All Commentary
Sunday, July 1, 1979

Blaming the Victims: The Government’s Theory of Inflation


Robert Higgs is Professor of Economics at the University of Washington. He is popular as a lecturer on economic and monetary affairs. His writings include numerous articles as well as books on The Transformation of the American Economy, 1865-1914, and Competition and Coercion.

In October, 1978, President Carter announced an elaborate program of wage-price guidelines to serve as the keystone of his administration’s anti-inflation policies. What makes the President’s advisers believe that the sword of guidelines can slay the dragon of inflation? Like other knights-errant, they are convinced that they understand the anatomy of the beast, that they know just where they must drive their lance in order to kill or at least disable it. Putting metaphors aside, I am saying that they have a theory about the nature and causes of inflation that suggests guidelines can be an effective anti-inflation policy. It is not a very coherent or well articulated theory, but its main elements can be discerned fairly readily in the statements emanating from the ?resident himself, from the Council )n Wage and Price Stability COWPS), and from the Council of Economic Advisers (CEA).

The Official Line

The fundamental assumption of the government’s theory is that competitive market forces have little or nothing to do with the determination of prices and wages. “The pay and price standards,” the President’s advisers say, “are designed to be guides for decision-making agents who have discretionary power in wage and price determination.”’ They believe, in other words, that ‘firms can set whatever prices they want and, in conjunction with the unions, whatever wages they want. Alfred Kahn, the chairman of COWPS, and his fellow enforcers obviously believe that this discretionary power resides especially within the largest corporations and labor unions, for those institutions have been the focus of their monitoring efforts from the very beginning. The notion that large firms and unions possess significant power to resist competitive market pressures is known to economists as the administered-price theory. The President’s men clearly embrace this theory root and branch.

From the administered-price theory of price and wage determination, it is but a short step to the cost-push theory of inflation. The government economists have taken this step. In this year’s Report of the Council of Economic Advisers, one finds repeated assertions that during the current expansion the economy, even in 1978, has not yet experienced excessive aggregate demand for its output. Idle plant and labor, it is said, have been ample to accommodate increases in the economy’s rate of output.2 Rather than the pressure of excess demand driving up prices, the government economists see cost increases, particularly increased costs of labor, pushing prices up. “[T]he rise in unit labor costs,” it is alleged, was “a major factor in the acceleration of inflation” in 1978.3

By combining the assumption of discretionary market power, the administered-price theory, and the cost-push theory of inflation, the government economists arrive at the concept of a wage-price spiral as a characterization of the causal structure of inflation. In this view, large firms and unions conspire to push up wages excessively; the firms then pass the increased labor costs along to final consumers and other purchasers in the form of higher product prices, thereby creating inflation. In response to this inflation, which reduces real wages, the unions subsequently return to the bargaining tables with even more outrageous demands. The economy is propelled through successive rounds of inflation kept in motion by the powerful but socially irresponsible actions of the large companies and unions. The rest of the economy, with its smaller firms and mostly nonunionized workers, falls passively into line with the patterns set by the large firms and unions.

The wage-price spiral is the government’s accepted view of the basic inflationary process, but the President’s men complement this basic conception with two auxiliary theories of inflation: the exogenous shock theory and the self-sustaining expectations theory.

The exogenous shock theory has been especially popular of late. In his economic report to the Congress this year, the President relied on it almost exclusively to explain the recent increase in the rate of inflation. Mr. Carter identified several important shocks:

Cold winter weather affected food supplies and prices. Depreciation of the dollar in foreign exchange markets added to prices of imports and to prices of goods produced by U.S. firms that compete with imported products. Costs of land and building materials were driven up by exuberant demands for new homes, and the rise of mortgage interest rates added to the costs of buying a home. At the same time, the cumulative effects of government legislation and regulation over recent years gave further impetus to cost pressures. A large part of the worsening of inflation last year, however, stemmed from poor productivity.4

Of course, the most frequently cited exogenous shock of all is the effect on fuel and related prices when the OPEC cartel raises the price of oil. All of these exogenous shocks are thought to be external to the normal functioning of the American economy but additive to its allegedly inherent wage-price spiral. They are seen as unfortunate accidents—our luck seems always to be bad—that make inflation even worse than it would be as a result of the internal wage-price spiral.

Finally, the self-sustaining expectations theory completes the government’s overall conception of the inflationary process by suggesting that, once inflation has gone on for a while, people expect it to continue; and these expectations, all by themselves, can then continue to push prices up year after year. In the words of the CEA, “Once under way, a high rate of inflation generates responses and adaptations by individuals and institutions that perpetuate the wage-price spiral, even in periods of economic slack. . . . The formal and informal adaptations to a longstanding inflation exert a powerful force tending to sustain inflation even after the originating causes have disappeared.”5 Those who regard economics as the dismal science will certainly find ample confirmation in this theory.

Fallacies of the Official Line

Unfortunately, the entire edifice of the government’s theories-the assumption of discretionary power, the administered-price theory, the wage-price spiral, the exogenous shocks, the self-sustaining expectations—all of it is the rankest nonsense as an explanation of inflation. There are a variety of pertinent reasons for rejecting the official line. Consider for a moment the assumption of discretionary power. This unfortunate belief seems to have grown out of the common observation that many firms can increase their prices somewhat without losing all their sales. What the notion of discretionary power neglects, however, is that, unless the demand for its product has increased, a firm that raises its prices will experience a reduction in unit sales volume. Even the true monopolist, the single seller with the market all to himself, must contend with the law of demand—and, of course, true monopolists are as rare as hen’s teeth. Clearly, even firms in highly concentrated industries must, and do, compete for the customer’s favor. Despite what Professor J. K. Galbraith and a host of lesser known polemicists have asserted, it simply is not true that large firms can raise their prices at will without suffering any consequent reductions in sales. Even if this ever had been the case, we can be confident that business managers would long since have taken advantage of such a marvelous opportunity for adding effortlessly to their profits. The idea that large firms possess bottomless reservoirs of discretionary pricing power is preposterous in its logic and without any basis in fact.

The closely related theory of administered pricing is similarly flawed. George Stigler and James Kindahl, in the most painstaking and carefully designed study of industrial prices ever conducted, found that industrial markets, including those with only a few large firms, are not “unresponsive in their pricing to changes in general business conditions”;6 that is, the price data refute the administered-price theory.

Economists have also tested the relationship between industrial concentration and the rate of price increase among industries. Both in the late 1960′s and in the decade terminating in 1977, they have found that the correlation between concentration and price increases is negative; that is, the industries with a few large firms have had smaller average increases in prices than the industries with many small firms.’

George Shultz, the former Secretary of the Treasury who occupied an important administrative position during the period of President Nixon’s price controls, has pointed out that between 1971 and 1974 prices rose most rapidly in sectors with many small firms (e.g., agriculture), in sectors dominated by the government (e.g., health services), and in sectors heavily involved in international trade (e.g., petroleum).8

One can draw similar conclusions for the past 11 years by examining the broad components of the consumer price index: since 1967 (index = 100), the greatest increases have occurred in the prices of home ownership (238.8) and medical care (227.0), both sectors that are dominated by a multitude of small suppliers. Even increased fuel and utilities prices (218.5), which have been so profoundly affected by the actions of the OPEC cartel, have barely equaled the increased prices of food (217.8), which is supplied by tens of thousands of stores and middlemen and millions of farmers.9

The administered-price theory, scientifically speaking, is a joke—though not a very funny one. Nevertheless, it is very popular among the general public, who are infected with a chronic distrust of big business’ motives and actions. And it is, if anything, even more cherished by politicians. As Shultz has said, “The politician . . . knows the political mileage to be gained by pushing around the big boys in the economy, whether or not it makes any economic sense.’”

Without the assumption of discretionary power and the administered-price theory to support them, the cost-push theory of inflation and the notion of a wage-price spiral collapse of their own weight.

Inflation versus Relative Price Changes

In any event, the cost-push theory, along with the exogenous shock theory, fundamentally misconstrues the issue in question. Inflation is a persistent, ongoing increase in the average price of the economy’s total output; or, looking at it from its other side, inflation is a persistent, ongoing decline in the average purchasing power of money. Unfortunately, it has become commonplace for people to refer to any increase in the money price of a particular product, no matter how small or how transitory, as inflationary. This confuses the price of a particular good with the average price of all goods. It is extremely important to understand that in any real economy some increases in the prices of particular goods would necessarily occur even if the overall price level were perfectly stable. Obviously, such particular price increases would change only the relative prices of particular goods; declines in other individual prices would offset these increases, thereby keeping the aggregate price level constant.

The fallacies of the cost-push theory can be illustrated well by a simple, hypothetical example. Suppose a firm and a union enter into a conspiracy to raise the wage paid to the firm’s workers far above the competitive level; the firm then raises the price of its product enough to offset the increased labor costs; but the total volume of money expenditures in the overall economy remains the same. What will happen?

Under these circumstances, the firm will find that because the relative price of its product has increased, it will be unable to sell as much of its output as before; it will have to reduce production and lay off workers. These workers must go elsewhere to obtain employment.

The increased supply of workers elsewhere will tend to reduce the wage rate, lower production costs, and encourage enlarged production and therefore reduced product prices elsewhere. The ultimate outcome of these readjustments is that the conspiring firm to some extent prices itself out of the market; its labor force shrinks, and some of its initial workers find work elsewhere at lower wages. The price of the firm’s product does increase, to be sure, but prices elsewhere decrease. Inflation, most emphatically, does not occur.

The truth is that as long as the aggregate volume of money expenditures is held fixed, cost increases in particular firms or sectors, no matter what their origin, can cause only relative price changes. Such cost increases alone cannot cause inflation, which is a persistent, ongoing increase in the average price of all goods and services.

Recall the alleged causes of increased inflation in 1978 as identified by President Carter. They include bad weather, dollar depreciation against foreign currencies, increased demand for housing, and higher mortgage interest rates. Each of these can cause a change in relative prices, but none of them can cause inflation. The cost-push theory of inflation, from an intellectual standpoint, is simply indefensible. It remains immensely useful for politicians, however, because it shifts the blame for inflation onto the private sector. But private citizens cannot cause inflation, because they cannot regulate the volume of aggregate money expenditure. Whoever controls that bears the blame for inflation and holds the only key to stopping it.

What Really Causes Inflation?

Inflation occurs, by definition, when the economy’s aggregate volume of money expenditure grows faster than its aggregate real output. The excessive growth of money expenditures can have, again by definition, only two sources: either the velocity of monetary circulation grows excessively or the money stock itself grows excessively (or both). Our current inflation is attributable almost entirely to excessive growth of the money stock.

Because the excessive growth of the money stock and the inflation it causes do not happen simultaneously, some people always fail to perceive the relationship. Increases in the money stock take some time before their effect on the volume of expenditure becomes significant. But once the actual lag is recognized, the relationship is seen to be very close. By relating the rate of inflation in a given year to the average rate of growth of the broadly-defined money stock (M3) during the three previous years, one can chart a clear parallel relationship. During the 1970′s, the only breakdown of this relationship occurred in 1972; and, of course, that anomaly disappears when one adjusts the inflation data for the effects of the severe Phase II price controls in force in 1972.

In short, inflation is not caused by cost-pushes, wage-price spirals, depreciation of the dollar on foreign exchange markets, regulatory constraints, minimum wage laws, or lagging productivity growth. Inflation is a purely monetary phenomenon: when the purchasing power of the dollar falls steadily and persistently over many years, it is because dollars have steadily and persistently become more abundant in relation to the total quantity of real goods and services for which they exchange. Inflation, in sum, is caused by excessive growth of the money stock. Period.

The Government’s Responsibility

As the Federal Reserve System authorities can control the rate of growth of the money stock, they clearly are to blame for its excessive expansion. Of course, the executive and legislative branches of the federal government have put heavy pressures on the monetary authorities to expand the money stock fast enough to “facilitate” the easy financing of the enormous, unprecedented peacetime deficits in the federal budget. In general, however, the Fed has been an easy touch, quite responsive to these pressures. William Miller, the current chairman of the Federal Reserve Board, has been variously described as “cooperative,” a “team player,” and “a tool of the [Carter] administration.”11 One wishes the central bankers had had more backbone.

If they had, we would have found that mere deficits, in the absence of excessive monetary expansion, can not cause inflation. Clearly, the deficits, working through the political process as it influences the Fed, encourage a loose monetary policy. But it is essential to recognize that it is the excessive growth of the money supply, whether to finance deficits or for some other reason, that causes inflation. Conversely, with a sufficiently slow growth of the money stock, there can be no inflation, no matter what is happening to the federal budget, labor costs, regulatory standards, minimum wages, and so forth. To repeat, inflation is a purely monetary phenomenon.

It hardly needs to be added that once excessive monetary expansion has been halted, inflation cannot be kept alive merely by expectations of inflation. People will find that, in the absence of continuing monetary stimulation of aggregate expenditures, the inflation they expected just doesn’t happen. If they are obstinate and continue to act as if inflation is not abating, they will simply price themselves out of their markets in the same manner as the conspiring firm in the example above. It is far more likely, however, that they will adjust their expectations as the rate of inflation falls.

Expectations cannot sustain an inflationary process unless they are validated by the actual course of inflation; and that validation can occur only so long as the growth of the money stock remains excessive.

 

—FOOTNOTES—

1Council of Economic Advisers, Annual Report, 1979, p. 84; emphasis added.

2lbid., pp. 58-60.

3Ibid., p. 57.

4The Economic Report of the President, 1979, p. 6.

5Council of Economic Advisers, Annual Report, 1979, p. 55; emphasis added.

6George J. Stigler and James K. Kindahl, “Industrial Prices, as Administered by Dr. Means,” American Economic Review, 63 (Sept. 1973): 720.

7Leonard W. Weiss, “The Role of Concentration in Recent Inflation,” in Yale Brozen, ed., The Competitive Economy: Selected Readings (1975), pp. 206-212; and research by J. Fred Weston, cited in Fortune (March 26, 1979): 40.

8George P. Shultz and Kenneth W. Dam, “The Life Cycle of Wage and Price Controls,” in Economic Policy Beyond the Headlines (1977), p. 77.

9Council of Economic Advisers, Annual Report, 1979, p. 239; latest price index values given are for November 1978.

¹ºShultz and Dam, op. cit., p. 78.

11Wall Street Journal, February 16, 1979.