Forty Centuries of Wage and Price Controls

19

The Economic Effects Of Wage and Price Controls

Perhaps we can be thankful that wage and price controls can rarely be maintained over any long period, for there is a great deal of evidence that these controls, to the extent that they are successful, can cause severe and sometimes permanent damage to the economy. One of the most penetrating and effective accounts of these adverse effects of controls comes from C. Jackson Grayson, Jr., who was Chairman of the Price Commission under Phase II of the Nixon Economic Stabilization Policy. His attacks on price and wage manipulation began with Confessions of a Price Controller1 and a magazine article of 1974 in which he remarks with graceful brevity that “as a result of my sixteen months as a price controller, I can list seven ways that controls interfere (negatively) with the market system and hasten its metamorphosis into a centralized economy. ”2

Let us briefly examine Grayson’s seven points and add some comment to them:

(1) Controls lead to distortions in the market system. Hayek calls the free price system a “miracle” because it informs buyers and sellers of the relative scarcities of all products and simultaneously encourages them to restore supply and demand to equilibrium. For normal products, when demand exceeds supply, prices will be bid up. The prospect of higher profit margins will draw more sellers into the market or will encourage present sellers to increase their supply and hence supply and demand will once more be restored to equilibrium. When supply exceeds demand, prices will fall and buyers will absorb more of the product, while sellers will reduce their output. Equilibrium is once more restored.

When prices are manipulated, however, these “signals” indicating relative scarcity cannot be detected. It becomes impossible to distinguish real signals from artificial, manipulated ones. Shortages become common because firms are not induced by higher profitability to expand their supply. Black markets emerge to meet the demands of customers who would otherwise have to suffer long delays on the delivery of commodities at the controlled price. Firms that would be fully profitable under a freely-adjusting price mechanism are squeezed out of production or are not induced to enter production under artificially depressed prices.

In capital markets, these conditions create a major problem for investors; it becomes impossible to invest rationally when some firms are being driven to bankruptcy by the controls, when shortages are common but cannot be detected in terms of a price rise, and when black market operations account for a sizeable proportion of the trade of an industry. Consequently, the flow of investment funds to the various producing sectors in the economy becomes distorted, firms which would not be profitable under normal conditions are able to survive, and nothing is done to prevent the serious shortages that emerge through the imposition of controls.

This, of course, offers a good argument to those who would advocate the institution of a centralized economy. They say that the “market” is clearly unable to allocate resources properly, and to keep supply and demand in equilibrium. Controls themselves make further government intervention (to correct the disequilibria caused by controls) more likely.

(2) Controls penalize those who wish to claim non-inflationary wage or price increases. “During a period of controls,” says Grayson, “the public forgets that not all wage-price increases are inflationary.” A wage increase, for example, is not inflationary if it does not lead to the government borrowing or increasing credit and money supply to satisfy it. If some particular firm has a good performance record, and is enjoying a larger share of the market and higher profits, it is natural that it might wish to pass on some of these higher profits to its labor force. This increase would not be inflationary, since it comes out of profits that are willingly given to the firm by consumers. Wage controls, however, would stop this transfer of profits from firms to workers, since they never distinguish between inflationary and non-inflationary wage increases.

(3) Controls negate the profit principle. Controls are introduced when the government declares that prices, or the rise in prices, are “too high.” This suggests that there is something that sellers can do about their prices, if only they were public-spirited or if they were forced. It further suggests that profits are also “too high,” but it is through the profit motive that investment resources are drawn to worthwhile industries and so, by calling this motive into question, controls undermine the philosophy of the free market and cause dislocations in capital formation and investment.

(4) Controls can be used for noneconomic motives. The fourth instance in which price controls may damage the economy is when lobbyists ask for them in order to fulfill noneconomic objectives. There are controls on the price of food, for example, they say, because food is important to consumers. If this is true, then why not have controls on the prices of firms which cause pollution, or do not employ sufficient numbers of minorities? This is the beginning of the political manipulation of the market system.

(5) Controls engender comfortable attitudes. Grayson says that “wage-price controls can easily become a security blanket against the cold winds of free-market uncertainties.” In the market, decisions have to be made, profits rise or fall, firms succeed or go bankrupt, and men are given jobs or laid off. Under control, the illusion is sometimes maintained, at least in the short term, that these decisions do not have to be faced. The behavior of prices and wages is predictable under controls and, therefore, they do not have to be taken into consideration in the decisions of firms.

(6) The regulatory body becomes more important than the market. Under controls, business and labor leaders begin to pay more attention to the mechanism of regulation than to the dynamics of the marketplace. Years of wage regulation in Britain, for example, have encouraged a situation in which the trade union leaders are, in effect, another branch of government and are consulted by government officials before any economic policy can be put into effect.

Employers and union leaders themselves, observing that wages and prices can be fixed or increased only by the agreement of some regulatory body, pay more attention to influencing the decisions of that body in their own favor than they do to improving their market performance and the productivity of their labor.

(7) Controls draw attention away from the real causes of inflation. Grayson says that price controls “draw attention away from the fundamental factors that affect inflation—fiscal and monetary policies, tax rates, import-export policies, productivity, competitive restrictions, and the like.”3 There is an enduring belief that controls are a cure for inflation itself, not merely temporary suspensions of its symptoms.

OTHER ECONOMIC EFFECTS

There are some other comments on the economic effects of wage and price controls that might be given here:

Firstly, as Roger Blough writes in the Monthly Labor Review, “Controls sometimes. . . do a disservice by masking the need for structural reforms where needed in the economy.”4 It is not merely that controls draw attention away from the real causes of inflation, but that they give governments an excuse for inaction. “Controls put a damper on inflation without seeming to require restraints on aggregate demand or any increase in unemployment,” remarks Phillip Cagan.5 Small wonder that they are so popular with politicians!

Secondly, controls shift the traditional economic powers wielded by government, labor organizations, businesses and consumers. For the most part, power is put into the hands of the former three at the expense of the latter. Once more, this process has reached a critical stage in Britain, where price controls have been in effect over long periods since World War II. The Free Nation remarks caustically that “Incomes policies arouse the bargaining powers of the unions,” giving them a rallying-point from which further support can be drummed up, and “can lead to unjustifiable union arrogance. . . .Detailed concern by the government in wage negotiations ascribes more influence to the trade unions than economic experience shows is their due. Voluntary incomes policies which solicit the blessing of union leaders . . . make the unions appear as allies of stability and responsibility instead of their principal enemy.”6 Like the unions, the government, by taking upon itself the important economic task of setting wages and prices, of intervening in wage disputes and other crucial activities, expands its economic influence to gigantic proportions when compared to its influence in a free economy.

A minor but interesting effect of recent British and American wage and price restrictions has been the introduction of “list prices.” If a retailer believes that his prices are going to be frozen by the government, he will tend to fix an artificially high list price and then offer his goods at a considerable discount on that price. By this means, the retailer maintains a degree of slackness that can absorb the effects of the controls. Hence, in those two countries and others, scores of “discount shops” have sprung up, particularly in the luxury goods sectors, where the range of controls is wide. So, in this situation, the real (selling) price continues to rise as sellers’ costs rise, while the cosmetic (list) price remains static, fixed by the controls. Were it possible to calculate the impact of this effect upon real and reported inflation, then the notion that controls really are able to hold down selling prices would receive yet another blow and the Consumer Price Index would edge higher than it has been doing during the recent inflations in the Western world.

There are two more ways, in addition to Grayson’s seven considerations, in which wage and price controls serve to dislocate the price system and disrupt production. Controls, it will be noted, are always imposed during a period of inflation, when prices are rising and workers are claiming higher wages to keep abreast of the increased cost of living and are struggling to retain their wage differentials with other groups of workers. Similarly, sellers are raising their prices to pass on these cost increases without reducing profit margins. In this situation, as Phillip Cagan notes,7 “There is never any right moment when an inflationary process can be frozen by decree without imposing hardships on many sellers who need to raise prices to cover recent cost increases.” Similarly, hardships are imposed on workers who find themselves behind in the struggle to maintain traditional differentials. In addition to dislocating prices and wages, therefore, controls serve to promote unrest among workers and sellers alike.

The second instance in which controls disrupt the economy takes place not when they are imposed, but when they are lifted. “Controls are unlikely even to make the ultimate total rise in prices less than it would have been had they not been imposed, given the same path of aggregate demand,” writes Cagan.8 “Prices gravitate toward an equilibrium determined by the interaction of demand and supply conditions. Constraints such as controls can delay the adjustment, but eventually prices will find their equilibrium. . .after the controls are lifted.”

There is one last economic effect of wage and price controls that might be mentioned here. The common rationale for controls is that they curb the bargaining power of the large unions and reduce the ability of the large corporations to force prices up. As we have seen, their effect is quite the opposite with respect to the power of the unions and with respect to the power of the large corporations; the evidence suggests that these firms do not initiate inflationary increases, but usually fall behind in the inflationary process. Large firms incur higher administrative costs in making a price change, there is a reluctance among oligopolists to start price wars, and a large firm is unable to be sure of what the “equilibrium” price really is for a wide-selling range of products. Consequently, there is a reluctance among large firms to change their prices when an inflationary movement begins. Controls serve only to keep them further behind, so there is no economic reason that the great weight of the controls should be directed at the large corporations.

CONTROLS AND EMPLOYMENT

Controls may increase employment in two ways. The first and most important is that they reduce anticipations of price increases. In the unregulated inflationary economy, there is always a tendency for wage claims and price rises to result in overestimated predictions of future price rises. Often it is impossible even to guess just what future price rises will be, so workers and sellers tend to set their price and wage claims at the higher end of the range of possibilities. This insulates them from future, anticipated price rises. Prices and wages are set far above their equilibrium price, and an inflationary pressure is the consequence. If controls reduce anticipated price rises, then prices can be brought into line with the equilibria, and the inflationary pressure is reduced. “The fact of the controls. . .,” reported the Council of Economic Advisers in 1974,9 “reduced inflationary expectations, held down total spending, restrained the tendency to boost wages and prices, and permitted output to rise more rapidly than it would otherwise have done.”

A second way in which controls seem to increase employment can be seen in the formation of public service regulatory bodies to administer the controls themselves! The number of agencies that have been created for price regulation is staggering. Consider: The National Board for Prices and Incomes; the Council on Prices, Productivity and Incomes; the National Economic Development Council; the National Incomes Commission. So far, these organizations are the only ones in Britain. We must not forget the Dutch Board of Government Mediators, the Social and Economic Council, and the Central Planning Board. In France there were the Conference des Revenus, the National Accounting Commission and the Center for the Study of Incomes and Costs.

Wage controls were a major part of the work of the German Council of Economic Experts and of the Austrian Federal Chamber of Industry and Trade, as well as the latter country’s Economic Commission. The Austrian Joint Commission for Prices and Wages examined the subject of controls full time, as did the Advisory Council for Economic and Social Questions. The Danish Economic Council was another such agency with the primary purpose of administering controls; and, moving across oceans, there are the Canadian Economic Council, the Prices and Incomes Commission, as well as the United States Price Commission, and various subcommittees of the Council of Economic Advisors.

Wage and price controls, it seems, require such a multitude of agencies, commissions, councils and boards to administer them. Each organization has its own research and economic experts, executives, planners, members, and supervisors. The employment potential of the administration of price controls (although quite unproductive) is apparently enormous!

In the private sector, however, controls undoubtedly increase unemployment, although the employment function is so complicated that no hard and fast quantitative answer can be given to the question of the precise effect of controls on employment. From a common sense position, however, we can agree with the British economist Sam Brittan, who says,10 “A price ceiling that squeezes profits in relation to wages is, from the employer’s point of view, equivalent to an increase in real wages. It thus becomes less profitable to employ as many people as before.” As margins are squeezed, of course, it is the less-valued workers who will be the first to go, but the marginal workforce is made up of exactly those people—poorer paid and less skilled workers—whom price controls are designed to help. It was because of this unemployment effect as much as any other that the Labor government in Sam Brittan’s own country ended price controls when they acceded to power in 1974 and gave some industries tax relief in order to rescue their eroding margins.

Brittan cites a subtle effect of price controls that might be recounted here. The same unemployment effect can occur, he says, when controls are removed, as happened in the United Kingdom in the winter of 1971:11

Faced with a sudden acceleration of money wage increases following the abandonment of incomes control, employers became less confident about passing them on in higher prices—partly because the effect of [the then Chancellor of the Exchequer] Roy Jenkins’s monetary restraint was still being felt, but also because they were unsure how their competitors would react to an unprecedented situation. The result was an increase in the share of wages relative to profits, above what was normal in the downward phase of the [business] cycle, and a level of unemployment in the winter of 1971–2 that surprised the official forecasters.

Such an effect cannot be permanent, of course, as firms eventually discover how much they can raise prices following the abandonment of controls, without initiating price warfare from other firms. Nevertheless, the effect is disrupting to business and is harmful for the employment prospects of the workforce.

Moreover, the phenomenon strikes publicly-owned industries as well as private ones. A price ceiling coupled with continually rising costs will reduce the profit margins (or more likely, will increase the deficits) of public industries. These losses have to be financed out of taxation, or through government borrowing, which is a further pressure on the inflation rate.

Sir John Hicks once warned that “When the real demand for labor falls (as it has fallen) then traditional theory says that either there must be a fall in real wages or there must be unemployment.”12 Under price restraint, the demand for labor certainly does fall as margins are squeezed. The ingenious government of Great Britain found a way out of such a dilemma between falling wages and unemployment by preventing employers from declaring their workers jobless. The effect which this featherbedding has had on the British economy is now only too well known: firms have been unable to survive under the constricting regulations, the number of bankruptcies has risen dramatically, and both capital and initiative have been drained out of the country.

FOOTNOTES

1. G. Jackson Grayson, Jr., Confessions of a Price Controller (New York: Dow-Jones, Irwin, 1974).

2. C. Jackson Grayson, Jr., “Controls are Not the Answer,” Challenge, November-December 1974, p. 10.

3. Ibid., p. 12.

4. Roger M. Blough, “Minimizing the Effect of Controls,” Monthly Labor Review, Vol. 97, No. 3, March 1974.

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

6. “The Fatal Temptation,” The Free Nation (London: National Association for Freedom) September 3, 1976, p. 9.

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

8. Ibid., p. 56.

9. Annual Report of the Council of Economic Advisors, February 1974, p. 99.

10. Samuel Brittan, Second Thoughts on Full Employment Policy (London: Barry Rose, for the Centre for Policy Studies, 1975) p. 48.

11. Ibid., p. 50.

12. Sir John Hicks, Crisis ’75. . .? (London: Institute of Economic Affairs, 1975). See especially pp. 17–25.