The vast majority of economists understand that economy-wide price controls are a bad idea. The reason is that they prevent prices from adjusting in individual markets. Supplies and demands for various goods change a lot, and avoiding price controls allows prices to adjust to those changes in supplies and demands. We saw a huge problem with President Nixon’s price controls in 1973, when the prices his controllers had set for oil and gasoline were based on a world price of oil of about $3 per barrel. In the fall of 1973, when a suddenly powerful OPEC raised the world price of oil to about $11 dollars per barrel, there was a shortage of oil and gasoline. People who drove vehicles during that time probably remember their frustrating time in line, sometimes to buy less than a full tank of gasoline.
Price controls don’t work, period. You might think that’s the end of the story. Unfortunately, it’s not. Economists occasionally give sophisticated justifications for policies that are bound to fail. Because price controls are so destructive, it’s important to say what’s wrong with economic thinking that lays the groundwork for such controls. It’s also important to say, yet again and if only briefly, what’s wrong with wage and price controls.
Soft-Pedaling “Incomes Policy”
Two prominent economists who recently laid the groundwork for price controls are New York Times columnist Paul Krugman and Olivier Blanchard, an emeritus professor of economics at MIT. First, consider Krugman. In a January 3 column, he came close to advocating wage and price controls.
Back in the 1970s, there was widespread talk of “incomes policy” — some combination of incentives and moral suasion that might reconcile low inflation with a hot economy. Such talk faded away partly, I think, because of a bad experience with Richard Nixon’s price controls, and partly because of a general loss of faith in government competence.
But there have been some historical examples of successful incomes policy. Notably, in 1985 Israel cured high inflation without a severe recession, in part by imposing temporary wage and price controls.
Actually, Krugman’s characterization of “incomes policy” is incorrect. Even Wikipedia gets it right, stating, “Incomes policies in economics are economy-wide wage and price controls, most commonly instituted as a response to inflation, and usually seeking to establish wages and prices below free market level.”
I think Krugman understands that. After all, if incomes policy is simply a “combination of incentives and moral suasion” and not actual wage and price controls, why would belief in it fade because of a bad experience with Nixon’s price controls? There should be no connection. Whatever else Nixon’s wage and price controls were, they were not “moral suasion.” The only way Krugman’s statements make sense is if incomes policy is the same as wage and price controls. Interestingly, in his second paragraph above, Krugman dropped his attempt to redefine incomes policies; he pointed to Israel as an example of a country that used price controls.
So Krugman seemed to be inching his way toward advocating wage and price controls without coming out foursquare for them.
Olivier Blanchard and “Distributional Conflict”
Krugman built his case largely on a series of tweets by well-known economist Olivier Blanchard. To be fair, Blanchard did not advocate wage and price controls; it wasn’t clear what policies, if any, Blanchard was advocating. But his concept of inflation could, if accepted, easily lead other people to advocate wage and price controls. It certainly led Krugman to the water’s edge.
On December 30, Blanchard started his series of tweets with this one:
A point which is often lost in discussions of inflation and central bank policy. Inflation is fundamentally the outcome of the distributional conflict, between firms, workers, and taxpayers. It stops only when the various players are forced to accept the outcome.
What causes this “distributional conflict”? In Blanchard’s view, it happens because workers want higher wages and firms want higher prices. But then why didn’t we get high inflation a few years ago—and not just a few years ago, but for the past few decades? Didn’t workers want higher wages and didn’t firms want higher prices back then? You can’t explain a change by pointing to something that’s constant. And the desire for higher wages and prices is constant.
Something must have changed to cause higher inflation. What was it? The growth of the money supply.
Here’s what I wrote in Defining Ideas on May 20, 2021:
I would put an 80 percent probability on the prediction that before the end of 2022, there will be at least one twelve-month period in which the CPI has risen by at least 5 percent. I would also estimate less than a 20 percent probability that in the same time period, there will be a twelve-month period in which the inflation rate hits Carter-era 10 percent.
Why did I predict that? Because, as I noted in my article, “Between December 16, 2019, just before we were aware of the COVID-19 pandemic, to February 1, 2021, M2, a broad measure of the money supply, grew by 26.7 percent.” On its face, that high growth of the money supply might lead you to believe that inflation would be double-digit. But, I noted at the time, the velocity of money, which is the inverse of money demand, had fallen substantially. Thus, my conclusion of higher, but not double-digit, inflation.
If you read all eight of his tweets, you’ll notice that Blanchard doesn’t even mention the growth of the money supply. Interestingly, though, he does briefly discuss monetary policy. Unfortunately, in his discussion he confuses cause and effect.
The New Keynesian Confusion
If I had to identify the view of macroeconomics that most economists hold today, I would say that it’s “New Keynesian.” “Keynesian,” of course, refers to John Maynard Keynes. Whereas Keynes thought monetary policy was unimportant, New Keynesians tend to believe that monetary policy matters. One main reason they came to that view was the evidence that Milton Friedman and Anna J. Schwartz presented in their 1963 book, A Monetary History of the United States, 1867–1960, on the potency of monetary policy. Among other things, Friedman and Schwartz showed that the failure of the Federal Reserve to keep the money supply from falling by 30 percent was an important contributor to the Great Depression.
In the late 1960s and early 1970s, Friedman and other economists who shared similar views explained why unexpected decreases in the growth rate of the money supply would cause higher unemployment. The idea was that when unemployed workers have come to expect a particular growth rate of wages, they reject some job offers because the wage being offered isn’t quite as high as they expect. So, for example, if wages were growing at 4 percent per year, due to productivity growth of 1 percent and inflation of 3 percent, a reduction in inflation due to a decrease in the growth rate of the money supply would cause wages to grow at less than 4 percent. A worker who didn’t take account of this would mistakenly think that a wage he is offered is lower in real terms than it really is. So some workers would hold out longer. Even if only five million unemployed workers hold out for an extra few weeks, the effect would be to increase the unemployment rate. With more unemployment, the growth of the economy falls.
Notice the causation. A reduction in the growth rate of the money supply leads to higher unemployment and lower growth. A central bank that conducts such a policy is not trying to cause higher unemployment and lower growth. That’s simply the result of a tighter monetary policy.
New Keynesians adopted this way of thinking. But somewhere along the line, many of them reversed the causation. They saw the central bank as causing higher unemployment and lower growth to cut inflation.
Blanchard fell into this trap. In his sixth of eight tweets, Blanchard wrote:
But, in the end, forcing the players to accept the outcome, and thus stabilizing inflation, is typically left to the central bank. By slowing down the economy, it can force firms to accept lower prices given wages, and workers to accept lower wages given prices.
If you get the causation wrong, you can be led to some bad policies. If you think, for example, that slowing growth will reduce inflation, you might be tempted to advocate higher tax rates or more regulation, both of which would slow growth but would do nothing to reduce inflation.
Remember Why Price Controls Are Bad
Some macroeconomists seem to forget that although inflation is an overall measure of price increases, individual price increases matter. The main problem with price controls is that they prevent prices from rising when demand increases or supply falls. If the government doesn’t allow prices to rise in such circumstances, we get shortages and line-ups. That’s what happened in the gasoline market with Nixon’s price controls. It’s true that price controls will reduce the measure of inflation, but they actually hide inflation. Inflation is, after all, an increase in the cost of living. Most of us would rather buy steak at $10 a pound from the butcher who has steak than go to the butcher who doesn’t have steak but is charging $8 a pound. That $8 a pound does not signify a lower cost of living if we can’t get the steak.
One of President Biden’s most outrageous proposals is for nationwide rent controls. It would be nice to see Krugman or Blanchard, or ideally both, lay out something they must know, namely that rent controls cause housing shortages and discourage new building. Rent controls also increase racial discrimination by landlords. The reason is that because the rent controls cause shortages, landlords who face a queue of qualified applicants can exercise their “taste” for discrimination without giving up any rental income. One danger of Krugman’s dalliance with price controls is that it can lay the groundwork, whatever his intent, for destructive measures like rent controls.
In replying to Blanchard on January 1, Jared Bernstein, a member of President Biden’s Council of Economic Advisers (CEA) tweeted:
What I like about this thread is the recognition of the role of power: bargaining power, pricing power. This is the bridge from econ to political econ; woe betide a social science that provides inadequate space for the role of power in the determination/distribution of outcomes.
Bernstein, by the way, earned his Ph.D. in social welfare, not economics. Woe betide a country if one of its government’s main economists thinks power, rather than supply and demand, is what matters for prices and income distribution.