Wage and Price Controls Are Not the Answer to Inflation

Prominent New York Times economic columnist Paul Krugman has done it again. Standing against accepted principles in economics, he comes out in favor of universal wage and price controls.

Price controls have been thoroughly debunked by history and economic theory. In fact, one of the first lessons in a standard freshman introductory microeconomics class is explaining how controls on prices (and wages, hereinafter, just “price controls”) cause shortages and surpluses. Whenever a price is set below or above a market clearing price, it creates an imbalance between quantities demanded and supplied, leading to either a shortage or a surplus of the commodity in question, whether it is gasoline, milk, or low-skilled labor.

Price Control Diagrams from an Introductory Economics Textbook

Stating the issue in positive terms, economist Alex Tabarrok says that “a price is a signal wrapped in an incentive.” The father of economics, Adam Smith, identified the importance of incentives when he talked about the “invisible hand” of the market. Motivated solely by the incentive of self-interest, the butcher, the baker, and the brewer act in harmony with each other to provide us with our dinner. All of this happens (in just the right quantities and using the most efficient methods of production) because of the operation of the market price mechanism. The coordinating effect of prices as signals of what and how much to produce was famously explained by Nobel Laureate economist Friedrich Hayek in his 1945 paper, “The Use of Knowledge in Society.” This principle was later popularized by economist Leonard E. Read in his 1958 essay “I, Pencil”, and more recently in the elegant 2012 video, “I Pencil: The Movie.”

Reinforcing what economic theory tells us, evidence of the harm of price controls abounds in history, from the infamous 303 A.D. Edict of Emperor Diocletian in Ancient Rome to America’s 1970s gasoline price controls and, perhaps most infamously, New York City’s disastrous eight-decade-long experiment with rent control.

The most infamous example of universal price controls – which Professor Krugman endorses – is the Soviet Union. Under communism, the government controls all means of production, so a communist government faces the burden of deciding every single price in the economy. In its attempt to perform this impossible task, the Soviet Union at one time employed 30,000 price setters and economic planners at Gosplan, its central economic bureaucracy charged with managing its economy and carrying out successive Five Year Plans. Unsurprisingly, it was a disaster, resulting at its worst in mass starvation (a result documented in every communist society) and, at best, widespread poverty and a complete inability to make technological advances on its own, without importing or stealing them from the West. Ultimately, the Soviet economy could not be planned, and it finally collapsed in 1991.

In this context, Mr. Krugman blithely suggests that economy-wide wage and price controls could be the answer to inflation in the United States. Economy-wide wage and price controls were tried earlier in the 1970s in an effort to stop inflation. Both failed then, as every such attempt is bound to fail, because they do not address the cause of inflation. Economist Milton Friedman identified that cause when he said that “inflation is always and everywhere a monetary phenomenon.” Inflation is caused fundamentally by a central bank’s overly expansionary monetary policy or by excessive government spending, which is then monetized by the central bank. Turning deficits into dollars that flood the economy causes prices to rise. It is no coincidence that massive pandemic spending and monetization by the Federal Reserve, America’s central bank, caused our recent spike in inflation. It is also no coincidence that every hyperinflationary episode in history has been marked by a rapid expansion of the money supply.

The other disturbing error of Mr. Krugman, and a common one made by economists,is what I call the “Philosopher-King Fallacy.” It is the failure to consider the political context in which economic policies are made. Mr. Krugman cites a single example where a small country (Israel) imposed weakly enforced, partial price controls in the mid-1980s. By citing the apparent success of this policy in reducing inflation (which also entailed significant pro-market reforms, not credited by Krugman, such as reduced subsidies and privatization of businesses), Krugman implies that we could surgically and precisely impose and remove price controls without harmful effect, achieving the hoped-for goal of slowing down or stalling inflation, without other unwanted deleterious consequences.

This naivete is inexcusable in a worldly and well-read economic scholar who regularly confers with political leaders and understands the political process. Once government intervenes in the economy, it immediately creates new vested interests that will lobby for retaining the harmful policy. This has proven intractably true for a wide range of price controls, such as New York City’s rent control. Initially, NYC rent control was just part of the web of temporary, economy-wide, wartime price controls imposed during World War II. When those controls were repealed in 1946 shortly after the war ended, the liberated US economy undertook a rapid post-war expansion.

Unfortunately, controls on New York City apartment rents were kept in place, first by the city government, later by the state government, ostensibly in order to keep apartment rents low for soldiers returning from the war. But controls didn’t have that effect. Instead, rent control immediately created a shortage of housing, one that has only worsened in the decades since. Rather than making apartments available at low rents, it has created an artificial scarcity of housing, which has had the perverse effect of driving market rents to the highest level in the country and, in some years, the world. At the same time, it created a powerful vested interest of existing rent-controlled (and “stabilized,” the new term for rent control after 1969) tenants who did not want their rents raised, at the expense of landlords whose properties were economically impaired (and even destroyed) by the loss of rent revenue, and at the expense of future tenants who had to pay much higher prices for the fewer market-rate apartments available, or languished for years in poorly maintained rent-regulated apartments.

Similar vested interests were created with agricultural price controls (mandatory minimum prices, or “price floors”) enacted during the Great Depression for dairy and wheat farmers. Like rent control (a “temporary wartime” measure) those “temporary” measures designed to fight the 1930s Great Depression are still with us today, nearly 90 years later. They are kept in place by the extensive lobbying efforts of farmers, who contribute millions of dollars to congressmen to make sure they stay in place.

If the US imposed economy-wide price controls, as Krugman proposes, it would not stop inflation, just as the Emperor Diocletian’s economy-wide controls did not stop Roman inflation and just as the 1970s economy-wide controls did not stop US inflation. But it would throw sand into the gears of the economy, destroying the coordinating effect of the Invisible Hand. It would reduce our standard of living and create new vested political constituencies for maintaining parts of it, even if one could precisely remove the “temporary” controls at just the right time, as hoped for by the Economic Philosopher-King.

The advantage of established, true economic theory is that we do not need to keep repeating the mistakes of the past. There are unsettled parts of economic theory, but the beneficial coordinating effect of free, market-determined prices is not one of them. It surprises and disappoints me that a prominent economic columnist at the self-described “newspaper of record,” the New York Times, would traffic in such absurdities.

The post Wage and Price Controls Are Not the Answer to Inflation was first published by the American Institute for Economic Research (AIER), and is republished here with permission. Please support their efforts.

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