rates of inflation, albeit with higher unemployment rates. Even deflation was possible if aggregate demand, and hence employment, were sufficiently low. The position that a government adopted along the Phillips Curve was thought to depend entirely upon its policies, monetary, fiscal or other, to stimulate aggregate demand, and therefore employment.

Economists began to search for the numerical relationship between inflation and unemployment in a number of countries. Over time, however, it became clear that there was in fact no stable and negative correlation. At the postwar “full employment” rates, higher and higher rates of inflation seemed to be possible. The same level of employment apparently required an increasing degree of inflationary economic stimulation.

Milton Friedman, in his Nobel Prize acceptance speech, compared the employment rates with the rate of change of prices (after a short lag to accommodate the period necessary for price rises to work through after wages are increased) and found that the Phillips relation did indeed tend to be negative until the 60s, but after that, unemployment and inflation increased together. An exception is the United States, where the relation did not become positive until about 1973, which might explain why leading economists and world policymakers were so slow in accepting the turnaround, preferring to attribute it to special factors (trade union militancy, for instance) in each country. Nevertheless, as the 70s dawned, it became clear that “stagflation” was not only possible, but characteristic of many Western economies. It is as if the Phillips Curve itself has moved outward.

Why has this happened? In Friedman’s view, it is surprises that matter; a 20 percent inflation rate could very well be accompanied by low unemployment rates, provided that it was constant and predictable. He says:

An unanticipated change is very different. Firstly, the unpredictability of prices will make it difficult for producers to invest rationally, will generate doubt and uncertainty. Hiring will therefore tend to be diminished. Secondly, a volatile price level shortens the optimum length of unindexed labor commitments. In a volatile situation, employers will be much less likely to hire labor for a long period at a fixed wage, because of the risks that prices will fall while wages and other costs will continue to rise. An adverse effect on employment will be the result.

Furthermore, the effect of controls will confuse market prices and performance even further, as has already been explained. Governments set prices for a wide range of services—postal services, energy, and many more—and regulate even more. Under inflation, they take it upon themselves to control nearly all prices, either by explicit controls or by “voluntary” restraint. The resulting inability of the price system to guide economic activity leaves a given level of inflation compatible with rising unemployment. If employment becomes the principal end of government policy, then inflation could rise higher and higher. The old policy trade-off no longer operates. As Cagan says, “Policy makers face a dilemma. Inflation can be stopped, but the traditional policies work less effectively, and the nation has become more reluctant to incur the costs of using them forcefully. Hence doubt of the nation’s ability to control inflation deepens, thus weakening price responses and, in turn, the effectiveness of policy restraint. Thus does inflation feed on its own strength.”1

FIGHTING INFLATION BY ‘INDEXING’

Governments are under considerable pressure to maintain an inflationary expansion. Employers who granted large wage increases in the expectation of continued inflation and borrowers who borrowed at high rates for the same reason would be in dire straits if an inflation were suddenly stopped. Furthermore, the government itself benefits from inflation, as has been noted. The problem of curing inflation is therefore reduced to the problem of finding ways in which this pressure upon the government can be reduced.

One particularly promising approach is the concept of indexation, which has been extensively reviewed in an excellent book by Herbert Giersch and others.2 Indexation means the linking of financial agreements—mortgages, wages, taxes and others—to the rate of inflation. That is, these contracts are set in real terms, not nominal terms, through the use of what are commonly called “escalator” clauses. Such indexation can help reduce the side effects that must follow from ending inflation and reduce anticipations of future inflation.

The U.S. government already has escalator clauses on social security and other retirement benefits, the wages of many government employees, and other items. Taxes which are expressed as a certain percentage of price are also escalated automatically. Other escalator clauses are needed, however, if inflationary pressures are to be reduced to any extent.

The personal income tax could be easily adjusted so that rates were tied to the cost of living and the personal exemption and other deductions were raised according to inflation. These measures were adopted in Canada. In addition, the base for calculating capital gains can be adjusted to cover inflation, as can the base for calculating depreciation. For corporate taxation, these latter items could be included, as could book profits and losses.

Government securities could also be indexed, interest being paid in terms of the rise in the cost of living, rather than by a flat percentage. Such indexed bonds might prove so attractive under an inflationary situation that private enterprises would be forced to do the same. Because capital markets would begin to work in real terms, increased certainty and predictability in investment would result.

There is one major objection to the concept of indexation, which is in fact a misunderstanding of the principle, but which should be treated here. It is alleged that escalators actually have an inflationary effect on the economy, that the government has to expand the money supply to cover cost-of-living agreements as they respond to previous inflations. It should be noted, however, that escalators have no effect on the rate of inflation. They may allow an existing inflation to be transmitted more quickly and evenly through the economy (and this evenness might itself be an advantage in countering inflation) but this does not, in itself, raise or lower the rate of inflation. Adjustments for cost-of-living agreements come out of an existing expansion and do not prompt a future one.

OTHER WAYS TO FIGHT INFLATION

Other structural changes in the economy could help to reduce the pressure on governments to cause and prolong an inflationary over-stimulation. Some of these suggestions have been incorporated in an extensive anti-inflation package devised by Washington’s Republican Study Committee,3 and although these policies apply specifically to the United States, many of their lessons would be appropriate in other countries.

The first step would be to remove not only wage and price controls, but all other price manipulations by the government, and the power of government authorities to regulate prices and competition. Suitable targets for repeal are the “resale price maintenance” or state “fair trade” laws which exist in many countries and regions. Under these laws, all retailers are prevented from lowering their prices below a certain level; inefficiency and wastefulness are protected. This is, however, a luxury which we cannot afford if we are to come to grips with inflation.

A fresh look should be taken at the regulatory agencies, particularly the Civil Aeronautics Board, that has the power to keep air fares artificially high and to limit competition. A similar effect results from a country’s membership in the International Air Transport Association, which fixes higher fares and lower standards of service than many of the airlines would wish to provide. In many countries, foreign and domestic air travel is a significant part of business costs; keeping air travel expensive keeps business costs—and therefore prices— artificially high.

Some federal safety regulations are far from cost-effective and constitute a new tax on businesses and individuals. Stringent safety standards in the automobile industry, for example, have served to increase prices and prevent competition and innovation—particularly in the development of small cars, where the cost of the safety standards is a large part of the overall cost of the vehicle. These costs could be cut by making some of the more stringent and expensive regulations optional. Then, those vehicle buyers who thought that the changes were really worth the cost could be satisfied. Similarly, the Occupational Safety and Health Act constitutes a “tax” on businesses. Often the costs are very large, especially for the small businessman, and the benefits minimal. Frequently, small businesses cannot afford to replace outmoded plants and machinery. That is why in the years following the implementation of OSHA, there has been a tendency to increased prices and simultaneously an increase in bankruptcies and unemployment.

Government monopoly in some services, such as the post office, is a statutory elimination of free competition. As such, the post office can charge whatever prices it likes and can offer standards of service that are much lower than those possible under competition. At present, the U.S. Postal Service makes use of United Parcel Service to deliver some of the parcel post. Furthermore, UPS can guarantee delivery within a specified period, which is more than the U.S. Postal Service can do. The high cost of first class mail has caused some firms, such as certain electricity suppliers, to deliver bills by hand rather than through the mail. It has now become economical to invest large sums in major capital equipment so that accounts can in future be settled by telephone. Government monopolies such as the U.S. Postal Service are a luxury which the inflationary economy can well do without.

There are numerous other regulations designed to “protect” American farmers and industrialists, which in fact serve to keep prices high. Examples are the Meat Import Act, Dairy Import Quotas, the Jones Act (U.S. monopoly in coastal waters) and many more quota or price-support schemes.

MINIMUM WAGE LAWS

Minimum wage laws are also designed to “protect” workers, but in fact such inflationary laws raise prices and reduce employment.

Dr. Walter E. Williams, an economist at Temple University (and a Distinguished Scholar at The Heritage Foundation) has explained with eloquence the negative effect of minimum wage laws (another form of “price-fixing”) on the employment of youth, especially minority youth. It is largely because of this government attempt at wage-fixing that upwards of half of minority teen-agers who are seeking work are unemployed in many of our large cities.

Writing in Policy Review (Fall 1977) Dr. Williams analyzed exactly how minimum wage laws reduce employment and add to inflation (further reducing employment).

Federal and State minimum wage laws are acts of governmental intervention in the labor market that are intended to produce a pattern of events other than that produced in a free market. In practice, legislated minima specify a legal minimum hourly wage that can be paid. The legislated minima raise the wage to a level higher than that which would have occurred with free market forces.

Legislative bodies have the power to legislate a wage increase, but unfortunately, they have not found a way to legislate a worker productivity increase. Further, while Congress can legislate the price of a labor transaction, it cannot require that the transaction actually be made. To the extent that the minimum wage law raises the pay level to that which may exceed the productivity of some workers, employers will predictably make adjustments in their use of labor. Such an adjustment will produce gains for some workers at the expense of other workers. Those workers who retain their jobs and receive a higher wage clearly gain. The adverse effects are borne by those workers who are most disadvantaged in terms of marketable skills, who lose their jobs and their income or who are not hired in the first place.

This effect is more clearly seen if we put ourselves in the place of an employer and ask: If a wage of $2.60 per hour must be paid no matter who is hired, what kind of worker does it pay to hire? Clearly the answer, in terms of economic efficiency, is to hire workers whose productivity is the closest to $2.60 per hour. If such workers are available, it clearly does not pay the firm to hire those workers whose output is say, $1.50 per hour. Even if the employer were willing to train such a worker, the fact that the worker must be paid a wage higher than the market value of his output plus the training cost makes on-the-job training an unattractive proposition.

The impact of legislated minima can be brought into sharper focus if we ask the distributional question: Who bears the burden of the minimum wage? As suggested earlier, the workers who bear the heaviest burden are those that are the most marginal. These are workers whom employers perceive as being less productive or more costly to employ than other workers. In the U.S. labor force, there are at least two segments of the labor force that share the marginal worker characteristics to a greater extent than do other segments of the labor force. The first group consists of youths in general. They are low-skilled or marginal because of their age, immaturity and lack of work experience. The second group, which contains members of the first group, are racial minorities such as Negroes and Hispanics, who as a result of racial discrimination and a number of other socioeconomic factors, are disproportionately represented among low-skilled workers. These workers are not only made unemployable by the minimum wage, but their opportunities to upgrade their skills through on-the-job training are also severely limited.4

THE ROOT CAUSE AND THE LASTING CURE

David I. Meiselman, the author of the foreword to this book, is a leading specialist in monetary economics. He has summed up the root cause of inflation and the only way it can be permanently ended in the following paragraphs.

Inflation is the most thoroughly researched topic in all of economics. Every inflation, including all contemporary inflations, has the same explanation. There are no exceptions to the rule.

The rule is that prices, on average, depend on the ratio of money to output.

Inflation results, as in recent years, when the quantity of money increases faster than output, the nation’s total production of goods and services (“real” Gross National Product). Prices, on average, tend to be stable, as in much of the 1920s, when money increases at the same pace as output. There is deflation, prices fall, when, as in the thirty years after the end of the Civil War, money increases less than output.

Money, which consists of both cash (bills and coins) and bank deposits (checkbook and passbook money), is closely controlled by the Federal Reserve, our central bank and an agency of the federal government.

In the 1960s, when output increased an average of 6.6% per year, the Federal Reserve increased the quantity of money by an average of 10.6% per year, or 4.0% per year faster than output. Consistent with the rule, inflation also averaged 4.0% per year.

Thus far in the 1970s, U.S. output has increased at the average rate of 2.1% per year. Because the Federal Reserve has increased money by 9.5% per year, or 7.4% faster than output, inflation has also averaged 7.4%. The old laws of economics still hold.

There is no way inflation can be slowed or eliminated unless the Federal Reserve also slows the growth of money to match the real growth of the economy.

It is the Federal Reserve rather than the coffee in Brazil, the freeze in Florida or even the Arab oil cartel which is the principal factor in the U.S. inflation story. Like so many other problems, inflation is largely made in Washington, not on Main Street or even Wall Street.5

If David Meiselman’s advice is ultimately adopted by those who make economic policy in the United States, there will be no need for wage and price controls since inflation will be eliminated for all practical purposes.

FOOTNOTES

1. Phillip Cagan, The Hydra-Headed Monster (Washington, D.C.: American Enterprise Institute, 1974) p. 55.

2. Herbert Gierch, et. al., Essays and Inflation and Indexation (Washington, D.C: American Enterprise Institute, 1974).

3. Republican Study Committee, U.S. House of Representatives, 50 ways to Fight Inflation (Washington, D.C., 1975).

4. Walter E. Williams, “Government Sanctioned Restraints That Reduce Economic Opportunities For Minorities,” Policy Review (Washington, D.C.: The Heritage Foundation) Fall 1977, reprinted [with revisions] July 1978, pp. 4–6.

In his article, Dr. Williams has cited other research which tends to substantiate his thesis. On p. 6 he refers the reader to the following works. David E. Kaun, “Minimum Wages, Factor Substitution, and the Marginal Producer,” Quarterly Journal of Economics, August 1965, pp. 478–486; Yale Brozen, “The Effect of Statutory Minimum Wages on Teenage Unemployment,” Journal of Law and Economics, April 1969, pp. 109–122; Marvin Rosters and Finis Welch, “The Effects of Minimum Wages on the Distribution of Changes in Aggregate Employment,” American Economic Review, June 1972, pp. 323–332; William G. Bowen and T. Aldrich Finegan, The Economics of Labor Force Participation (Princeton University Press, 1969); Edmund S. Phelps, Inflationary Policy and Unemployment Theory (New York: W. W. Norton and Company, 1972); Arthur F. Burns, The Management of Prosperity (New York: Columbia University Press, 1966); Thomas G. Moore, “The Effect of Minimum Wages on Teenage Unemployment Rates” Journal of Political Economy, July/August 1971, pp. 897–902; James F. Ragan, Jr., “Minimum Wages and the Youth Labor Market,” The Review of Economics and Statistics, May 1977, pp. 129–136; Martin Feldstein, “The Economics of the New Unemployment,” The Public Interest, Fall 1973; Andrew Brimmer, Minimum Wage Proposals, Labor Costs, and Employment Opportunities in the Nation’s Capital (Brimmer & Company, Inc., 1978) demonstrates the adverse employment and business migration effects of the minimum wage law in Washington, D.C.

5. David I. Meiselman, “Inflation, Who Did It?”, National Public Policy Syndicate, New York, August 12, 1977.