The 1970s called and they want their economic policy back. This may sound like a cheap quip against the growing popularity of attempts to control prices in the face of inflation. After all, France is implementing price controls right now, while Canadian Prime Minister Justin Trudeau also forced grocery stores to come explain price hikes with the hint that he might start doing the same. These policies and scapegoating of businesses are the same as in the 1970s, hence the quip. But I could have quipped about any number of historical examples – the 1940s, the 1930s in Germany, the 1910s, the 1790s in France, and on and on. After all, as one aptly titled book made explicit – “forty centuries of wage and price controls” teach us exactly “how not to fight inflation.”
The best way to understand why is by invoking an analogy about thermometers and temperature that Milton Friedman employed when inflation was a big issue during the 1960s and 1970s. Prices function somewhat like a thermometer inside your house. They indicate the point where the quantities that producers are willing to supply to the market match the quantities consumers demand, based on their available budget. Monetary policy for its part, is the thermostat. If the thermometer says that the temperature is going up, it’s either because there are changes in the economy in general (i.e., the outside temperature) or because someone turned up the thermostat. Sometimes, it can be a mixture of both factors (i.e., loose monetary policy and supply shocks occurring simultaneously). Distinguishing between them is not an easy task. People who propose to impose price controls are essentially trying to break the thermometer by preventing it from showing the rising temperature and claiming the problem is solved.
This approach doesn’t address the underlying issue, but instead deprives us of information about its scope and progression. All it does is create noise around the price signals because the underlying fundamental factors (i.e., monetary policy, factors that affect productivity etc.) are unchanged. As such, the fact that measured prices stop increasing when the government enforces price controls doesn’t mean that real prices stop rising. Something must give! With controlled prices, people must either wait in line, suffer some form of rationing, be offered lower quality goods, or be forced to engage in involuntary substitution towards less desirable goods.
Historical examples of each of these consequences of price controls abound. In my native Canada during WW II for example, the federal government imposed strict price control measures on a wide array of goods. At controlled prices, supply fell short, an issue made worse by the many thousands of Canadians who were taken out of the labor force and sent to fight. Many goods were too scarce, so rationing was necessary. Canadians were thus compelled to wait in long lines with ration books. The waiting time was a cost in and of itself. The rationed quantities were another form of cost, such that calories consumed by civilians in Canada – which was spared the physical destruction of the war – actually fell. When too unsatisfied with the consequences of rationing, Canadians turned to the black market, where they could be ripped off with no possible recourse (food adulteration was, for example, a recurrent issue). If caught making illicit purchases, the fines were hefty. To top it all off, retailers often served lower-quality goods to the public at controlled prices while selling higher-quality goods on the black market. All of these are “real” costs that “reported prices” no longer communicated.
These kinds of costs are very real. In an article in Social Science Quarterly, Casey Pender and I estimated the true inflation in Canada during the war. Using pre-war relationships between economic activity, money supply, and inflation, we predicted what would have been the rate of inflation absent price controls. We found that the official reported increase of 28 percent in prices from 1939 to 1945 was actually 48 percent. That rate is probably too conservative. Indeed, newspapers at the time frequently discussed black markets, which led to occasional reporting of “shadow market prices” which could be compared with official prices. These suggest figures well above the 48 percent that Pender and I found (probably closer to 60 or 70 percent).
One example of involuntary substitution resulting from price controls can be found in Nazi Germany before WW II. The regime implemented strict price controls in ways that did not reflect previous consumption patterns. As such, given the prices posted, Germans could not consume what they truly desired. To illustrate, imagine that the price of beef was twice the price of pork before price controls. Yet, Germans consumed more beef than pork. Once price controls were imposed, the price of beef was set equal to that of pork. Germans should consume more beef. But rationing was still an issue – beef was simply unavailable at posted prices. They thus consumed more pork. This is involuntary substitution, and it has a cost in terms of welfare. Economic historian Robin Winkler attempted to measure the cost of this involuntary substitution by comparing some 4,000 households in 1927 (before price controls) and 1937 (after price controls), with the assumption that the former year revealed true preferences relative to the distortions in the latter year. The distortions could then be expressed as a share of income – which Winkler estimates was roughly 7 percent. Simply put, Germans would have needed 7 percent more income to compensate them for the value of the lost well-being resulting from the price controls.
I could keep going. Price controls have long been studied by economic historians in the case of the French Revolution, many countries during and soon after World War I, the 301 AD price edict of emperor Diocletian, the Song dynasty’s 13th century experiments with paper money, and the attempt to quash inflation with price controls, and even the price and wage controls of the Nixon administration. All of them point to the same thing – price controls do not stop inflation; they only make things worse. If prices are going up, it’s either because monetary policy is too loose or because the economy suffered a decline in productivity. There is no way around it, and the only solutions are to tighten monetary policy or enact reforms that promote productivity growth. Everything else is a fool’s errand that ends in economic pain.
0 Comments