A Tiger by the Tail

VII. The Outlook for the 1970s:
Open or Repressed Inflation?

By F.A. Hayek

In the last 40 years monetary policy has increasingly committed us to a development which has recurrently made necessary further measures that weakened the functioning of the market mechanism. We have now reached a point when it is widely proposed to combat the effects of our policy by further controls which would not only make the price mechanism wholly ineffective, but also make inevitable an ever-increasing central direction of all economic activity.

The development began with the acceptance of the given structure of money wages as not capable of being altered by the lowering of any wages, and the consequent demand that total money expenditure be raised sufficiently to take up the whole supply of labour at whatever wage rates prevailed. The result of this policy has been not only greatly to increase resistance to the lowering of any wage, but also to remove the main safeguard in the past to pushing wages above the point where the current supply of labour could be sold without further monetary expansion; i.e., to remove the acknowledged responsibility of the trade unions for the unemployment caused by their wage policies.

Long-run Vicious Circle

That it is always possible temporarily to reduce unemployment by a sufficient degree of monetary expansion was of course never doubted by anyone who had studied the major inflations of the past. If nevertheless the deliberate use of inflation to reduce unemployment was opposed by some economists, it was because of their belief that the employment thus created could be maintained only by continued and probably even progressive inflation. The reliance on what appears in the short-run as the politically easy way out thus tends to preserve and intensify a disequilibrium position in which the maintenance of an adequate volume of employment would require ever more drastic doses of inflation.

These apprehensions have been fully confirmed by the developments since the war. A continuing moderate degree of monetary expansion has proved insufficient to secure lasting full employment. There are two important reasons for this failure. Inflation tends not only to preserve but to increase the maldistribution of labour between industries, which must produce unemployment as soon as inflation ceases. Secondly, some of the stimulating effects of inflation are due to prices being for a time higher than expected, so that many undertakings are successful which would have failed if prices had not risen.

But a given rate of price increases comes to be expected after it has continued for some time, and the stimulating effect of inflation will therefore be maintained only if the rate of increase of prices accelerates and runs ahead of the expected rate of increase of prices. A continuing constant rate of increase of prices, on the other hand, must soon create a position in which future prices are correctly anticipated and present costs adapted to these expectations, with the result that the gains due to inflation disappear.

The magnitude of unemployment caused by a cessation of inflation will increase with the length of the period during which such policies are pursued. It not only becomes politically more and more difficult for policy to extricate itself from the train of events it has set up, but governments facing reelection find themselves recurrently forced to speed up inflation to whatever degree proves necessary to secure an acceptable level of employment.

While a mild degree of inflation is widely regarded as not too high a price for securing a high level of employment, the fact that inflation achieves this result only if it accelerates means that sooner or later the other effects of inflation will cause increasing discontent and a growing dislocation of economic processes. There are many harmful effects of inflation through which it endangers the efficiency, stability and growth of production, but that which first tends to cause widespread discontent is the effect of rising prices for consumers’ goods on those classes whose incomes, for one reason or another, do not keep pace with the rise of prices. It is the complaints of groups who find themselves poorer as a result of the increased costs of living that usually impel the first steps to combat inflation. These consist of attempts to prohibit or otherwise prevent the rise of prices caused by demand overtaking supply.

All measures of this kind do not of course remove the cause of the rise of prices but serve rather to make it possible for governments to continue with their inflationary policies without the effects manifesting themselves in the way in which they are most rapidly noticed. Because in a free market the general rise of prices is the most conspicuous sign of an excess of the stream of money expenditure over the stream of goods and services to be bought, people tend to think that if prices stop rising the evil of inflation has been conquered.

Repressed Inflation a Special Evil

It is probably no exaggeration to say that, although open inflation that manifests itself in a rise of prices is a great evil, it is less harmful than a repressed inflation—i.e., an increase of money which does not lead to a rise of prices because price increases are effectively prohibited. Such repressed inflation makes the price mechanism wholly inoperative and leads to its progressive replacement by central direction of all economic activity.

It is very doubtful, moreover, whether, after the imposition of price ceilings, the excess supply of money will still secure full employment. A significant part of the existing employment will have been based on the expectation of a further rise of prices which will now be disappointed. And in so far as the increase in the supply of money is reduced, those goods and services on which the additional money first impinged will suffer a reduction of demand. It is, however, unlikely that in such a situation the increase of the amount of money will stop. Since its immediate effects are rendered less obvious, it is likely to continue and to build up a further ‘overhang’ of excess money (i.e., cash holdings people would wish to spend if the commodities they wanted were available) which will make a removal of the imposed controls more and more difficult.

Preventing the rise of prices does not of course secure that everyone can buy more than they would if prices had risen. Instead of being certain to be able to buy goods and services at known though rising prices with the money they have to spend, buyers will be faced with shortages; who will get the available goods will be determined by accident or the favour of the sellers, and sooner or later inevitably by a more formal system of rationing.

The allocation of resources will at first still be determined by the structure of prices frozen after being distorted by inflation. These frozen relative prices will of course no longer be able to bring about the adjustment of production to changing conditions and needs. Consequently the direction of production will also have to be increasingly determined by decisions of government.

Central Control and ‘Politically Impossible’ Changes

This process by which attempts to control inflation by price ceilings lead to ever more comprehensive governmental controls, is self-accelerating also, because once production becomes dependent on rationing, licensing, permissions and official allocations, a constant overhang of money becomes necessary to keep goods flowing. No centrally directed economy has yet been able to operate without relying on the effect of an excess supply of money to help overcome the obstacles it creates.

The ultimate transition to a centrally directed economy seems thus inevitable if inflation is allowed to continue while its effects are partly suppressed by a price stop. There seems little prospect that governments in such a situation will effectively prevent further inflation and not merely suppress its most visible consequences. As inflation becomes more rapid the demand for its discontinuance will also become more pressing, but the amount of unemployment caused by every slowing down of inflation will simultaneously increase. We can probably expect governments to make repeated further attempts to slow down inflation, only to abandon them when the unemployment they produce becomes politically unacceptable.

It is to be feared that we have already reached a stage in this process when to save the market economy will call for much more drastic changes in our institutions than most commentators are ready to contemplate or than will be thought by many to be ‘politically possible’.1 There seems little immediate prospect that we shall be able directly to eliminate that determination of wages by collective bargaining which is the ultimate cause of the inflationary trend,2 or that we can reimpose upon trade unions the restraint which in the past stemmed from the fear of causing extensive unemployment. The only hope of escape from the vicious circle would seem to be to persuade the trade unions that it is in the interest of the workers in general to agree to an alternative method of wage determination which, while offering the workers as a whole a better chance of material advance, at the same time restores the flexibility of the relative wages of particular groups.

Profit-sharing a Solution

The only solution of this problem I can conceive is that the workers be persuaded to accept part of their remuneration, not in the form of a fixed wage, but as a participation in the profits of the enterprise by which they are employed. Suppose that, instead of a fixed total, they could be induced to accept an assured sum equal to, say, 80 percent of their past wages plus a share in profits which in otherwise unchanged conditions would give them on the average their former real income, but, in addition, a share in the growth of output of growing industries. In such a case the market mechanism would again be made to operate and at the same time one of the main obstacles to the growth of the social product would be removed.

This is not the place to develop in detail a suggestion which evidently raises many difficult problems. It is only mentioned to indicate that if we want to stop the process of cumulative inflation we shall have to consider much more radical changes in existing institutions than have yet been contemplated. If the dangers of present trends are clearly recognised, it may not be too late to extricate ourselves from a development in which we increasingly lose power over our fate. But unless we soon remedy the basic cause, we may find ourselves irrevocably committed to a path which leads to the destruction of far more than the material basis of our civilisation: not only economic progress but political and intellectual freedom would be threatened.

Basic Causes of Inflation

What is clear is that we must completely change the direction in which we have been endeavouring to reform the international monetary system during the last 25 years. Ever since Bretton Woods and the concern with the supposed lack of ‘international liquidity’, all efforts culminating in the creation of Special Drawing Rights have been aimed at enabling individual countries to inflate sufficiently to produce the maximum of employment which can be secured in the short run by monetary pressure. Now when it is becoming evident that employment is not simply a function of total demand, and that a rise in total money expenditure may indeed increase the part of employment dependent on a further rise in expenditure, it is crucially important that we turn our attention to the more fundamental factors governing employment: namely, the adjustment of the labour force and the structure of relative wages to the continuous changes in the direction of demand.

It should always have been obvious that whether a given total of money expenditure is sufficient to take off the market the amount of labour offered will depend on how this money expenditure is distributed between the different commodities and services relative to the distribution of labour devoted to their production. However much money may be spent on some part of total output, it will not secure the employment of those who produce more of other commodities than is demanded, certainly in the short run and not even in the long run.

The illusion that maladjustments in the allocation of resources and of relative prices can be cured by a manipulation of the total quantity of money is at the root of most of our difficulties. Such a use of monetary policy is more likely to aggravate than to reduce these maladjustments. Monetary policy can at most temporarily, but never in the long run, relieve us of the necessity to make changes in the use of resources required by changes in the real factors. It ought to aim at assisting this adjustment, not delaying it.

The fact that in the long run a market economy cannot operate effectively if relative wages are not determined by market forces has for a time been concealed by the effects of inflation. The time when this truth can be concealed by moderate inflation is probably past. And there clearly is a limit to the degree of inflation with which a market economy can operate. Combating inflation by price fixing makes the market inoperative even sooner.

If we want to preserve the market economy our aim must be to restore the effectiveness of the price mechanism. The chief obstacle to its functioning is trade union monopoly. It does not come from the side of money, and an exaggerated expectation of what can be achieved by monetary policy has diverted our attention from the chief causes. Though money may be one of them if it is mismanaged, monetary policy can do no more than prevent disturbances by monetary causes: it cannot remove those which come from other sources.

 

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3See W.H. Hutt, Politically Impossible...?, Hobart Paperback 1 (London: IEA, 1971).

4Professor James E. Meade has proposed limits on trade union wage-bargaining power in Wages and Prices in a Mixed Economy, Wincott Memorial Lecture, published as Occasional Paper 35 (London: IEA, 1971).

• 1Charles Gascom, “The Current Recession: How Bad Is It?” Federal Reserve Bank of St. Louis Economic Synopses 4 (January 8, 2009): 2, available at http://research.stlouisfed.org/publications/es/09/ES0904.pdf.
• 2It should be briefly noted that this was the same cheap money policy that ignited and stoked the unsustainable real estate boom in the first place. Thus from December 1999 through December 2005, the Fed increased the money supply as measured by MZM by about $2.5 trillion, or 57 percent, which works out to an uncompounded annual rate of 9.5 percent. During the same time period another Fed monetary aggregate, M2, registered an increase of $2 trillion, or about 44 percent, which yields an uncompounded annual rate of 7.3 percent. This massive monetary inflation was naturally accompanied by a precipitous decline in interest rates, with the target Fed Funds rate plunging from 6.5 percent in late 2000 to 1.0 percent in mid-2003 and being pegged at that level for nearly a year and then remaining below 3.0 percent for almost another year. Mortgages rates followed this sharp downward movement, with the rate on 30-year conventional fixed mortgages dropping 3 percentage points, from 8.52 percent in mid-2000 to 5.58 percent in mid-2005. But this understates the looseness in the home loan markets generated by the monetary inflation, which also induced the development of a remarkable laxity in credit standards. The statistics in this footnote and in the associated paragraph in the text are based on data from The Federal Reserve Bank of St. Louis Economic Research available at http://research.stlouisfed.org/).
• 3The publication of the new edition of this classic could not have come at a better time, moreover. For it is not merely an outstanding contribution to intellectual history, but also a tract for our times. The U.S. has been mired in an officially-recognized recession for more than a year now with no end in sight. Our current downturn is fast becoming the lengthiest and most severe of the post-World War II era. Entering its fourteenth month, it has already surpassed the average length of the last six recessions and is rapidly approaching the postwar record of sixteen months. The net decline in employment of 2.6 million recorded for 2008 represents the greatest absolute decline in the number of jobs since 1945. With over a half-million workers losing their jobs in December 2008 alone, the unemployment rate unexpectedly spiked from 6.8 percent in November 2008 to 7.2 percent, the highest level in sixteen years. The 4.78 million Americans now claiming unemployment insurance is the highest since 1967, when this statistic began to be recorded and represents the highest proportion of the work force since 1983. Adding to the dismal employment picture, the average work week for the month plummeted to 33.3 hours, the lowest level since 1964, while part-time jobs shot up by 700,000, or nearly 10 percent, from the previous month, indicating that many part-time workers counted as officially employed were either previously terminated from full-time jobs or reduced from full-time to part-time employment by their current employers. Other indicators of the severity of recession besides employment reveal that the current recession has been deeper than the average recession, including industrial production, real income, and retail sales. As one Fed economist concluded, “Main recession indicators tend to support the claim that this recession could be the most severe in the past 40 years.”
• 4Indeed the dread word “depression” is now being used by some economists and media pundits to portray our current difficulties, conjuring up the specter of the prolonged mass unemployment amidst idle industrial capacity and unsold piles of raw materials that marked the 1930s. For most recognized experts and opinion leaders, how we got into our current difficulties is now a moot question. Everyone is clamoring for a way out. A massive government bailout involving $700 billion to purchase risky assets and to subsidize troubled financial service and domestic automobile firms has proven spectacularly ineffective in reversing or even slowing the contraction of the economy, although it has led to a staggering projected federal budget deficit of $1.2 trillion for the current fiscal year. Accompanying this deluge of red ink is highly inflationary growth in the official Fed monetary aggregates, with MZM shooting up by 10.1 percent and M2 by 7.6 percent year-over-year as of November 2008. Driving this monetary inflation has been the Fed’s expansion of the adjusted monetary base by 76 percent over the same period, which has reduced the target Fed Funds rate from 5.25 percent in mid-2007 to less than .25 percent by the end of 2008.