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Remarks by

Mark H. Willes
President
Federal Reserve Bank of Minneapolis

at the
St. Scholastica College

June 1, 1978
Duluth, Minnesota

WAGE AND PRICE CONTROLS ARE WORSE THAN WE THINK

Isaac Newton was once asked why he was able to make so many
great scientific discoveries.

He responded; 1if I have seen further
1

than other men, it is because I have stood on the shoulders of giants.”
Unfortunately, when we talk about economics, we mostly stand on each
others feet.

For example, according to a recent national opinion poll,

inflation is now regarded as the number one economic problem in the
United States.

And according to the same poll, 50 percent of the people

feel that because of our worsening inflation problem, wage and price
controls should be imposed on American businessmen and workers.

This

faith in the ability of wage and price controls to improve the inflation
outlook is unfortunate, because the available evidence suggests that
controls are ineffective in solving the inflation problem.
In fact, if we get off each others feet and try to stand back
where we can get a clear view of wage and price controls, we see that
they merely attack the symptoms rather than the causes of inflation.
The principal causes are excessive monetary growth, large deficits in
the federal budget, and government policies that inhibit the workings of
our market economy.

Consequently, only by cutting the government deficit,

reducing the rate of growth of money, and improving the structure of our
economy can we expect to make lasting progress against inflation.

Wage

and price control programs (including so-called TIP programs) won't
work.

In fact, they tend to make our inflation problem worse.

I.

Why Wage and Price Controls Cause Higher Inflation
It has always been recognized that price controls can cause

disruptions in economic activity.

Because an economy under price con­

trols is constrained in its ability to adjust to changing tastes and




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resource availability, lower production will generally accompany any
controls program.

If the underlying factors that cause inflation are

unaffected by price controls, the economy will end up with higher, not
lower, prices.

That is, with the same amount of money and government

debt outstanding and with a smaller volume of goods produced, the
average price of those goods will be higher.
A brief look at what happened in our ill fated use of controls
in 1971-74 will hopefully remind us that such wage and price policies
have very unfortunate and undesired effects.

Rigid Prices Produce Bottlenecks and Shortages
In setting prices in a market economy, individual decision
makers process a lot of information.

Each day, some businessmen adjust

the prices of their goods and services in response to new information—
they increase some prices, decrease others, and leave the rest unchanged.
These relative adjustments in prices ensure that markets "clear" and
that resources are directed toward uses most highly valued by spenders.
But the imposition of wage and price controls short-circuits this auto­
matic adjustment process.

Prices of goods are locked into fixed rela­

tionships to each other, with the result that changing market conditions
produce shortages in some sectors of the economy.
For example, in the summer and fall of 1973— two years after
comprehensive controls were first imposed— we had extensive shortages of
a wide variety of goods.

But at the same time we had substantial slack,

or excess capacity, in many sectors of the economy.
Production cutbacks in the aluminum industry, for example,
caused serious shortages in other key industries.




In the fall of 1973,

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a large aluminum company announced that it was cutting production of
several major items due to "poor cost-price relationships present under
price restrictions.1 Other companies also reportedly cut production of
1
low-profit items.

At the same time, shortages of critical aluminum

inputs threatened a significant reduction in production for air condi­
tioning and refrigeration manufacturers.

And according to a major

architectural trade association, operations of its members were cut back
30 percent in the fall of 1973 due to shortages of aluminum.

In each of

these cases, many jobs were lost as production was shut down.
Similar problems developed in the steel industry.

Although

faced with substantial excess capacity and strong market demand in many
product lines, steel manufacturers nevertheless cut production because
the controls had frozen prices too low for them to make a reasonable
profit.

Production in both the coal and the petroleum industries was

hurt by cutbacks in steel products necessary for oil drilling and coal
mining.

These cutbacks came in the weeks just after the OPEC embargo

when energy shortages were mounting in the U.S.

Increased Exports at the Expense of Local Needs
Producers faced with controlled domestic prices often sought
relief by stepping up their exports— and by selling abroad at higher
world prices, more shortages were created at home.

Both the chemical

and fertilizer industries responded to low domestic prices set by the
controllers by increasing sales of products abroad.

By late 1973

foreign prices of chemicals were two to four times higher than domes­
tically controlled prices, and some firms doubled their exports.

In

fertilizer, where the difference between foreign and domestic prices was




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also large, exports increased substantially in 1973 before controls were
removed late in the year.

Once controls were eliminated, planned exports

of all goods dropped precipitously.

(Shortages of fertilizer, I might

add, had a significant impact on output per acre in agriculture and,
consequently, on food prices.)

Bartering and Other Distortions
Controlling relative prices also increased the number of firms
bartering to exchange one scarce good for another.

In some cases a

scarce good passed through half a dozen or more hands, each time being
bartered for something equally scarce before reaching a final purchaser.
In fact, the revenues of chemical trading specialists, who locate and
acquire chemicals for their customers, doubled in 1973; they jumped from
$300 million to $600 million.

And I don’t have to tell you how ineffi­

cient and costly bartering is compared to exchange in a monetary economy.
Illegal activities were also on the rise as the controls
program unwound.

There were frequent reports of tie-in sales, which

forced a purchaser to buy an unneeded good in order to get a needed good
in short supply.

Also, suppliers of such scarce goods sometimes arranged

to sell them for export at the high world price; but the "importer"
turned out to be a domestic firm, and the goods never left the country.

Disincentives for Investment
These distortions could conceivably have been anticipated and
eliminated by a much wiser control authority— one that possessed the
collective knowledge of all market participants, an obviously impossible
task.

But one distortion even an all-knowing control authority could

not have prevented was the stifling of business investment spending.




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It is easy to see why businesses would be reluctant to expand
capacity during a controls program.
In an uncontrolled economy, a producer’s desired level of
capacity is based on a comparison of the costs and expected benefits of
holding excess capacity.

When producers decide whether or not to build

a new plant, they do not know for sure how profitable their investment
will be.

They are uncertain about raw material and labor costs and

about product demand.

In effect, most producers face a distribution of

possible outcomes ranging from a small chance of large losses through
much more likely probabilities of moderate profits to some small chance
of large profits.
Price controls narrow this range of probable profits considerably,
thus reducing the average or expected profits from excess capacity.
That is, under price controls, even when demand is heavy firms know they
can make only modest profits because prices will not be allowed to rise
to reflect the increased demand.

Since the expected benefits of holding

excess capacity are therefore reduced, some facilities which otherwise
would have been built are left unbuilt.

And more generally, the economy

loses its ability to respond to future surges in demand.
This is clearly what happened during the recent U.S. price
controls program.

In manufacturing, for example, the Federal Reserve

Board’s index of capacity grew at an average rate of 5 1/4 percent
between 1962 and 1970.

For the two years just before price controls,

the growth rate averaged 4 percent; however, that fell to 3 1/4 percent
in the first two years of controls.

This drop occurred even though the

controls period was one of strong economic growth, while the period just
before it included a recession.




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The experience of individual industries in the materialsproducing sector illustrates even more dramatically the depressing
effects of price controls on investment.

In the major materials in­

dustries— including paper, steel, aluminum, chemicals, and many others—
capacity grew more slowly during the first two years of the controls
program than during the two years before it.

And by 1973, after very

rapid growth in the economy, most industries continued to expand ca­
pacity at a slower rate than before the controls period— in fact, at a
rate well below the trend growth of the 1960s.

This investment slow­

down, I should note, came at a time when capacity utilization rates were
at or near record highs in many industries.

So the reluctance of firms

to expand capacity had to be mostly due to the wage and price controls
program.

Controls Encourage Overly Expansive Monetary and Fiscal Policies
Aside from lowering real output, controls produce another
major problem for the economy.

During the early stages of a controls

program, measured price increases are lower than the actual rate of
inflation.

With the inflation problem thus temporarily swept under the

rug, policy makers have a tendency to become less concerned about infla­
tion in formulating monetary and fiscal policies.

They are thus tempted

to let the money supply grow too fast or the deficit become too large in
an effort to provide a stronger "stimulus" to the economy.
This appears to have happened during the 1971-74 wage and
price controls program.

In 1972, the first full year of price controls

in the U.S., the narrowly defined money supply— Ml— grew at a 9 percent
annual rate, the most rapid annual growth ever for Ml.




At the same

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time, the federal budget deficit was almost $25 billion.

And this

occurred, I might add, while the economy was operating at nearly full
capacity.
This tendency of policy makers to seek short-term gains at the
expense of longer-term goals provides still another reason why wage and
price controls have a negative impact on the economy.

II.

Will Tax-based Incomes Policies— "TIP"— Work?

Recently people have been talking about a form of incomes
policies that hasnTt been tried in the U.S.:

for example, using the

governments taxing power to slow the rate of inflation by penalizing
fexcessivel wage increases.
,
f

Yet I doubt these policies work to reduce

inflationary pressures, because all of the criticisms of wage and price
control programs apply also to tax-based programs.
A common version of a "TIP1— or ,Tax-based Incomes Policy1—
1
f
1
plan would tax employers who increased wages more than some percentage
set by the government.

In effect, the "TIP" plan falls somewhere

between full wage controls and no controls at all.

Unlike a standard

controls program, which effectively imposes an infinitely large tax on
wage settlements larger than government guidelines (since such settle­
ments are prohibited), the TIP plan would permit wage settlements that
exceed guidelines and would tax these settlements at some finite rate.
Just as any other incomes policy, this one is not likely to
reduce inflation.

TIP could be evaded by "promoting1 employees receiving
1

above-guideline pay increases and by expanding fringe benefits.

The

only way to avoid this would be to have detailed rules and regulations
which were "enforced1 by a large bureaucracy— just like any other wage
1
and price control program.




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In sectors where demand grew rapidly, TIP could actually
increase inflation.

Firms in these industries would want to bid labor

away from other industries so that production could be increased to meet
demand.

But this would require firms in growing industries to raise

wages more than the government allowed and thereby pay higher taxes.
The total wage cost— including both wages paid to employees and wage
taxes paid to the government— could therefore be higher under TIP than
without it.

Thus, under TIP the very industries producing goods most

highly valued by society would be placed at a disadvantage relative to
industries facing weaker demands.
TIP could lead to higher unemployment^

The tax penalty levied

against "excessive" wage increases represents a tax against labor.

And

everybody knows that whenever the government puts a tax on a particular
item, that item becomes less popular in the marketplace.

Put another

way, the TIP tax on labor would encourage businessmen, seeking to keep
their costs down, to substitute other factors of production for labor.
TIP would be hard and costly to administer too (as is any
controls program).




For example:

Since TIP would be tied to the corporate income tax, how
would unincorporated businesses and nonprofit institu­
tions be treated?
How would the program be applied to new firms with no
past records of salary expenses?
How would TIP be applied to salary increases based on
previously negotiated contracts?
How would it handle costs associated with work contracted
out?

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How would demands for "catch up" wage increases be
handled?

Might not aluminum workers, for example, argue

that a large pay increase is required in their next
contract to preserve comparability with steel workers who
received a large settlement in 1977?
In short, TIP would require detailed and cumbersome regulations,
enforced by a large, costly bureaucracy, and cause many of the same kinds
of economic distortions that we had in the recent U.S. control program—
without reducing inflation.

Ill.

Conclusion:

There is Still No Free Lunch

Those who currently propose incomes policies to reduce inflation
appear to think that a modest control program will yield major benefits
in terms of reduced inflation.
that way.

But, as w e fve seen, things don't work

Controls produce shortages and other distortions, and they

reduce the incentives of businessmen to invest in the plant and equip­
ment necessary to sustain a growing, dynamic economy.

The economy with

its massive needs for continual adjustment to changing conditions stag­
nates under controls as the natural adaptive mechanism of the market is
destroyed.

Prices themselves may be held down temporarily.

But the

inevitable lifting controls unleashes even more inflation.
The evidence suggests that we are worse off after any incomes
policies than before.

The lower supply of goods aggravates inflation,

and inequities of all kinds are created.

Bureaucratic waste and a

growing stack of government regulations emerge as the controllers
adjusted to endless unanticipated effects of shackling the economy.
if maintained long enough, controls erode some of our basic political
and personal freedoms.




And

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Inflation is a serious problem— our most serious economic
problem— but we cannot solve it through programs that ignore its funda­
mental causes.

The price level and its rate of growth are largely

determined by government policies.

Businessmen and consumers operate

within this framework to determine the relative prices of goods and
services.

The solution to our inflation problem, therefore, cannot be

wage and price controls; it can only be more responsible fiscal, mone­
tary, and other governmental policies.
Attempts to try the "free lunch" of stable prices with the
currency of incomes policies are doomed to failure.

Whether we call it

jaw boning, TIP, wage and price controls, or anything else, they are not
going to provide easy answers to a most difficult problem.

I hope we

will have the courage to stop looking for the easy way out, and instead
meet the inflation problem head on.

For if we continue to try for a

free lunch through incomes policies, we will all too soon again realize
we can't really afford the price.

Prudent monetary, fiscal, and other

government policies are the only really cost-effective alternatives we
have.