Chapter 7. The Dependence of the Division of Labor on Capitalism III: Price Controls and Economic Chaos

CHAPTER 7

THE DEPENDENCE OF THE DIVISION OF LABOR ON

CAPITALISM III: PRICE CONTROLS AND ECONOMIC

CHAOS

PART A

PRICE CONTROLS AND

SHORTAGES

1. Price Controls and Inflation

K nowledge of the dependence of the division of labor on capitalism deepens profoundly with an understanding of the destructive consequences of price controls, which are the subject matter of the present chapter.

Price Controls No Remedy for Inflation

Price controls are advocated as a method of controlling inflation. People assume that inflation means rising prices and that it exists only when and to the extent that businessmen raise their prices. It appears to follow, on this view, that inflation would not exist if price increases were simply prohibited by price controls.

Actually, as we shall see later in this book, in Chapters 12 and 19, this view of inflation is utterly naïve. Rising prices are merely a leading symptom of inflation, not the phenomenon itself. Inflation can exist, and, indeed, accelerate, even though this particular symptom is prevented from appearing. Inflation itself is not rising prices, but an unduly large increase in the quantity of money, caused, almost invariably, by the government. In fact, a good definition of inflation is, simply: an increase in the quantity of money caused by the government. A virtually equivalent definition is: an increase in the quantity of money in excess of the rate at which a gold or silver money would increase. These two definitions are virtually equivalent, because without government interference in money over the course of our history, the supply of money today would consist mainly or even entirely of precious metals and fully backed claims to precious metals. The increase in the supply of such a money would almost always be quite small and at all times would be severely limited by the high costs of mining additional quantities of the precious metals. Rising prices as a chronic social problem are a consequence of the government’s overthrow of the use of gold and silver as money and putting in their place irredeemable paper currencies whose quantity can be increased without limit and virtually without cost.

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Because it is necessary to approach the subject of price controls with clear ideas about why prices chronically rise in the world around us, it is necessary to anticipate here some of the discussion of later chapters and to show in no uncertain terms that the quantity theory of money—viz., the increase in the quantity of money— is the only valid explanation of the phenomenon. 1

The truth of the quantity theory of money follows

220 CAPITALISM from the best known principle in the theory of prices, which is that prices are determined by demand and supply and vary directly with demand and inversely with supply. By demand in this context is to be understood the willingness combined with the ability to spend money, and by supply, the existence of goods combined with the willingness to sell them. Demand manifests itself in the spending of money; supply, in the quantity of goods sold. 2

When people complain of “inflation,” what they have in mind is not an isolated rise in some prices here and there, offset by a fall in prices elsewhere, but a rise in prices in general, that is, a rise in the general consumer price level. The general consumer price level is the weighted average of all consumer prices.

It follows from the law of supply and demand that the general consumer price level can rise only if the aggregate demand (the total spending) for consumers’ goods rises, or the aggregate supply (the total quantity sold) of consumers’ goods falls. Indeed, the general consumer price level can be conceived of—as it was by the classical economists—as an arithmetical quotient, with demand (spending) as the numerator and supply (quantity of goods sold) as the denominator, for the average of the actual prices at which things are sold is, literally, nothing more than the total spending to buy them divided by the total quantity of them sold. In effect, in any given year, some definite mass—however measured—of houses, cars, soap, matches, and everything else in between, exchanges against some definite overall expenditure of money to buy them, and the result, the arithmetical quotient, is the general consumer price level. 3

Rising prices in the United States are obviously not the result of falling supply, since supply has been growing in practically every year. The same is true of the countries of Western Europe, Japan, and even many of the Latin American countries. There can be no question, therefore, but that the rise in prices in these countries can be the result only of an increase in aggregate demand. Moreover, in the few cases in which supply appears to have fallen, such as Chile and Uruguay in the late 1960s and early 1970s, the rise in prices was enormously out of proportion to any possible decrease in supply in those countries. In those countries above all, demand grew. 4

An increase in aggregate demand is the result of an increase in the quantity of money in the economic system. When new and additional money enters the economic system, whether it is newly mined gold in a country using gold as money, or newly created paper currency or checkbook money, as in the present-day United States, that money will be spent, and those who receive it in the sale of their goods and services will respend it. The additional money will be spent and respent in every year of its existence, thereby raising aggregate demand and spending in the economic system to a correspondingly higher level. Indeed, the more rapidly new and additional money enters the economic system, the more rapidly the previously existing quantity of money tends to be spent, because people progressively lose the desire to hold balances of such money. 5 (For example, who wants to hold Argentine pesos? Who wants to hold U.S. dollars as much today as a generation ago?) Aggregate demand and spending thus begin to rise more than in proportion to the increase in the quantity of money. The rise in aggregate demand is what bids up the prices of all goods and services in limited supply, and is what enables price increases initiated by sellers, whether businessmen or labor unions, to take place as a repeated phenomenon. In the absence of the rise in aggregate demand, price increases initiated by sellers would reduce the amount of goods and services that could be sold. This loss of sales volume, and the mounting unemployment that goes with it, would soon put an end to such price increases. 6

Once the truth of the quantity theory of money is recognized, the government’s responsibility for rising prices follows immediately. Under the conditions of the last seventy-five years or more, the government has had virtually total control over the quantity of money. It has deliberately brought about its rapid increase. Since the inauguration of the New Deal in 1933, the quantity of money in the United States has been increased by more than 58-fold, from little more than $19 billion to well over $1,100 billion at the end of 1993. Since 1955, the rate of increase has shown a pronounced tendency to accelerate, despite the absence of any major war. Today, rates of increase are considered “normal” and even “modest” that a generation ago would have been considered huge. 7

Inflation Plus Price Controls

The imposition of price controls to deal with inflation does not stop inflation. Rather it combines with inflation to produce a different and worse set of consequences than would inflation alone. It is as illogical—and as self-destructive—as would be an attempt to deal with expanding pressure in a boiler by means of manipulating the needle in the boiler’s pressure gauge. The last two chapters have shown, in effect, that prices are equivalent to an instrument panel on the basis of which everyone plans his economic activities and which enables the plans of each individual to be harmoniously adjusted to the plans of all other individuals participating in the economic system. When price controls are imposed, the gauges on this instrument panel are frozen. Not only do the gauges no longer record the fact of inflation, which still continues

PRICE CONTROLS AND ECONOMIC CHAOS 221 and probably accelerates because the government need no longer fear rising prices, but the gauges also no longer reflect any other aspects of the state of supply and demand, which people must be able to take into account if their actions are to be coordinated with one another. Thus, economic activity under the division of labor becomes discoordinated and chaos ensues. It follows, and every page of this chapter will confirm it, that a government which imposes price controls is in process of destroying the economic system of its own country.

2. Shortages

We have seen that the price system of capitalism—the free market—constitutes a rational, ordered system of social cooperation; indeed, that it is a truly awe-inspiring complex of relationships in which the rational self-interest of individuals unites all industries, all markets, all occupations, all production, and all consumption into a harmonious, progressing system serving the wellbeing of all who participate in it.

All of this is what price controls destroy.

The one consequence of price controls that is the most central and the most fundamental and important from the point of view of explaining all of the others, and which most directly threatens the ability to produce under the division of labor, is the fact that price controls cause shortages.

A shortage is an excess of the quantity of a good buyers are seeking to buy over the quantity sellers are willing and able to sell. In a shortage, there are people willing and able to pay the controlled price of a good, but they cannot obtain it. The good is simply not available to them. Recalling the gasoline shortage of the winter of 1974 should make the concept real to everyone who experienced it. The drivers of the long lines of cars all had the money that was being asked for gasoline and were willing, indeed, eager, to spend it for gasoline. Their problem was that they simply could not obtain the gasoline. They were trying to buy more gasoline than was available.

The concept of a shortage is not the same thing as the concept of a scarcity. An item can be extremely scarce, like diamonds, Rembrandt paintings, and so on, and yet no shortage exist. In a free market, as we saw in the last chapter, the effect of such a scarcity is a high price. At the high price the quantity of the good demanded is levelled down to equality with the supply available, and no shortage exists. Anyone willing and able to pay the freemarket price can buy whatever part of the supply he wishes; the height of the market price guarantees it, because it eliminates his competitors. It follows that however scarce a good may be, the only thing that can explain a shortage of it is a price control, not a scarcity. It is a price control that prevents the price of a scarce good from being raised by the self-interest of the buyers and sellers to its freemarket level and thus reducing the quantity of the good demanded to equality with the supply of the good available.

Of course, if a price control on something exists, and a scarcity of it develops or grows worse, the effect will be a shortage, or a worsening of the shortage. Scarcities can cause shortages, or worsen them, but only in the context of price controls. If no price control existed, the development or worsening of a scarcity would not contribute to any shortage; it would simply cause the price to be higher.

It should be realized that a shortage can exist despite a great physical abundance of a good. For example, we could easily develop a severe shortage of wheat in the United States even with our normally very abundant supplies, or even much larger supplies. This is because the quantity of wheat demanded depends on its price. If the government were to roll back the price of wheat sufficiently, it would create a major increase in the quantity demanded—not only a larger quantity demanded for export, but a larger quantity demanded for raising cattle and broilers, making whiskey, and perhaps for many other employments for which one does not presently think of using wheat, because of its price. In other words, no matter how much wheat we produced, we could have a shortage of it, because at an artificially low price we could create a demand for an even larger quantity.

It should be held in mind, therefore, that shortages are not a matter of scarcity or abundance. Scarcity need not cause them; abundance is no safeguard against them. Shortages are strictly the result of price controls. Price controls are the only thing that allows scarcities to cause shortages; and they create shortages even when there is no scarcity, but abundance.

Indeed, the true relationship between scarcities and shortages is the reverse of what is usually believed. While scarcities per se do not cause shortages, shortages cause scarcities. That is, no matter how abundant are the supplies with which we begin, we have only to impose price controls, create shortages, and we will soon bring about growing scarcities. As an example of this, consider the fact pointed out in the last chapter that in the oil crisis oilmen needing oil products to keep their wells running were prohibited from outbidding homeowners needing oil to heat their garages. It is obvious what such a situation is capable of doing to the subsequent supply of oil.

The fact that it is shortages that cause scarcities will be a recurring theme of this chapter.

In a free market shortages are a virtual impossibility.

The closest thing that exists to them is that sometimes people may have to wait in line for the next showing of a popular movie. The typical case in a free market is that a seller is in a position to supply more than his present number of customers. There are very few stores or factories in a free market that are not able and eager to do more business. Even goods and services in limited supply are priced in such a way that the sellers are usually able and willing to do more business. For example, the wine shops have some reserve inventory of the rare wines. Landlords have a certain number of vacancies. There is even some limited degree of unemployment in most occupations. This is because, in a free market, the prices of goods and services in limited supply are set somewhat above the point that would enable the sellers to sell out entirely and the workers to be 100 percent employed. The reason prices are set in this way is because the sellers, including the workers, believe that by waiting before they sell, they can find better terms. They are holding out, waiting for the right customers or the right job.

3. Price Controls and the Reduction of Supply

The preceding discussion showed how price controls create shortages by artificially expanding the quantity of a good demanded. To the degree that the controlled price is below the potential freemarket price, buyers judge that they can afford more of the good with the same monetary wealth and income. They judge that they can carry its consumption to a point of lower marginal utility. In this way, the quantity of the good demanded comes to exceed the supply available, whether that supply is scarce or abundant.

Price controls also reduce supply, which intensifies the shortages they create.

a. The Supply of Goods Produced

In the case of anything that must be produced, the quantity supplied falls if a price control makes its production unprofitable or simply of less than average profitability.

It is not necessary that a price control make production unprofitable or insufficiently profitable to all producers in a field. Production will tend to fall as soon as it becomes unprofitable or insufficiently profitable to the highest-cost or marginal producers in the field. These producers begin to go out of business or at least to operate on a smaller scale.

For example, the price controls on oil held down the supply of oil. They did not totally destroy the supply of oil, but they did discourage the development of high-cost domestic sources of supply. They also made the more intensive exploitation of existing oil fields unprofitable, which fields can be made to yield from one-third to two-thirds more oil over their lives by the adoption of such methods as thermal or chemical flooding, sometimes known as “tertiary recovery.” At the same time, in restricting the profits from the lower-cost oil deposits, price controls held down both the incentives to discover and develop new such deposits and the capital necessary to the oil companies for expanded oil operations of any type. Thus, it should not be surprising that following the repeal of price controls on oil in 1981, a major surge in domestic drilling and production occurred—despite the fact that the government imposed a confiscatory “windfall-profits tax” that deprived the oil companies of a major part of the benefit of the repeal of the price controls. For now domestic oil production became more profitable.

Rent controls on housing that has already been constructed provide a similar example of the destruction of supply. As inflation drives up the operating costs of housing—namely, such costs as fuel, maintenance, and minor repairs—more and more landlords of rent-controlled buildings are forced to abandon their buildings and leave them to crumble. The reason is that once the operating costs come to exceed the frozen rents, continued ownership and operation of a building become a source merely of fresh losses, over and above the loss of the capital previously invested in the building itself.

This destruction of the housing supply starts with the housing of the poor and then spreads up the social ladder. It starts with the housing of the poor because the operating costs of such housing are initially so low that they leave relatively little room for economies. For example, there are no doormen to eliminate and therefore no doormen’s salaries to save. Also, the profit margins on such housing (that is, profits as a percentage of rental revenues) are the lowest to begin with, because the land and the buildings are the least valuable and therefore the amount of profit earned is correspondingly low. As a result, the housing of the poor is abandoned first, because it provides the least buffer between rising operating costs and frozen rents.

b. The Supply of Goods in a Local Market

A price control reduces supply whenever it is imposed in a local market and makes that market uncompetitive with other markets. In such a case, the local market is prevented from drawing in supplies from other areas, as was the Northeast and the United States as a whole during the Arab oil embargo.

The Natural Gas Crisis of 1977

In exactly the same way, in the winter of 1977, price controls on natural gas prevented areas of the United

States that were suffering freezing weather from bidding for additional supplies from the producing regions in the South and Southwest. Natural gas shipped across state lines was controlled by the Federal Power Commission at a maximum of $1.42 per thousand cubic feet. Natural gas sold within the states where it was produced, and thus outside the jurisdiction of the FPC and free of price controls, was selling at $2.00 per thousand cubic feet, with lower costs of transportation besides. It was therefore much more profitable to sell natural gas in the states where it was produced, such as Texas and Louisiana, than in such states as New Jersey or Pennsylvania.

Indeed, in the absence of government controls over the physical distribution of supplies, price controls would have resulted in still less gas being shipped outside the producing states and more being sold inside, in accordance with the difference in price and profitability. This process would have gone on until enough additional gas was retained within the markets of the producing states to make its price in those markets actually fall below the controlled interstate price by an amount equal to the costs of transportation; only at that point would it have paid producers to ship their gas out of state. The shortage in the rest of the country, of course, would have been correspondingly more severe. As I say, government controls over the physical distribution of natural gas prevented this outcome; the government simply forced the gas producers to sell a major part of their output in the interstate market. But the government’s allocation formulas did not take into account the extremely cold winter of 1977, and its allocations proved inadequate to keep people from the threat of freezing. Price controls then prevented the people of the affected regions from obtaining the additional supplies they urgently needed. 8

The Agricultural Export Crisis of 1972–73

A price control not only prevents a local market from drawing in supplies from elsewhere, but it can also cause a local market that normally exports, to export excessively. In this case, as supplies are drawn out, the price control prevents the people in the local market from bidding up the price and checking the outflow.

This phenomenon occurred in the United States in 1972 and 1973. Our price controls on wheat, soybeans, and other products made possible an unchecked exportation that jeopardized domestic consumption and led to an explosion of prices each time the controls were taken off, in President Nixon’s succession of on-again, off-again “phases” of price controls.

In this instance, the fall in the value of the dollar in terms of foreign currencies played a critical role. When President Nixon imposed price controls in August of 1971, he also took steps to devalue the dollar by 10 percent. Over the following two years, the dollar continued to fall in terms of foreign currencies and in 1973 was formally devalued a second time. The fall in the dollar’s foreign exchange value meant a lower price of dollars in terms of marks, francs, and other currencies. Since the prices of our goods were frozen, a lower price of dollars meant that all of our goods suddenly became cheaper to foreigners. As a result, they began buying in much larger quantities—especially our agricultural commodities. As they began buying, domestic buyers were prevented by price controls from outbidding them for the dwindling supplies. As a result, vast accumulated agricultural surpluses were swept out of the country, and domestic food supplies were threatened, which is why prices skyrocketed each time the controls were taken off.

Price Controls as a Cause of War

The fact that price controls jeopardize supplies in markets that export leads to embargoes against further exports, as occurred in this country in the summer of 1973, when we imposed an embargo on the export of various agricultural commodities. In addition, price controls in markets that must import make such markets helpless in the face of embargoes imposed by others, as we were made helpless in the face of the Arab oil embargo. It follows that to the degree that countries impose price controls, they must fear and hate each other. Each such country must fear the loss of vital supplies to others, as the result of excessive exportation, and the deprivation of vital supplies from others, as the result of their embargoes and its helplessness to cope with them. Each such country makes itself hated by its own embargoes and hates the countries that impose embargoes against it. Our embargo on agricultural products in 1973 did not endear us to the Japanese. And there was actual talk of military intervention against the Arabs. Simply put, price controls breed war. A free market is a necessary condition of peace.

c. The Supply of Goods Held in Storage

A price control reduces supply whenever it is imposed on a commodity of the kind that must be stored for future use. The effect of a price control in such a case is to encourage a too rapid rate of consumption of the commodity and thus to reduce supplies available for the future. As we have seen, buyers are led to buy too rapidly by the artificially low price, and sellers are led to sell too rapidly, since the fixity of the controlled price does not enable them to cover storage costs and earn the going rate of profit in holding supplies for future sale.

If the buying public and the professional speculators were unaware of the impending exhaustion of supplies, the effect of sellers placing their supplies on the market

right away would be to depress the current market price below the controlled price. This process would go on until the current market price fell far enough below the controlled price, so that once again it would have sufficient room to rise in the months ahead to be able to cover storage and interest costs. The resulting structure of prices would guarantee the premature exhaustion of supplies.

An elaboration on the example of the deficient wheat harvest will make these points clear. 9 Assume that in a year of normal wheat supplies, the price of wheat begins at $1.00 per bushel in the harvest month, when supplies are most abundant, and then rises a few cents per month, to cover the costs of storage and interest, and reaches a peak of $1.20 in the month immediately preceding the next harvest. Now assume that when the harvest is one month’s consumption below normal, the price of wheat should begin at $1.30 in the harvest month and gradually ascend to something over $1.50 in the month preceding the following harvest, in order to reduce the quantity of wheat demanded to equality with the smaller total supply available. Assume further that a price control limits the price of the deficient wheat crop to no more than $1.20 in any month. In this case, when the deficient crop comes in, its value cannot remain even at $1.20 for very long, because it has no prospect of ever getting above $1.20; as a result, it will be sold more heavily. It will tend to be sold until the price in the harvest month is driven down to $1.00, and from there the price will gradually ascend in the succeeding months toward $1.20. This structure of prices will encourage the same rate of consumption as prevailed in years of normal supplies, and will threaten famine conditions at the end of the crop year.

Hoarding and Speculation Not Responsible for Shortages

Under conditions such as those described above, the buying public sooner or later becomes aware of the fact that supplies will run out. At that point, demand skyrockets, as the buyers scramble for supplies. As soon as this occurs, and it may be very early, the larger supplies that sellers are encouraged to place on the market under price controls are not sufficient to depress the market price below the controlled price, because they are snapped up by the speculative buying of the public, which is aware of the shortage to come. (In our example of wheat, the whole supply would tend to be carried off at the controlled price of $1.20 per bushel as soon as the public becomes aware of the inevitable shortage of wheat to come.) The consequence of the speculative buying of the public is that the item disappears from the market right away; it is hoarded.

The hoarding of the buying public is not responsible for the existence of shortages. The public hoards in anticipation of shortages caused by the price controls. The public’s speculative demand cannot even be blamed for hastening the appearance of a shortage. That too must be blamed on price controls, because in the absence of the controls the additional demand of the public would simply raise prices; at the higher prices, the rise in the quantity of goods demanded would be cut back; prices would rise to whatever extent necessary to level down the quantity demanded to equality with the supply available.

Speculation on the part of the suppliers of goods is likewise blameless for the existence of shortages. Contrary to popular belief, price controls do not give suppliers a motive to withhold supplies, but, as we have seen, an incentive to unload them too rapidly.

There is, of course, an important exception to the principle that price controls give sellers an incentive to sell their supplies too rapidly. This is the case in which the sellers are able to look forward to the repeal of the controls. In this case, a price control makes it relatively unprofitable to sell in the present, at the artificially low, controlled price, and more profitable to sell in the future, at the higher, freemarket price. In this case, sellers do have a motive to withhold supplies for future sale.

Even in this case, however, it is still the price control that is responsible for the existence of any shortage that develops or intensifies. In this case, the price control discriminates against the market in the present in favor of the market in the future; it prevents the market in the present from competing for supplies with the market in the future. Furthermore, in the absence of a price control, any build-up of supplies for sale in the future would simply be accompanied by a rise in prices in the present, which would prevent the appearance of a shortage, as we have seen repeatedly in previous discussion.

Finally, it should be realized that the withholding of supplies in anticipation of the repeal of a price control does not imply any kind of antisocial or evil action on the part of the suppliers. Price controls, as we have seen, lead to inadequate stocks of goods; in many cases, it is probable that the build-up of stocks in anticipation of the repeal of controls merely serves to restore stocks to a more normal level. Even if the build-up of stocks does become excessive, its effect later on, when the stocks are sold, is merely to further reduce the freemarket price in comparison with what that price would otherwise have been. In any event, all ill-effects that may result are entirely the consequence of price controls.

Rebuttal of the Accusation That Producers Withhold Supplies to “Get Their Price”

The preceding discussion applies to the accusation that producers withhold supplies in order to “get their

price.” This accusation was levelled against the oil companies during the oil crisis and, again, during the natural gas crisis. It will undoubtedly be levelled anew if price controls are imposed in the future.

Once more, the fact is that price controls generally cause sellers to sell too rapidly, and not to hold even normal stocks. Where the anticipation of the controls being removed does lead to the withholding of supplies, the fault is not that of the sellers, but of the existence of controls in the present. It is simply absurd to tell producers that soon they will be permitted to sell at the freemarket price while for the present they must pay fines or go to jail if they attempt to sell at as good a price. Responsibility for the withholding of supplies in such a case lies with those who impose price controls and whose support of price controls makes their imposition possible. For no other result can be expected. To blame the producers and the profit motive in such a case is comparable to blaming the rocks and the laws of physics for the damage done by a delinquent who throws the rocks against windows. In acting to make profits, the producers are doing nothing more than acting in accordance with their nature—their moral nature as rational beings who wish to live by means of production and exchange.

Although this did not happen in the oil or gas crisis, and is unlikely ever to happen so long as the great majority of businessmen remain ignorant of sound economic theory and lack moral courage, it would be perfectly proper if sellers really did withhold supplies to “get their price”—that is, not merely to take advantage of the higher freemarket price they expect to follow the government’s removal of controls, but to withhold supplies in a deliberate attempt to force repeal of the controls. Such a withholding would be a kind of strike; more correctly, it would be a refusal to work under conditions of forced labor. By putting an end to price controls, it would be an action in the public interest in the true sense of the term.

It should be realized in connection with this discussion, that in a free market the speculative withholding of supplies is not a means by which sellers can arbitrarily enrich themselves. It is not possible, as widely believed, for sellers arbitrarily to raise prices by withholding supplies and then to sell the supplies they have withheld at the higher prices they themselves have caused. Any attempt to do this would necessarily cause losses to the sellers who tried it. First of all, when these sellers put their supplies back on the market, they would push prices back down by as much as they had first increased them, and in the meanwhile they would have incurred additional costs of storage and have had to forgo the profits or interest they could have earned by selling sooner. In addition, so long as the high prices lasted, other sellers would be encouraged to place on the market whatever stocks they could spare, so that when the first set of sellers returned to the market they would find their normal market already partly supplied, and thus would end up having to sell at prices lower than they could have received had they not attempted to raise prices in the first place. The only way the speculative withholding of supplies can be profitable in a free market is when it takes advantage of a prospective rise in price that is independently caused, which, of course, means, not caused by the speculators themselves. 10

In the specific case of the oil crisis the withholding of supplies turned out to be entirely mythical. Reports of large numbers of fully loaded tankers standing offshore to “get their price” had no more foundation in fact than the stories about full tank farms and storage depots. 11 As concerns the natural gas crisis, the charge was ultimately withdrawn by one of the principal original accusers, President Jimmy Carter’s then Interior Secretary Cecil D. Andrus. According to The New York Times, the secretary “said today that a series of studies had produced no evidence that oil companies were withholding natural gas from offshore leases. . . . The interior secretary insisted today that he had had no part in raising those charges and contended instead that they were initially leveled by reporters. . . . Mr. Andrus also made it clear today that the question of withholding was now closed. ‘I’m not going to continue to chase a rabbit,’ he said.” 12

Price Controls and the “Storage” of Natural

Resources in the Ground

Price controls have a particularly destructive effect on the supply of natural resources. Unlike products, natural resources in the ground are imperishable and have zero storage costs. This means that it is possible to consider reserving their use to much more remote periods of the future than is the case with regard to products. The consequence is that under price controls a tendency exists to withhold natural resources from current exploitation even though their current exploitation might be profitable. The reason is that their future exploitation— following the repeal of price controls—is expected to be sufficiently more profitable to justify waiting. In this way, price controls on natural resources act to bring about a twofold restriction of supply: they prevent the development or exploitation of high-cost deposits by making them unprofitable and they postpone the development or exploitation of lowcost deposits by making their development or exploitation in the present less profitable than it will be in the future.

The question may be raised of why price controls would not encourage the more rapid exploitation of lowcost natural resources if the controls were expected to exist permanently. To answer this question, it is only

necessary to realize what “permanently” would have to mean in this context. “Permanently” would have to refer to a period of at least a decade and, more probably, at least a generation. For suppose the effect of a price control is to hold the real value of a resource to half of what it would be in the absence of controls. This means the owners of the resource can look forward to the prospect of a doubling of its real value whenever controls are repealed. Since they incur no storage costs of any kind by waiting, even if they had to wait twenty-five years for price controls to be repealed, their gain would work out to something on the order of 3 percent per annum compounded. Such a rate of return, in real terms (which means, adjusted for losses in the purchasing power of money), is by no means insignificant in a period of inflation, when it is common for many or most investments to show losses in real terms. 13 In such conditions, it might pay to wait even for the prospect of a considerably lower positive real rate of return. Of course, if price controls undervalue a resource less severely, the inducement to postpone exploitation is less powerful. But it does not take very much undervaluation to make the owners of the resource prefer to wait five or ten years for the repeal of a control if they have to.

On the basis of these considerations, it is not surprising that the repeal of the price controls on crude oil was followed by a substantial increase in the supply of lowcost oil as well as by additional supplies available only at higher costs.

d. The Supply of Particular Types of Labor and Particular Products of a Factor of Production

A price control reduces supply if it is applied to the wages of any particular occupation or to the wages paid by any particular industry while wages in other occupations or industries are left free. In these cases, the workers in the controlled occupation or industry simply leave to take better-paying jobs at uncontrolled wages elsewhere; and new workers do not enter the occupation or industry. The controlled occupation or industry is made uncompetitive and loses its labor force. For example, if the government were to control just the wages of steel workers, say, the effect would be that steel workers would start going into other industries in response to higher, uncontrolled wages in those industries. Young workers would stop becoming steel workers. Exactly the same would happen if the government controlled just the wages of carpenters, say.

A price control reduces supply whenever it applies to some products of a factor of production, but not to other products of that factor. In this case, the production of the controlled products is curtailed, because it is more profitable to use the factor of production to produce the uncontrolled products. For example, if the price of milk is controlled, but cheese is not, then the production of cheese will be more profitable than the production of milk. As a result, raw milk will be used more heavily to produce cheese, and less milk will be available for drinking. In other words, the supply of milk for drinking will fall. In view of the continuing popularity of rent control, it is worth pointing out that exactly the same principle applies specifically to apartment houses. Apartment houses can be viewed as a factor of production with multiple possible uses, namely, use as rental housing or use as condominium or cooperative housing. If rent controls are imposed, then landlords will convert their housing to condominiums or co-ops if they are free to do so, because the effect of rent controls is to reduce the profitability of using apartment buildings for rental housing in comparison with that of using them for condominium or cooperative housing. Of course, their decision to do so evokes the same kind of outbursts of self-righteous irresponsibility and irrationalism that we observed a few paragraphs back in connection with the blame heaped on producers for withholding supplies in the face of price controls and the prospect of imminent relief from the price controls.

e. Price Controls and the Prohibition of Supply

Sometimes, the question is raised as to what argument one could give to a consumer to convince him to be against price controls; especially what argument one could give to a tenant to convince him to be against rent controls. Our discussion of how price controls reduce supply indicates a very simple argument to give to any consumer against any price control. This is that if he wants something, he must be willing to pay the necessary price. It is a natural law—a fact of human nature—that a good or service can only be supplied if supplying it is both worthwhile to the suppliers and as worthwhile as any of the alternatives open to them. If the price is controlled below this point, then it is equivalent to a prohibition of supply. To command, for example, that apartments be supplied at rents that do not cover the costs of construction and maintenance, and the going rate of profit, is equivalent to commanding that buildings be built out of impossible materials like air and water rather than steel and concrete. It is to command construction in contradiction of the laws of nature. In the same way, to command that oil be sold less profitably in New York than in Hamburg, say, or that natural gas be sold less profitably in Philadelphia than in Houston, is equivalent to commanding that these materials become drinkable and that water become burnable, for it is no less an act in contradiction of the nature of things.

Now it is simply absurd for a consumer who wants a

good, to support a measure which makes its supply impossible. And that is what one should tell him. That is what the consumers themselves should tell the legislators as soon as the latter become busy trying to enact price control laws for the consumers’ alleged benefit. These would-be benefactors of the consumers prohibit the consumers from making it worthwhile for businessmen to supply them. They destroy the businessmen. In doing so, they destroy the consumers’ ability to find agents to act on their behalf. Such legislators are capable of reducing the consumers to the point where if they want anything, they will have to produce it themselves, because price controls will make it unprofitable for anyone to supply it to them. Already, rent control has “benefitted” tenants to the point that it is has become increasingly necessary if one wants an apartment to own it oneself: one must buy a “co-op” or a condominium. Price controls made it extremely difficult, and at times absolutely impossible, to buy oil or natural gas. If the legislators go on “benefitting” the consumers long enough with their price controls, they will benefit them all the way back to the economic self-sufficiency that was the leading characteristic of feudalism. They will have destroyed the division of labor.

The Destruction of the Utilities and the

Other Regulated Industries

It may be thought that price controls on genuine monopolies, such as government-franchised electric utilities, are an exception to the principle that price controls reduce, indeed, prohibit, supply. In fact, they are not. On the contrary, they have been an excellent illustration of it.

In the absence of inflation these controls are largely without effect, for then they do not actually impose below-market prices. At such times, they are set at a level that, if anything, is almost certainly higher than would have prevailed in a free market. This is the case because they are set high enough to provide the going rate of profit, and then some, to legally protected monopolists, whose costs of production are almost certainly above the costs of production that would prevail in a free market with its legally open competition. But when they exist in conjunction with inflation, the price controls on these monopolies begin to operate as genuine price controls. This occurs because inflation drives up the production costs of the monopolies, while the regulatory authorities either refuse to allow rate increases or allow only insufficient rate increases. In this way, the utilities, and all the other regulated industries, become unprofitable. At first, they merely cease to grow rapidly enough, because their reduced profitability throttles their ability to generate additional capital—that is, they lack the profits to plow back and they lack the profits to provide an incentive to the investment of sufficient additional outside capital.

When the reduced profitability of these industries is understood to be permanent, or when the policy of the regulatory agencies inflicts actual losses on them in terms of making it impossible for them to replace wornout equipment at the higher prices caused by inflation, then these industries go into actual decline. They do not have the means of replacement, and their owners withdraw capital to whatever extent they are able in the form of taking dividends.

We are already very far along in this process. Areas such as New York City and much of the state of Florida, for example, have been skirting for many years on the edge of power disasters. Almost every year there is a question of whether generating capacity will be adequate to meet the demand in such places. Socalled brownouts, and even blackouts, are not uncommon. Problems of this kind would undoubtedly be far more common and severe if it were not for the relatively depressed state of the American economy in recent years.

The situation of an inadequate supply of power is the result of the restricted profitability of the utilities, caused by price controls. It is compounded, of course, by the ecology movement’s policy of harassment of energy producers. Both causes have prevented the construction of sufficient additional generating capacity to keep pace with demand. 14

At the present time, the traditionally regulated industries, such as the electric utilities, the railroads, and telephone service, are the principal victims of price controls, along with rental housing in various towns and cities. Although the situation by and large is probably much improved in comparison with that of the late 1970s, when conditions in these industries appeared more critical—and the oil and natural gas industries were in a state of growing crisis as well, thanks to price controls—these industries are still capable of being destroyed by price controls. And, since the rest of the economic system is vitally dependent on them, their destruction would be disastrous for the entire economy.

Indeed, despite the improvements brought about in the 1980s under the Reagan administration, one must still regard the future with a high degree of pessimism. The public’s state of knowledge of economics has not significantly improved. Thus, the causes of the improvements in the situation are not understood. Even those who were responsible for the improvements—through such measures as the repeal of the price controls on oil, the easing of “environmental” restrictions, and the abandonment, at least for the time being, of the policy of accelerating inflation—apparently do not know enough to take credit for their good work, despite the fact that it would be very much to their political advantage to do so. Instead, the

improvements are regarded as essentially accidental and are more or less taken for granted.

Thus, the continued existence even of the remaining price controls holds out the specter of growing power shortages, a disintegrating railroad network, and deteriorating telephone service. The potential for destruction is especially great in the case of electric power, where the effects of price controls are compounded by the actions of the ecology movement. So long as these industries are subject to price controls, and so long as the potential exists for significant inflation, all of these industries are capable of being reduced to the level of rent-controlled housing in the slums of New York City. The only difference will be that if they suffer comparable devastation, they will carry down with them the rest of the economic system. These problems will become apparent if and when a policy of accelerating inflation is resumed.

4. Ignorance and Evasions Concerning Shortages and Price Controls

The fact that price controls are the cause of shortages has been known to all economists at least since the time of Adam Smith. Nevertheless, this elementary knowledge is either unknown or simply evaded by the great majority of today’s presumably educated political and intellectual leaders.

These people do not have any idea of the connection between price controls and shortages. In their view, shortages are the result of some kind of physical deficiency in the supply or of an innate excess of needs. They simply do not have any knowledge of the role of price in balancing demand and supply. As a result, it is common to hear them blame shortages on such things as poor crops, an alleged depletion of natural resources, even that old standby the “greed” of consumers. Their level of knowledge is typified by a provision of the rent control law that governed New York City for many years. According to this law, rent controls could not be lifted until the vacancy rate in apartments had first climbed to a certain substantial level. In other words, only when the shortage that rent controls created and maintained was over, could rent controls be lifted.

The same point of view was expressed by a former mayor of New York, Abraham Beame, when still in office. When asked to comment on an economic regeneration plan for New York City that had urged the repeal of rent control, he “refused to endorse the rent control proposal, saying, ‘we still have a vacancy rate of less than 5 percent and we still have a housing shortage.’” 15

To find a parallel for this kind of reasoning, one would have to find a badly overweight person, say, who was firmly resolved to go on a diet just as soon as he lost twenty pounds, or an alcoholic who was firmly resolved to stop drinking just as soon as he sobered up. Of course, these are not perfect analogies, because the overweight person and the alcoholic at least know the causal connections and are evading them. In the case of the government officials and the intellectuals responsible for rent control, most of them do not even know the causal connection. They are too ignorant even to be guilty of evasion in this particular instance.

The confusion of our public officials extends to the point that when they are confronted with the fact that the repeal of a price control would actually end a shortage, they then deny the very reality of the shortage: they view the shortage as “artificial” or “contrived.” For example, during the natural gas crisis the then Governor of Pennsylvania, Milton Schapp, declared before television news cameras that if price controls were lifted and the gas shortage came to an end through the appearance of additional supplies, the very appearance of the additional supplies would prove that the shortage had been “contrived.” The governor simply did not know that a higher price increases supply by enabling a local market successfully to compete for supplies with other markets, and, of course, that it leads to an expansion of the total supply by making production more profitable. He also did not know that the supply available for vital purposes can be increased by enabling those purposes to outcompete marginal purposes, and that the elimination of shortages eliminates the need to hoard supplies, which supplies then also appear on the market.

Inflation and the Appearance of High Profits

In an important respect, the ignorance that surrounds the effect of price controls is made possible by the fact that inflation raises the apparent or, as economists say, the nominal rate of profit that businesses earn. It does not increase the real rate of profit—the rate in terms of the actual physical wealth that business firms gain—(in fact, quite the contrary), but it does increase the rate of profit expressed in terms of the depreciating paper money.

To understand what is involved, it must be realized that the costs which enter into the profit computations of business firms are necessarily “historical”—that is, the outlays of money they represent are made prior to the sale of the products. This follows from the fact that production always takes place over a period of time. Materials and labor must usually be bought weeks or months before the resulting products are ready for sale, and sometimes even further in advance. Machinery and factory buildings are bought many years, even decades, before their contribution to production comes to an end. Thus the costs of business enterprises in producing their

products represent outlays of money made weeks, months, years, or even decades earlier.

Now to whatever extent inflation occurs, the sales revenues of business firms are automatically increased: the greater spending that inflation makes possible is simultaneously greater sales revenues to all the business firms that receive it. Since costs reflect the given outlays of earlier periods of time, the increase in sales revenues caused by inflation necessarily adds a corresponding amount to profits.

A slightly different way to grasp the same basic idea is to realize that the total outlays business firms make for productive purposes at any given time are a reflection of the quantity of money in existence at that time, while the sales revenues they will subsequently take in for the products resulting from those outlays, will be a reflection of the quantity of money in existence later on. It follows that the more rapidly the quantity of money grows, the greater must be the ratio of sales revenues to costs of production and to capital previously invested. This, of course, implies a corresponding rise in the general rate of profit on capital previously invested. The rate of profit in the economy is raised to progressively higher levels the more rapidly the quantity of money, spending, and sales revenues rise.

It cannot be stressed too strongly, however, that the rate of profit that rises is purely nominal, that is, it is strictly in terms of money. All that is happening is that the more rapidly money is increased, the faster is the rate at which money is gained. If there are different monies, increasing at different rates, then the nominal rate of profit is higher in the monies that increase more rapidly. For example, it is higher today in U.S. dollars than in Swiss francs, and higher in Argentine pesos than in U.S. dollars. (The same principle and example apply to interest rates, since the most important determinant of interest rates is the rate of profit that can be earned by investing borrowed money in business.)

The rise in the nominal rate of profit does not imply any increase in the real rate of profit, that is, the rate of gain in actual wealth, because the same rise in spending that raises sales revenues and profits in the economy also raises the level of prices. The extra profits are almost all necessary to meet higher replacement costs of inventory and plant and equipment, and the rest are necessary to meet the higher prices of consumers’ goods that the owners of businesses were previously able to buy in their capacity, say, as stockholders receiving dividends. Indeed, the real rate of profit firms earn actually falls while the nominal rate of profit rises. One major reason it does so is because the additional nominal profits, while mainly necessary for the replacement of assets at higher prices, are taxed, as though they were real profits. Thus firms are placed in a position in which, after paying taxes, they are actually worse off as the result of the rise in the nominal rate of profit.

A good illustration of these facts is the case of a hypothetical merchant who normally buys $100 worth of goods on January 1 and sells them at the end of the year for $110. If a rapidly increasing quantity of money increases total spending in the economy by 10 percent over the year, this merchant will tend to sell his goods for $121 instead of $110, that is, also by 10 percent more. Consequently, his nominal profit will be increased from $10 to $21. However, the same increase in the quantity of money and volume of spending that enlarges our merchant’s sales revenues and profit also raises the replacement cost of his inventory. Instead of being able to replace his inventory for $100, as he was able to do in the past, he will now have to replace it at a cost of $110. Thus, the whole increase in the merchant’s profit is purely nominal, not real. While his profit rises from $10 to $21, fully $10 of this additional profit is required merely to replace inventory at higher prices. This leaves the merchant with $11 that he can use for other purposes. But these $11 will probably buy no more than $10 used to buy, because the increase in the quantity of money and volume of spending has probably raised the prices of the things the merchant can buy outside of his business. Thus, the $21 profit the merchant now has represents no more in terms of actual wealth and ability to buy goods than the $10 profit he used to have.

Indeed, as I have said, our merchant will actually be worse off as a result of his higher nominal profit. Because, apart from other reasons that will be presented later in this book, he must pay additional taxes on the additional nominal profit, and must restrict his consumption or new investment in order to do so. 16 To understand this point, assume a tax rate of 50 percent on profits. Thus, initially, when our merchant made $10 in profit, he paid $5 in taxes and had $5 left to himself, which he could either consume or add to his business. When his profit rises to $21, his taxes rise to $10.50. Of the $10.50 left over, fully $10 are required to replace inventory at higher prices. Therefore, the merchant is left with a mere 50¢ that he can consume or use to expand his business, whereas he initially had $5, and at a lower level of prices as well.

Exactly the same principles as apply to the profit of our hypothetical merchant apply to the profits of all real-life merchants, and to the profits of businessmen in general, because the same kind of increase in nominal profits as occurs on inventories also occurs in the case of depreciable assets, such as buildings and machinery. 17

It is in this light that the consequences of the attitude that profits are “too high” must be considered. The fact

is that in the context of inflation the seemingly high rates of profit that firms earn represent a decline in real profits and, quite possibly, the total elimination of real profits. In such circumstances, to argue that because a rate of profit is high by historical standards it is high in any meaningful sense, is to display the utmost ignorance. To limit an industry’s profits in any way in such circumstances is simply to invite its destruction.

But precisely that is what is being done or has been done to the electric utilities, the railroads, the telephone companies, and the oil and natural gas industries. And it is what has been done to the rental housing industry in New York City for over half a century. For many years, for example, the government of New York City was proud of the fact that it guaranteed to landlords under rent control the right to earn a 6 percent rate of return on their initial investments, made, in most cases, before World War II. Six percent, reasoned the city officials, was a “fair” rate of return. What honest landlord could want more? The city officials neglected the fact that since the landlords’ original investments were made, replacement costs had increased many times over and that a 6 percent return on the construction costs of decades earlier had to represent a disastrously losing proposition.

Amazingly, when landlords began to stop keeping up their properties as a result of such loss-making conditions, they were the ones accused of “milking” their properties—as though the city or the tenants had originally constructed the buildings and the landlords were now trying to squeeze out of them whatever they could. (And then, as punishment, the city refused to grant rent increases even when called for by its own criterion of providing a 6 percent return.) The simple truth is that the city government of New York, with the support and participation of hundreds of thousands of ignorant tenants, has milked the rental housing industry to the point of virtually totally destroying it. Today, in New York City, the point has been reached where if one wishes a place to live, one must buy it. As already pointed out, the same fate may well be in store for other, more important industries in this country that labor under price controls.

The Destructionist Mentality

What is at root in these cases of wholesale industrial destruction is not ignorance alone, but a mentality that makes itself ignorant. It is a mentality that shows up in the cavalier assumption that the problems an industry experiences as the result of price controls, rising costs, mounting taxes, and harassment by the ecology movement are all somehow the result of “its own inefficiency.” This mentality is unaware that inefficiency is itself an inevitable consequence of government interference. If an industry is deprived of the prospect of profits, if its operations are encumbered with endless bureaucratic regulations, then it has no incentive or even possibility to be efficient. 18 It is absurd to blame an industry’s inefficiency on anything but government interference; in a free economy, profit and loss incentives and the freedom of competition operate steadily to increase efficiency.

The ignorance that underlies the destruction of our economic system is made possible by a protective shell of envy and resentment. People take the attitude that somehow the utilities, the landlords, the oil industry, or whoever, are “already rich enough,” and that they’ll be damned if they’ll let them get any richer. So, on with the price controls. That is the beginning and the end of their thinking on the subject, and they just don’t care to think any further. They are eager to accept high nominal profits as a confirmation of their view that the industries concerned are “rich enough,” and to let it go at that.

However, the simple fact is that none of these industries is rich enough, and in preventing them from becoming richer, or even staying as rich as they are, people foolishly harm themselves. None of these industries is rich enough for the simple reason that we really do not have enough power plants, enough good apartment buildings, or enough oil wells and oil refineries. Speaking for myself, as a consumer, I must say that I would like the power companies, the landlords of New York City, the oil industry, and so on, all to be worth many more billions than they are presently worth. I would benefit from that fact. If the utilities had more power plants, my supply of electricity would be better assured and I would not be subject to the power interruptions that I am now subject to. If the landlords of New York City had more and better buildings, tenants and possible prospective tenants, such as myself, would be able to have a better apartment. If the oil industry had more wells and refineries, I would have a more abundant and secure supply of oil products.

If one thinks about it, I believe, nothing could be more absurd than consumers in a capitalist economy attacking the wealth of their suppliers. That wealth serves them— they are the physical beneficiaries of it. All of the wealth of the utilities, the landlords, the oil companies—where is it? It is in power plants and power lines, apartment buildings, oil wells and oil refineries. And whom does it actually, physically, serve? It serves the consumers. It serves us—all of us. We have a selfish interest in the preservation and increase of that wealth. If we deprive an electric utility of a power plant, we deprive ourselves of power. If we deprive our landlords of more and better buildings, we deprive ourselves of apartments. If we deprive the oil industry of wells and refineries, we deprive ourselves of gasoline and heating oil.

This harmony of interests between the consumer and

the producer under capitalism is one of the great, profound insights of von Mises. 19 Because of it, even if businessmen become cowardly and do not fight for their own interests, we, as consumers, must fight for them, and thereby for ourselves. For we have a selfish interest in being able to pay prices that make it profitable for businessmen to supply us. It is to our self-interest to pay utility rates, rents, oil prices, and so on, that enable the producers in these fields to keep their facilities intact and growing, and that make them want to supply us. And I must say, in view of the principles we have already learned, that we do not have to worry about being charged unfairly in a free market, because any high profits that might be made from us are simply the incentive and the means to an expanded supply, and are generally made only because of special efficiency on the part of the producers who earn them.

A Defense of Inventory Repricing

In early 1974, when inflation was proceeding more rapidly than now, supermarkets began to raise the prices of the goods already on their shelves, which had initially been marked with lower prices. Because the stores had purchased those goods at prices which had not yet risen, it was assumed that it was some kind of monstrous injustice for them to charge higher prices. The higher prices, it was argued, merely bloated the profits of the supermarkets and were the cause of a higher cost of living for consumers.

What those who spread this argument chose to ignore was that the replacement costs of the merchandise had risen and that if the supermarkets had not raised their prices, they would not have had the means of replacing their inventories. They would have been in exactly the same position as our hypothetical merchant if he had not raised his prices. 20 Assume that our merchant held to his old prices and thus continued to take in only $110, while his replacement cost rose from $100 to $110. His nominal profit that year, based on historical cost, would have remained at $10 and, after paying taxes, he would still have had $5. The only problem would have been that even if he allowed absolutely no dividend for his own consumption, he would have had no more than $105 available for replacing his inventory, while the sum he required for replacement was $110. He would have had to reduce the size of his operations. Exactly this would have been the position of the supermarkets if they had been unable to raise their prices in anticipation of higher replacement costs.

It follows that the consumers who wanted cheap goods at the supermarkets’ expense would have gotten fewer goods and, if this process were kept up long enough, eventually no goods at all. And, paradoxically, at whatever point the control on the nominal rate of profit was finally abandoned, they would have had to pay higher prices than if the control had never been imposed, because prices would then have had to rise on the basis of a decrease in supply as well as on the basis of an inflation-caused increase in demand.

In confirmation of the fact that little or nothing has been learned since 1974, the identical line of argument was raised against the oil companies in the fall of 1990, when they increased the prices of their refined products on the basis of the sharply higher current price of crude oil, which had been caused by Iraq’s invasion of Kuwait. Fortunately, the critics were not able to impose price controls on the oil industry in 1990, as they had in 1971.

The Campaign Against the Profits of the

Oil Companies

In early 1974, every release of a quarterly earnings report by an oil company was an occasion for The New York Times to run a story headlined as a staggering increase in oil company profits. Day after day, one would read a headline in that newspaper that the profits of oil company X were up 60 or 70 percent or more over the same quarter the year before. This rise in profits was constantly mentioned in conjunction with the rise in the price of gasoline and other petroleum products, which had also risen on the order of 60 or 70 percent over the same period of time. It was constantly implied—by The New York Times, by Time magazine, and by a host of television news commentators—that the rise in oil company profits was responsible for the rise in the price of oil products. And because the rise in these prices was presented as the cause of practically the whole problem of inflation, the impression was created that the oil companies were out to destroy the country with their insatiable greed for profits. By the same token, of course, the oil companies were depicted as eminently deserving to be throttled with price controls.

The evasions, distortions, and misrepresentations in this case were enormous. I think they are worth going into because they are a classic illustration of how the supporters of price controls argue and what they are capable of.

First of all, the supporters of controls evaded two facts that should have been known to everyone: They evaded the fact that the rise in the price of oil products in the United States was the result of a rise in the world price of crude oil brought about by the Arab embargo and the Arab-sponsored cartel, that is, that it was the result of a rise in the oil companies’ costs of obtaining imported oil. In addition, they evaded the fact that since August of 1971 the prices of oil and oil products produced or sold in the United States had been totally controlled by the

U.S. government, and were currently controlled at levels far below the world-market prices of these goods; indeed, at levels which, until the end of the crisis period, did not even allow the oil companies to pass on more than a part of the higher cost of imported oil. The truth is that our price controls made the importation of foreign oil highly unprofitable, which is one of the major reasons we suffered from a shortage of oil at the time. Furthermore, while The New York Times and the other news media were spewing headlines about the enormous rise in oil company profits, they neglected to mention that the profits of the oil companies on oil production within the United States increased only on the order of about 6 percent during the crisis period. This was in line with the increase in the physical volume of domestic production in the period. Profits on domestic production did not and could not have increased any more than that because the selling prices of the oil companies were all rigidly controlled by the government, in line with their costs of production.

The real facts, therefore, are that during the oil crisis the American market was a very unprofitable market for the importation of foreign oil and a not very profitable market for the production of domestic oil or oil products. Nevertheless, the news media constantly pointed to a sharp rise in oil company profits and claimed that it was responsible for the rise in prices.

To be sure, there was a substantial increase in oil company profits on a percentage basis. Technically, the media were correct in reporting profit increases of 60 and 70 percent or more. But in representing these profit increases as the cause of higher American oil prices, the media committed four distinct acts of dishonesty or misrepresentation.

First, the media neglected to inform the public that these higher profits were not earned on the production or sale of oil or oil products in the United States. In many cases, over half the rise in profits came from inventory profits on stocks of oil and oil products held abroad, where price controls did not apply, and from profits on foreign-exchange holdings. The inventory profits were the same in principle as the jump in profits of our hypothetical merchant or of the supermarkets that raised prices in anticipation of higher replacement costs. These inventory profits earned abroad reflected nothing more than that the oil companies possessed some inventories acquired before the rise in the world-market price of crude oil, and were able to sell the inventories at the higher prices corresponding to the higher replacement price of crude oil. The extra profits earned on the inventories merely served to enable the oil companies to maintain their level of operations, just as was the case with the supermarkets.

The profits on foreign-exchange holdings were similar. The oil companies are largely international and hold such currencies as Swiss francs and German marks, as well as U.S. dollars. During the oil crisis, the price of the dollar fell in terms of these currencies. This meant that the francs and marks held by the oil companies were suddenly equivalent to a larger number of U.S. dollars. This increase in the dollar value of their foreign-exchange holdings was included in the reported profit gains of the oil companies.

The rest of the increase in oil company profits was the result of higher profits on foreign operations other than profits on inventory or currency holdings, and higher profits on other lines of business, such as the chemical business, in which a number of oil companies were involved and which had a good year at the time. All of these facts about the sources of higher profits were simply ignored.

The second dishonesty of the media was that they did not point out that even with the 60 or 70 percent increase—from whatever sources—the profits of the oil companies were only restored to the same level in relation to sales revenues at which they had existed in 1968. It was not pointed out that the intervening years had been poor ones for the oil industry and that the sharp percentage increase in its profits was largely the result of measuring the increase against an unusually low base. I remember one case in particular, in which the headline in The New York Times blared “2-Month Earnings Soar at Occidental.” 21 It turned out, if one read the article very, very carefully, and did some arithmetic that the reporter and the editor had apparently not bothered to do, that the soaring earnings represented an increase in profits from about seven-tenths of 1 percent of sales revenues to about 5 1 ⁄ 2 percent of sales revenues, which latter figure was still below normal for the oil industry in previous years. Of course, with this type of misrepresentation, it would be possible to write headlines about infinite increases in profits. All one would need would be to find firms that earned some profits in the current period but which had earned zero profits or incurred losses in the period with which it was compared. The percentage increase would be infinite.

Closely related to this kind of dishonesty was a further misrepresentation. In all of the countless times that the news media mentioned 60 to 70 percent increases in profits in conjunction with 60 or 70 percent increases in product prices in the petroleum industry, they never once, to my knowledge, mentioned that profits are only a small percentage of prices—5 percent, 10 percent, rarely much more than 10 percent. This applies both to the petroleum industry and to practically every other industry. Accordingly, it was never pointed out that any given percentage

increase in profits must necessarily represent a much smaller percentage increase in prices. If profits are initially 10 percent of a price, a 70 percent increase in profits does not equal a 70 percent increase in price, but only a 7 percent increase in price. If, as in the case I mentioned, profits are initially seven-tenths of 1 percent of the price, even a 1,000 percent increase in profits would not mean some kind of fantastic increase in price, but a rise merely on the order of a few percent. Thus, even if the oil companies had earned their higher profits in the United States, which they did not, and even if those higher profits had been the cause of a rise in oil prices, which they were not, they could not have been of any significance as a cause of higher oil prices. Nevertheless, by the news media’s constant conjunction of their roughly equivalent percentage increases, it was made to appear that the rise in profits of the petroleum industry is what accounted for the rise in the prices of petroleum products.

Finally, just as the media regularly associated the percentage increases in profits with the percentage increase in the price of oil products, they just as studiously avoided ever mentioning the rate of profit on capital in connection with the rise in the consumer price index. Such a connection would have shown that the oil industry was far from being very profitable in real terms. The reasons are as follows. During the oil crisis, the consumer price level was rising at an annual rate of 13 percent, while the United States’ most profitable, most successful major oil company was earning only 18 percent a year on its capital. This meant that while $100 invested in that company would grow to $118 in a year, it would take $113 at the end of the year to buy what the $100 had bought at he beginning of the year. This meant that the real rate of gain of the owners of that company was less than 5 percent a year—it was $5 divided by $113. A real rate of profit of less than 5 percent for the country’s most profitable, most successful major oil company is quite low. And, of course, most oil companies were earning substantially lower real rates of profit. Any oil company whose nominal rate of profit was below 13 percent, say, 8, 10, or 12 percent, was actually losing money in real terms! But, as I say, one never found the media dealing with the real rate of return of the oil companies.

It may be asked where I obtained my knowledge of the facts I have cited. The answer, strangely enough, is the general news media themselves, especially The New York Times. The facts appeared there. They simply received no stress, or they weren’t integrated. They were buried in a mass of articles whose headlines and general tenor created exactly the opposite impression. Or they appeared at different times, in different stories. For example, as I have indicated, figures were reported showing dollar totals of profits and sales revenues; it was simply left to the reader to perform the necessary long division in order to compute profits as a percentage of sales revenues. Likewise, while the percentage increase in profits over the previous year was carried in headlines, only occasionally, in an almost offhand reference, would one find a mention of the actual nominal rate of profit on capital invested. And, while the rate of increase in the consumer price level was featured prominently, it was never mentioned in connection with nominal profit rates, so that one would know what to make of those rates.

One would also read statements, buried deep in articles denouncing oil company profits, that, according to oil company officials or other sources, the rise in profits was largely the result of inventory profits earned abroad and gains on foreign-exchange holdings. The statements were never disputed. They were simply ignored, as being of no significance. And, of course, it was certainly reported in the press that all of the prices charged by the oil companies were controlled by the government and that the Arabs had brought about a radical increase in the world price of crude oil, which, of course, meant higher costs to the oil companies. Yet, these two facts of fixed prices and radically higher costs, facts which were obviously incompatible with the oil industry being very profitable, were simply ignored in the articles reporting the profit increases, as I pointed out earlier.

The kind of distortions committed in the media’s treatment of the profits of the oil companies will almost certainly be committed in the future, in attempts to impose or continue controls on other industries. The reader should be on guard against them and should hold in mind, in addition to the need for nominal profits to allow for the replacement of assets at higher prices, such further important matters as the source of the alleged profits under attack, their size in relation to sales revenues, the basis of comparison used in showing their change, and the relation between percentage changes in them and percentage changes in selling prices.

In connection with the distortions present in recent attempts—that is, in 1992 and 1993—to blame the sharp rise in the cost of medical care over the last decades on the high profits made on a few patented drugs, the reader should also keep in mind the substantial losses incurred in the numerous unsuccessful research and development efforts that take place. He should also realize that the attacks made on the large size of the pharmaceutical companies’ outlays for advertising and promotion ignore the fact that much of the outlays for promotion represent the distribution of large quantities of free samples of new medications to physicians, who in turn give the samples to their patients without charge. Thus, alongside the accusation that the pharmaceutical industry charges too much for its products, this accusation turns out to repre—

sent an attack on the pharmaceutical industry for giving away too many of its products for free. Finally, the reader should realize that the attacks made on the pharmaceutical industry for spending large sums on the development of new drugs that do the same job as already existing drugs sold by other firms, represent the contradiction of attacking the industry both for the high profits to be made from successful drugs and for the competitive quest that serves to bring those high profits down by means of others being able to offer competing alternatives. Such attacks are attacks on the very nature of the profit system.

How the U.S. Government, Not the Oil Companies,

Caused the Oil Shortage

Let us try to keep in mind all that we have learned about shortages, and look further at the ignorance and evasions displayed during the oil shortage. I am concentrating on the oil shortage because it had such a dramatic effect on practically everyone in the United States and is so illustrative of all of the problems associated with price controls, including the kind of inappropriate mental attitudes that are connected with them.

There were two very popular explanations of the oil shortage that went around at the time, both of which tried to blame it on the oil companies rather than on price controls. According to one of these explanations, the oil companies had created the shortage in order to be able to obtain permission to build the Alaskan oil pipeline, which had been delayed for many years by the lawsuits of the ecology movement. According to the second explanation, the oil companies had created the shortage in order to eliminate the independent gas stations, to which they were reportedly observed denying supplies.

The first observation which must be made against both of these claims is that they do not see that shortages can result only from a price that is too low and must disappear as the price rises. To repeat once again, no matter how physically limited is the supply of a good or how urgent the demand for it, no shortage can possibly exist at the price established in a free market. For the freemarket price will be high enough to level the quantity of the good demanded down to equality with the supply that exists—all the while, of course, acting to expand the supply that exists. Even if one could establish—which one certainly cannot—that the oil companies had conspired to reduce the supply of oil, still, one could not blame them for the shortage. Had they reduced the supply of oil, they would have sold it at a higher price, and at the higher price there would have been no shortage. In order to blame the oil companies for the shortage, one would have to show that he oil companies deliberately charged too low a price for their oil. That would be the only conceivable way that they could have caused the shortage. But that is absolutely absurd. It was not the oil companies that were responsible for too low a price, but the government, with its price controls. The government stood ready to fine or possibly even imprison anyone selling oil or oil products at prices that would have eliminated the shortage.

The interests of justice, however, require that I show not only that the oil companies could not have caused the shortage, but also that they were not responsible for anything acting to raise the price of oil in the absence of price controls.

Observe. The oil companies were not responsible for the nationwide and worldwide increase in aggregate demand that acted to drive up all prices, including, of course, the price of oil. Nor were the oil companies responsible for any decrease in the world supply of oil. Both were exclusively the result of government actions. All governments, that of the United States included, were and are bent on reckless expansions of the money supply that act to raise the demand for everything and the price of everything. And it was governments that were responsible for the restriction in the supply of oil—not only the governments that are members of the international oil cartel or that participated in the Arab embargo, but also the U.S. government.

The U.S. government, acting largely under the influence of the ecology movement, restricted the supply of oil in the following ways: (1) It prevented exploration for and development of oil reserves in vast areas of territory arbitrarily set aside as “wildlife preserves” or “wilderness areas.” It even delayed the development of the vital North Slope Alaskan oil fields for many years, on the grounds of alleged concerns over the “environmental” effects of the pipeline required to transport the oil to Alaska’s south coast. (2) It prevented the development of offshore wells on the continental shelf. (3) It prevented the construction of other oil and gas pipelines, of new refineries, oil storage facilities, and facilities for handling supertankers. Where it did not totally prohibit these activities, it greatly increased their cost by creating enormous delays—a policy that was enthusiastically joined by the other levels of government. (For example, the plan for an oil pipeline from Southern California to Texas was abandoned, with a loss of over fifty million dollars, because the necessary permissions could not be obtained from the more than seven hundred and fifty federal, state, and local government agencies involved.) (4) The U.S. government imposed price controls on oil. (5) It acted further to restrict oil company profits, and thus oil industry investment, by punitively increasing their rate of taxation through first reducing and then totally abolishing the customary depletion allowance on crude oil. (6) It deterred investment in the oil industry through threats of

antitrust actions forcing the breakup of existing companies, and through threats of nationalization.

In addition, the U.S. government was responsible for an enormous artificial increase in the demand for oil, over and above the increase caused by its policy of inflation. It caused this artificial increase in demand in the following ways: (1) Since the mid-1960s, it controlled the price of natural gas, thereby undermining the growth of that industry. The demand for fuel that normally would have been supplied by natural gas therefore overflowed largely into an expanded demand for petroleum, which is its closest substitute for most purposes. (2) Under the influence of the ecology movement, the government prevented the construction of atomic power plants and restricted the mining of coal, policies which it continues to pursue. In these ways too, it forced, and continues to force, the demand for fuel to rely more heavily than necessary on oil supplies. (3) Again under the influence of the ecology movement, the government forced electric utilities to shift from the burning of coal to the burning of oil and it forced automobile manufacturers to produce engines requiring far higher gasoline consumption per ton-mile. 22

In sum, the government and the ecology movement have done everything in their power to raise the demand for and restrict the supply of oil.

It should be realized that it was only these actions of the U.S. government that made possible the dramatic rise in the price of oil. The U.S. government bears a far greater responsibility than the Arab cartel. It is the party that made it possible for the cartel to succeed. All that the cartel did was to take advantage of the artificial increase in demand and restriction of supply brought about by the U.S. government. Had the U.S. government not restricted the expansion of the domestic petroleum industry and forced up the demand for oil, the supply reductions carried out by the cartel would not have had such a significant effect on the price. Because in that case, such supply reductions would have been at the expense of far less important wants than actually turned out to be the case. With the larger domestic supply of oil and competing fuels that a free market would have produced, the marginal utility of any given amount of oil would have been far less. The loss of any given amount of oil by virtue of the supply reductions carried out by the cartel would therefore have been much less serious. As a result, the cartel would not have been able to raise the price nearly as much by virtue of any given amount of supply reduction. In such circumstances the cartel members would probably not have found it worthwhile to reduce the supply at all. In order to achieve a rise in the price of crude oil of the magnitude that actually occurred, the cartel members would have had to reduce their own production over and above the amount by which they actually did reduce it, by a further amount equal to the sum of the reduced supply and increased demand for oil caused by the policies of the U.S. government.

Furthermore, in the absence of our price controls, any rise in the price of oil achieved by the cartel would have worked to the advantage of the American oil industry at the expense of the oil industry in the countries belonging to the cartel. This alone would have been enough to frustrate the plans of the cartel. For in this case, the effect of the cartel’s restriction of supply would have been to hand the American oil industry the profits and the capital required for an expansion of supply. The cartel would then either have had to allow the price of oil to fall or else it would have had to restrict its own production still further, which would have meant that the American oil companies would have earned the high price of oil on a larger volume of production and have had still greater profits available for expansion, thereby creating still worse problems for the cartel in the future.

It should be obvious that it is impossible for any cartel to succeed that is confronted with a major competitor able to profit from its policies and expand his production. The Arab cartel was able to succeed only because the U.S. government did its utmost to prevent the cartel’s competition—the U.S. oil industry—from earning high profits and expanding. Although it was certainly not their intent, in imposing and then perpetuating price controls on oil and oil products, a majority of the highest elected officials in the United States—three presidents (from Nixon to Carter) and a majority of the members of the U.S. House and Senate during those three administrations—behaved as though they owed their election to voters in the member countries of the Arab cartel—as though they were elected in places like Saudi Arabia and Iran rather than in states and districts within the United States. For it was certainly not an American constituency that their actions served, but the interests of the Arab cartel.

In the absence of the U.S. government’s destructionist policies, the Arab cartel would probably never even have been formed in the first place, because the conditions required for its success would have been totally lacking. It is not accidental that following the repeal of our price controls on oil in 1981 and the easing of price controls on natural gas and the “ecological” restrictions on the development of oil reserves, the price of oil dramatically declined, despite all efforts to prevent it on the part of the OPEC cartel. If the United States were to abolish all the remaining controls on the production of energy, the OPEC cartel would be completely broken, and the real price of energy would resume the descent it enjoyed from the start of the Industrial Revolution until the enactment

of price controls in 1971. Such a policy, of course, would entail removing the prohibitions on the construction of atomic power plants and the restrictions on the strip mining of coal. It would also entail the privatization of the vast landholdings of the federal and state governments in Alaska and the other Western states and of the continental shelf, so that oil and gas reserves could be freely developed.

In sharpest contrast to the actions of the U.S. government, at every step of the way the oil companies sought, and have continued to seek, to expand the production of crude oil and oil products in order to keep pace with the growing demand for oil. They have consistently sought to develop new sources of supply, such as the Alaskan and offshore fields, and to construct new refineries and improved harbor facilities. In other words, they have done everything in their power to keep the price of oil and oil products as low as economically possible. Any other policy would have been against their interests.

This last point must be stressed. In a free market, the oil companies’ profit motive is tied to achieving as great a supply and as low a price as possible. Consider first the interests of the firms that are predominantly petroleum refiners. Their capital is invested primarily in refineries, pipelines, tankers, delivery trucks, and the like, rather than in deposits of crude oil in the ground. These firms clearly have an interest in the greatest possible supply and lowest possible price of crude oil. For the price of crude oil is their cost. These firms have the same interest in an abundant supply and low price of crude oil that every producer has in an abundant supply and low price of his raw material.

By the same token, consider the interests of the producers of crude oil. Their interests lie with the greatest possible efficiency of refining operations and the lowest possible price of refined petroleum products. Because the lower the prices of refined products, the greater the quantity of them demanded and therefore the greater the quantity demanded of crude oil: the price of crude oil can benefit by part of any cost savings in refining. This mutual tension between the interest of refiners and producers of crude oil makes it necessary for each group to try to improve its own production. If the existing producers of crude oil lag behind, they can expect competition from the refiners, who can develop their own supplies of crude oil or expand their existing crude oil operations. If the existing refiners lag behind, they can expect competition from the producers of crude oil, who, for their part, can undertake refining operations or expand their existing refining operations.

In addition, both groups can expect competition from total outsiders if they fail to exploit any significant opportunity for improvement. And, of course, within each group, whichever individual firm succeeds in improving production ahead of its rivals will almost certainly gain at their expense. For example, if one particular refiner improves his efficiency and cuts his costs, he will have higher profits and will thus be able to accumulate additional capital. It will almost certainly pay him to use his additional capital to expand his production, and to create a market for his additional production by lowering his prices. His lower costs will still enable him to have high profits even at lower prices, and his lower prices will both attract new customers to the industry and take away some customers from rivals who cannot afford to sell at such low prices. Exactly the same considerations, of course, apply to the producers of crude oil.

For these reasons, it was no accident, but logically necessary, that the oil companies have all along sought to expand their production. It was the operation of these very principles that brought the oil industry into existence in the first place and developed it from virtually nothing into the productive giant it later became and still is today.

To argue, therefore, that the oil companies were responsible for the oil shortage is an absurdity compounded by a triple injustice. It is an absurdity in that, as we have seen, it implicitly accuses the oil companies of charging too low a price for their oil. This is something they would never do. And the critics of the oil companies, who constantly accuse them of seeking to charge prices that are too high, should have a sufficient respect for logic not to accuse them simultaneously of causing shortages by charging prices that are too low. (Of course, the critics do not know that they are guilty of a contradiction, because they have no idea either of what causes shortages or what determines the price of oil.) The accusation embodies a triple injustice in that it evades: (1) the fact that it was the government’s price controls that kept the price too low and so created the shortage, (2) the fact that the government and the ecology movement did practically everything they could to restrict the supply and expand the demand for oil, and (3) the fact that by the nature of the profit motive the oil companies have always worked to expand the supply of oil and reduce its price.

To argue in addition that the oil companies created the shortage for the purpose of being able to build the Alaskan pipeline is to pile on still further absurdities. The obvious truth—given the price controls—is that the construction of the pipeline would have mitigated the shortage somewhat, had it not been so long delayed. To argue that its construction was the motive for the shortage is not only to display the utmost ignorance about the causation of shortages and callous indifference to the most elementary questions of justice, it is also to display a lack of comprehension of the law of causality in relation to the

physical world. Because according to this argument, the pipeline was something that only the oil companies wanted; the consumers of oil products, allegedly, could have gotten along quite well without the pipeline. Oil products, according to the mentality behind this argument, simply come from oil companies. The oil companies, it is believed, are perfectly capable of producing oil products without oil fields or oil pipelines. The oil companies desire oil fields and oil pipelines, one gets the impression, not because they are necessary to production—production is causeless—but in order to disturb the caribou and the grizzly bears and to pollute the air.

This denial of the elementary physical connection between products and the means of producing them, I must point out, is not an isolated phenomenon confined to the arguments about the Alaskan oil pipeline. It is simply a further manifestation of the same mentality we have already encountered in consumers who denounce the wealth of their suppliers—consumers who will be damned if they’ll let the utility that supplies them own the power plants necessary to do so, or their landlord own a decent building. This mentality pervades the whole ecology movement. It is the mentality of all of its members insofar as they both prevent the development of energy supplies and denounce the producers of energy for not producing enough. 23

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Let us turn to the second version of the argument that the oil companies were responsible for the shortage: the claim that they created it for the purpose of eliminating the independent gas stations by denying them supplies.

It may very well be the case that the oil companies did cut off or discriminatorily reduce supplies to the independents, as widely reported. My own personal experience does not confirm this, but I am willing to believe it—not because it was reported in the press, but because it would have been a logical consequence of the shortage. Given the existence of the oil shortage, every oil company that owned gas stations had the following choice: either it could reduce supplies to its own gas stations, where its own capital was invested and stood to suffer loss if the stations had to close or restrict operations; or it could reduce supplies to gas stations owned by others, where it was other people’s capital that was invested and would suffer loss. Naturally, if an oil company—or anyone else—is confronted with the choice of having to lose its own capital as a result of some absurd government action, or allowing the loss to fall on the capital of someone else, it will choose the latter. And there is no moral reason why it should not. It is no one’s moral obligation to offer up his wealth to the government’s destructionist policy so that he may suffer his “fair share” of the damage it inflicts.

I must point out that if it were not for the controls and the shortage, the oil companies and the independents would have enjoyed a perfectly harmonious, mutually profitable relationship, as they always did in all the years before the controls and the shortage. An oil company benefits from the existence of independent stations willing to sell its gasoline, and has absolutely no reason to try to undermine them, but every reason to try to promote them. Its benefit is that it can sell more gasoline without having to supply the capital necessary to buy or build gas stations. Even if the oil company owns some of its own gas stations, it still benefits from selling to independents—in just the same way that a company like Häagen Dazs or Carnation benefits by being able to sell its ice cream through retail outlets it does not own. The benefit is wider marketability of the product. An oil company benefits by selling to independent stations even if they are in direct competition with stations it owns, because it is better that it supply the competing stations than that some other oil company do so—if that happened, it would still have the same competition, but it would sell less gasoline. In the absence of price controls, even the physical scarcity of oil would not have stopped the oil companies from selling to the independents. They would have been glad to sell whenever an independent was in a position to pay a price higher than their own stations could afford.

The Conspiracy Theory of Shortages

I cannot help noting that this whole argument about the oil companies being out to eliminate the independents (or even just being out to build the Alaskan pipeline), and allegedly staging a nationwide, worldwide crisis to do it, introduces a strange element into the discussion. That is the element of alleged secret plots, dark conspiracies, evil forces, and all the rest of that syndrome.

Strange to say, this kind of argument is much more prevalent than one might imagine. It is present in implicit form whenever anyone asserts that a shortage, whether of oil or anything else, is “contrived.” This view of things is not only ignorant of all the consequences of price controls, but it implies the existence of a secret conspiracy. It assumes that price controls themselves create no problems, but that the problems are created by the evil of private firms who combine together secretly and arbitrarily to produce the consequences we have seen can result only from price controls.

In view of all that we have proved about shortages in general and about the oil shortage in particular, I believe I am justified when I say that these arguments really deserve no greater intellectual respectability than the fear some unfortunate people have of Martians or the evil eye. Certainly, they should not be taken seriously by the

media or by public officials, as, unfortunately, they have been. It is the intellectual and moral responsibility of the media and the public officials to stop engaging in slander based on ignorance and fear, and to acquire the enlightenment provided by economic science.

Rebuttal of the Charge That Private Firms

“Control” Prices

A rather vicious argument has been advanced as a justification for the imposition of price controls. This is the argument that private firms already “control” prices, only they “control” them in their own selfish interest. Instead, it is urged, the government should control prices, for it will do so in the “public interest.”

This argument was repeatedly presented in television commercials during the campaign for the 1976 Democratic presidential nomination by one of the leading contenders, Representative Morris Udall. Representative Udall repeatedly asserted that he believed that instead of the price of oil being “controlled” by the oil companies, in their selfish interest, it should be controlled by the president (i.e., Morris Udall), in the public interest.

The reason that Representative Udall and others believe that private firms “control” prices is that they can observe the producers of manufactured or processed goods, and also retailers and many wholesalers, engaged in the setting of prices. For example, these businessmen (or their employees, acting under their instructions) can be observed sending out price catalogs and price lists, and also posting prices on signs and writing them on tags. To set prices in this way is, according to Representative Udall and others, to “control” prices. The essential characteristic of a controlled price, on this view, is that someone sets it. It is considered secondary and inconsequential who sets it—whether a private businessman or a government official. Indeed, since prices do not create themselves, it is difficult to understand how, on this view, any price can avoid being described as “controlled.”

The distinction seems to be that a price is not considered controlled if it is formed in markets so broad—like the organized exchanges for common stocks and commodity futures—that it is difficult to trace from precisely whom any given price quotation emanates; such price quotations have the appearance of being formed independently of any definite individual. If, on the other hand, price quotations emanate regularly from the same, easily identifiable source—such as a steel mill’s published price at which it stands ready to ship steel, or a candy store’s sign announcing the price at which it stands ready to sell candy bars—the price is declared to be “controlled.” (Often, the word “administered” is used as a synonym for “controlled.”) The supporters of this idea rarely mention the fact that they believe candy stores and barbershops and the like are engaged in “price control”— they confine their attacks to large firms, like steel companies and oil companies, where they can count on envy and the existing hostility to big business—but that is the logic of their position.

The viciousness of this doctrine is that it evades and seeks to obliterate the fundamental and radical distinction between private action and government action. 24 Private citizens, and this, of course, includes private corporations, have no authority to resort to physical force against other people. If they do, they are in violation of the law and will be punished. Private action, therefore, is essentially voluntary in character—that is, it can only occur by peaceful means, with the mutual consent of all involved. Government action is totally different. The government has legal authority to resort to physical force—e.g. to arrest, fine, imprison, and even execute people. All government actions rest on this authority. There is no such thing as a law (or a ruling, edict, or decree) that is not backed by the threat of physical force to assure compliance.

Let us see what difference these facts make to whether prices are set by private firms or by the government. When prices are set by private firms, they are set with regard to the mutual self-interest of the buyer and seller, including the need to take into account the threat of competition or potential competition. Thus, a seller must ask prices that are not only high enough to enable him to stay in business and make the best possible profit he can, but, simultaneously, that are low enough to enable his customers to afford his goods and too low for other sellers or potential sellers to try to take away his market.

When the government sets prices, its prices are backed by the threat of physical force, and are necessarily against the mutual self-interests of buyers and sellers. The government invariably tries to sacrifice either the seller to the buyer (by imposing prices that are too low), or the buyer to the seller (by imposing prices that are too high). In the one case, it succeeds in destroying the sellers, leaving the buyers without suppliers. In the other case, it succeeds in destroying the buyers, leaving the sellers without customers (or the workers without employers).

This is the difference that is made by whether prices are set by private firms or by the government. This is the difference that Congressman Udall’s usage of the term “price control” evades and seeks to obliterate.

Private firms do not and cannot control prices because they have no power to resort to physical force. Only the government can control prices—i.e., only the government can use force to set prices in violation of the mutual self-interests of buyers and sellers. Price control means not the setting of prices, but the setting of prices by the government. 25

PART B

FURTHER EFFECTS OF PRICE

CONTROLS AND SHORTAGES

1. Consumer Impotence and Hatred Between

Buyers and Sellers

Once price controls result in shortages, their destructive effects are greatly increased. The combination of price controls and shortages not only deprives the consumer of the power to make it profitable for sellers to supply the goods he wants, but of all economic power of any kind over the seller. Instead of being a valued customer, whose patronage or lack of patronage makes a difference to the seller’s profit or loss, the buyer is reduced to the status of absolute insignificance, totally at the seller’s mercy. His position is much worse, in fact, than if he were dealing with a protected legal monopolist.

Consider. If a shortage exists, and a buyer is dissatisfied with his supplier, he dare not leave him, because he has nowhere else to go. In a shortage, even if there are many other suppliers of the same good, each of them has his own waiting line or waiting list, and, as a result, the dissatisfied customer of any one supplier cannot count on actually being supplied by any other supplier. The other suppliers, therefore, do not represent a real alternative for him in a shortage. Consequently, no matter how many sellers of a good there may be, price controls and shortages place each of them in the position of being the only one. In addition, just as in the case of a protected legal monopolist, these sellers are immune from potential competition. (The threat of potential competition, in a free market, would keep in check the occasional sellers who were in the position of being sole suppliers.) Potential competition is ruled out because the industry is forced to operate at a rate of return that is not competitive, and perhaps even at an outright loss. As a result, no outside firm would want to enter such an industry. 26

The situation for the customer is worse than if he were dealing with a protected legal monopolist, because under price controls and shortages, the seller who surpasses a customer’s limits of tolerance and succeeds in driving him away does not lose anything by doing so. This is because for each customer who is driven away, there is a multitude of others eager to take his place. The seller simply sells to someone else who otherwise would not have been able to buy or not buy as much as he desired. This goes beyond the conditions faced by a protected legal monopolist, because such a monopolist does not have a reserve of unsupplied potential customers willing to buy on just as good terms as his present customers. If such a monopolist drives away his present customers, he can find new ones only at lower prices. A protected legal monopolist who has any sense, therefore, will not do this. He will value his customers, because he knows that he cannot afford to lose them without harming himself. But under price controls and shortages, the seller is free to regard his customers as absolutely valueless—as being instantaneously replaceable by others drawn from waiting lines or waiting lists without any loss to himself.

By the nature of the case, shortages lead sellers to regard customers not only as valueless, but as a positive nuisance—as a source of trouble and expense, not a source of livelihood. This occurs because, in fact, under a system of shortages and waiting lines, that is just what customers become. Under such a system, when a seller renders a customer some service or goes to some expense on his behalf, he is no longer doing it for the sake of gaining or keeping the customer’s business and thereby earning his own livelihood, because having the customer’s business no longer depends on performing the service or incurring the expense. The seller can have the customer anyway, or, if not that customer, then any one of ten or a hundred or a thousand other customers. If the seller is to continue to provide the service or incur the expense for the sake of the customer, he can only do so out of a sense of altruistic duty, not out of the sense that in serving the customer he serves himself.

Thus, price controls and the shortages they create take the profit out of serving the customer and the loss out of not serving him. They break the harmonious union of the self-interest of buyer and seller that prevails in a free market and replace it with an altruistic relationship between the two. In this relationship, the customer is reduced to impotent pleading for the customary service and customary quality that the seller no longer has any economic motive to supply. Indeed, all of the seller’s motives, both economic and noneconomic, now work in the direction of reducing the quality of his product and the service associated with it.

The seller’s economic motive lies with reducing quality and service because by doing so he reduces his costs and perhaps his own labor, and he does not have to fear any reduction in his revenues. For the same reason, employees feel free to work less hard in serving customers. Their poor performance no longer threatens their employer’s revenue, and so he is no longer motivated to make them produce high quality products and to treat customers properly. (Thus, even under price controls, there is a tendency for customers to get what they pay for. To the extent that they pay prices below the potential freemarket prices, they tend to receive products that are below the level of the products they would have received in a free market.)

The fact that price controls inflict actual harm on the sellers, and the fact that this harm is inflicted for the avowed purpose of benefitting the buyers, introduces a noneconomic element into the attitude of many sellers. They see themselves as being sacrificed for the benefit of their customers, and they may actually come to hate their customers as a result of it. In some cases it is possible that they may derive actual pleasure from the reduction in quality and service that they impose on their customers.

Price controls and shortages, in fact, launch a spiral of mutually reinforcing hatreds between buyer and seller. The buyer arbitrarily demands the quality and service he is accustomed to, even though he is not paying the necessary price any longer. The seller has no economic reason to comply with these demands, but, on the contrary, has both economic and psychological reasons not to. The buyer then views the seller as an omnipotent tyrant whom he must beg for favors or threaten with reprisals in order to obtain what he wants. The seller views the buyer as a hysterical petty chiseler seeking values without payment. To the degree that the accustomed quality and service are not forthcoming, the buyers become more shrill and insistent in their demands, and the sellers become correspondingly more resistant.

This principle—of deterioration of quality and service accompanied by mutual hatred between buyer and seller— was illustrated to some extent in the gasoline shortage of early 1974. Suddenly, service station attendants who had always cleaned windshields and eagerly volunteered to check under the hood ceased to do so. Whereas before they had always been courteous and polite, seeking to encourage as much repeat business as possible, they now became surly and rude. The customer, who had always been king at the gas station, as everywhere else, suddenly became a useless pest waiting in line to have his tank filled and causing unnecessary labor to gas station attendants. The breakdown of the normal harmony of interests between buyer and seller, and its replacement with open hostility, was strikingly illustrated in a New York Times’ “Quotation of the Day.” (I quote first the statement quoted by The Times and then its description of the person and circumstances surrounding the quotation. I omit the individual’s name, in order to spare him possible embarrassment.) “‘If he’s that stupid, he waits in line an hour and doesn’t know the rules, I let him get to the pump—and then I break his heart.’— . . . a service station attendant in Elizabeth, N.J., where gasoline rationing rules went into effect yesterday.” 27 (For the benefit of readers who may be unfamiliar with the circumstances, what the attendant let unsuspecting motorists wait in line an hour to find out was that they were there on the wrong day: their license plates ended with an odd

number when they should have ended with an even number, or vice versa.)

The shortage of gasoline did not last long enough to make hatred between motorists and service station attendants become a regular feature of life. With the ending of the oil shortage in the spring of 1974, normal relations were restored, and the conditions of early 1974 were soon largely forgotten. A more enduring and, therefore, probably more significant example is afforded by the relations between landlords and tenants in places like New York City, which has had almost continuous rent control since early in World War II. In New York City mutual hatred between landlords and tenants is commonplace. It has become the norm. Nothing is more frequent than complaints about things landlords do not do, unless it is complaints about things they are trying not to do. For example, depending on the particular circumstances, landlords do not provide, or are trying to avoid providing, such services as doormen, painting, repairs, and even heat. Tenants regard all of these things as theirs by right, and hate the landlords for not supplying them or trying not to supply them. Landlords, on the other hand, often regard the tenants as people who want to live without paying the proper rent. And, in many cases, while they watch the real value of their investments shrink to zero, they observe tenants able to afford expensive automobiles and adopt a style of life that is above their own— made possible by the low, controlled rents they pay. In such circumstances, there are landlords who derive positive enjoyment from such things as providing no heat, as well as save money by it.

Of course, it should be realized that there are also many cases—and undoubtedly a far greater number—in which the controls simply make it impossible for a landlord to provide many things, even if he wants to for the sake of keeping up his building, such as a new boiler or wiring system or any major repair or improvement. The controls often make these things impossible by leaving the landlord with too little capital to make the necessary investments. In the long run, controls must produce a progressive elimination of services even if landlords have the best will in the world.

How Repeal of Rent Controls Would Restore

Harmony Between Landlords and Tenants

The hatred between landlords and tenants would disappear in a rental market that was free of controls. Such a market would restore economic power to the tenants: it would give tenants the power to make landlords serve them out of self-interest.

Consider how a free market would bring this about.

The first effect of the establishment of a free rental market would be a jump in the previously controlled

rents. This jump in rents would eliminate the shortage of rental housing. Immediately, even before any increase in the supply of rental housing could occur, the rise in rents would level the quantity of living space demanded down to equality with the limited supply that exists. In fact, the quantity of living space demanded would be reduced to a point somewhat below the supply that exists: landlords would have some vacancies on their hands at freemarket rents. Precisely these vacancies are what would restore to tenants their economic power over landlords. At freemarket rents, each tenant would be able to choose from a large number of apartments available in his price range. If he did not like the service his present landlord gave him, he would simply move when his lease expired. He would not be in the position of having to regard his present apartment as the only one in the world, and feel obliged to stay no matter how bad conditions in it became. By the same token, his landlord would no longer be able to count on easily replacing him. At freemarket rents, his landlord would not have a waiting list of potential tenants, but vacancies on his hands. If he were to act in such a way as to make too many tenants move, he would either be unable to replace those tenants or he would have to reduce his rents below the general market in order to attract replacements. In this way, a landlord who did not satisfy his tenants would suffer financial loss. The landlord’s self-interest would once again make him want to gain and keep tenants. Landlords would once again begin to compete with each other in terms of improved quality and service. They would have to, because they would need tenants once again, while tenants would no longer need any particular one of them.

2. The Impetus to Higher Costs

A major consequence of price controls and shortages is that they increase costs by means of creating various inefficiencies.

For example, in those cases in which goods come in a variety of models and price ranges, such as television sets, cars, lawn mowers—most goods—they create an incentive for producers to eliminate the more economical models while cutting corners in the production of the more expensive models. The reason this occurs is that, on the one hand, the buyers are able and willing to pay the higher prices of the more expensive models rather than do without the good altogether, and, on the other hand, corner cutting can generally be carried out more easily and with less serious results on the upper end of a product line than on the lower end. The process is actually a disguised way of raising prices and restoring profits. But it is a very uneconomic way of doing so, because, as a result of it, many buyers end up having to pay more for more expensive models that they don’t really need or want than they would have had to pay in a free market for the models they really do want. For example, someone seeking a sixteen-inch black-and-white television set may end up having to buy a nineteen-inch color set, because that’s all that’s available. At the same time, the buyers who do want the better models find they are not as good any more. 28

This process is a corollary of the decline in quality and service discussed in the previous section. And as soon as a shortage becomes severe enough, quality and service are cut to the point that buyers are offered models that would never appear in a free market in any price range. What happens is that sellers are led to cut corners in order to make relatively small savings to themselves and which have a great impact on the buyers. For example, situations can exist in which it is advantageous to a seller to save a few cents in manufacturing costs that later imposes many dollars in repair costs on the buyer. The harm inflicted on the buyers does not cause the sellers any economic loss, because at the controlled price there is a surplus of buyers eager to buy even a very inferior product.

In the same way that price controls and shortages make it impossible for a consumer to select his model on the basis of cost, they also make it impossible for a businessman to select his methods of production on the basis of cost. For one or more of the factors of production he requires may simply be unobtainable, because a price control has created a shortage of it. Under price controls, businessmen must select those methods of production for which the means happen to be available, and not necessarily those which have the lowest costs. The inability to find the right factors of production, of course, also frequently results in a decline in the quality of products as well, and should be viewed as a further and major cause of declining quality. The very deterioration of quality and service is itself a powerful source of higher costs both to businessmen and consumers, as I have already indicated. If, for example, a machine is produced or serviced in an inferior way, then even if its price remains the same, it will cause higher costs of maintenance and repair and may have to be replaced sooner. The same obviously applies to many consumers’ goods. If a television set lasts only half as long and has to be repaired twice as often, it is a lot more expensive to own, even though its price remains the same.

Shortages of supplies and the mere threat of shortages themselves directly raise the costs of production. The effect of a shortage of a factor of production is to delay production. This causes the capital invested in all the other, complementary factors of production that depend on it, to have to be invested for a longer period of time

than would otherwise be necessary. For example, a shortage of building-nails causes capital to be invested in half-finished houses and in piles of lumber for an unnecessary period of time. Since interest must be paid on capital for the full time it is invested, the effect of all such delays is to raise the interest cost of production. Similarly, the mere anticipation of shortages of supplies leads businessmen to hoard supplies of all types. This requires that production be carried on with a larger capital investment—in the additional stocks of supplies and in facilities for storing them. And this, of course, in turn, means extra interest costs and extra costs on account of the storage facilities. Finally, there is the loss of the valuable time of executives in searching for sources of supply and in performing all the paperwork required to comply with the government’s price controls and any associated regulations, such as rationing.

It should be noted that shortages and the threat of shortages also directly raise costs to consumers. Consumers too suffer effects analogous to wasted investment and the need for more investment. For example, consumers who could not obtain gasoline could not use their cars or enjoy their country homes until such time as they could obtain gasoline. To that extent, the money they had spent for these complementary consumers’ goods represented a kind of wasted investment. In addition, of course, consumers too are led to hoard supplies and thus to tie up larger sums of money in stocks of goods and, quite possibly, incur additional costs on account of acquiring extra storage facilities—for example, extra home freezers, if there should be the threat of a food shortage. Finally, one must mention the wasted manhours spent in waiting lines during every shortage, which, while not a money cost, are nonetheless a real hardship and burden and can well be at the expense of actual working time.

To some extent, the rise in production costs that price controls and shortages bring about may come out of profits. But it certainly does not always do so—as, for example, when it is a case of concentrating on the production of more expensive models that have correspondingly higher controlled prices. Moreover, it is possible for most or even all of the rise in costs not to come out of profits—at least, not out of nominal profits. For the government may very well follow a policy of allowing prices to rise insofar as the producers can prove a rise in costs. This was the case to a large extent in World War II. During World War II, most defense contracts were written on a cost-plus basis—that is, the government paid defense contractors their costs plus a percentage of their costs as profit. The same principle seems often to have been applied in setting the price controls on civilian goods. This procedure, it should be realized, is tantamount to the positive encouragement of extra costs, because it makes the incurrence of extra costs the way to raise profits. It thereby totally perverts the profit motive from being the driving force of greater efficiency to being a driving force of greater inefficiency.

By their very nature, price controls pervert the operation of the profit motive. One must charge to their account not only all of the actual inefficiencies they create, but all of the potential improvements in efficiency they prevent. Price controls create a situation in which it is no longer necessary to reduce costs or improve quality in order to raise profits. In a free market, the price every firm receives is the very best it can obtain under the prevailing state of the market. A firm has the legal right to ask a higher price than this in a free market, but does not ask such a price because it would drive away too many customers: its customers would turn to competitors, and new competitors would probably appear; or, even if there were no close competitors, its customers would simply buy too much less of its type of product to make a further rise in price worthwhile.

Thus, in a free market, a firm must accept the fact that its price is limited by forces beyond its control. In order to increase its profits, it cannot simply raise its price—it must reduce its costs of production or improve the quality of its products to attract new buyers. That is final. There is simply no other choice. But under price controls, the price a firm receives is not something that is imposed upon it by an unyielding external reality, to which it has no choice but to adapt its own conduct. The price it receives can be changed in its favor—if only it can prevail upon the officials in charge of the price controls to relax them, or if it can find ways of evading them. Thus, the firm’s focus necessarily switches. Instead of being focused on reducing costs and improving quality as the ways of increasing profits, it becomes focused on ways to have the price controls relaxed or to evade them. This alone represents a radical change in the way a firm directs its talents and energies.

Furthermore, as we have seen, firms lose the incentive to reduce costs or improve quality. Price controls and the shortages they create place these things beyond a firm’s power. Even if it wanted to, a firm has no power to reduce its costs or improve its quality when shortages prevent it from obtaining the appropriate means of producing its products or cause the quality of those means to deteriorate. But, of course, even if it had the power, there is simply no reason under price controls and shortages for a firm to reduce its costs or improve the quality of its products. There is no reason to improve the quality of its products, because its customers will snap up goods of lower quality than it now offers. It has no reason to reduce its costs (except at the expense of quality) in an environment in which customers are eager to pay prices that

would cover substantially higher costs and in which, besides, it has little or no prospect of profiting from any improvements in efficiency it might achieve.

This last is the situation of every price-controlled firm in a period of inflation, insofar as its suppliers are still free to raise their prices or to impose higher costs by virtue of declines in the quality of their products or services. Such phenomena will raise the costs and destroy the profitability of a firm that must operate under price controls, no matter what it does to control its costs by means of becoming more efficient. To the extent that it succeeds in retarding the rise in its costs through greater efficiency, the price-control authorities will use that very fact to deny its need for a price increase. The only effect of achieving greater efficiency in such a situation is to postpone the day that one is permitted to obtain relief by raising one’s prices. In other words, normal cost reductions, based on improvements in efficiency, simply cease to pay, even if they are still within the firm’s power to make. The only cost reductions that pay under price controls are the ones that can be made effortlessly, namely, cost reductions at the expense of quality—the kind of cost reductions that would not pay in a free market.

In sum, price controls and shortages thoroughly pervert or destroy the operation of the profit motive. In place of profit incentives to improve quality and reduce costs, they make it possible to profit by means of reducing quality and allowing costs to rise. For they destroy the resistance of buyers to declining quality and to higher prices to cover higher costs. Indeed, they often necessitate declining quality and positively encourage higher costs insofar as they entail cost-plus pricing.

The Administrative Chaos of Price Controls

It should be realized that the willingness of the government to allow higher controlled prices on the basis of higher costs of production introduces a significant complication into the administration of price controls. The complication arises because different parts of the supply of the same good will have different costs of production. As a result, the government must set a number of controlled prices on the identical good, depending on the particular cost of production incurred to produce the particular batch of goods in question. This procedure is generally accompanied by further procedures, all of which help to make price controls an administrative nightmare.

What the government does is to allow producers to sell to distributors (or to further processors) at varying prices, corresponding to their varying costs. The distributors, however, are required to sell to the ultimate consumers at a uniform price, based on an average of the varying costs to them as a group. By itself this procedure would threaten some distributors with financial ruin while offering other distributors the prospect of correspondingly higher profits. For all distributors must sell at the same price, while their costs may be significantly above or below the average on the basis of which that price is set. In order to deal with this problem, the government must assign to each distributor his “fair share” of lowcost and high-cost goods, or force the distributors to agree to some scheme of mutual compensation.

This sort of situation existed in the oil industry when it was under price controls. Oil produced from wells that had been in operation prior to the imposition of price controls in August of 1971, was classified as “old oil” and controlled at a price of $5.25 a barrel. Oil produced from wells brought into production subsequent to that date was called “new oil” and was controlled at approximately twice that price. Those firms that were supplied mainly with “old” oil were forced to compensate the firms that had to rely mainly on “new” oil, or on imported oil, which, since early 1974, was not subject to controls at all and (prior to the Iranian revolution of 1979), sold for about $14.50 a barrel. The compensation arrangement resulted from the fact that all the oil companies had to sell at essentially the same prices to consumers, and the consumer prices were based on an average of the price of old, new, and imported oil. Under this arrangement, some oil companies were forced to turn over hundreds of millions of dollars, called “entitlements,” to other oil companies.

The entitlement system was not only administratively chaotic, but actually represented an expropriation of the wealth of American oil companies for the benefit of the Arabs. Under it, the profits that were made by refiners that bought “old” oil at $5.25 a barrel were transferred largely to those refiners that bought Arab oil at $14.50 a barrel. This meant that money that should have gone to purchase American oil was instead used to finance the purchase of Arab oil. It was literally a system for keeping money out of the hands of American producers and putting it into the hands of the Arabs. 29

3. Chaos in the Personal Distribution of

Consumers’ Goods

In the last chapter, we saw that, in a free market, consumers’ goods in limited supply are distributed to the individual consumers in accordance with a combination of their relative wealth and income, on the one side, and the relative strength of their needs and desires for the goods, on the other. 30 Price controls and shortages totally disrupt this principle of distribution. What they substitute is not another principle, but merely the rule of the random, of the arbitrary and the accidental—the rule of chaos.

One should think back to the gasoline shortage and consider what determined the distribution of gasoline. It was a matter of luck and favoritism. Gasoline went to those who happened to be on the spot when deliveries were made to gas stations, or who had the time to waste waiting hours in line or following gasoline delivery trucks around. It went to those who happened to be friendly with service station owners or the employees of service stations. Both the wealth and the needs of the buyers were made irrelevant. The country’s most productive businessmen were placed on an equal footing with welfare recipients: the value of their higher incomes was simply nullified. It was just a question of who arrived first or who had the right friends. By the same token, people whose very livelihood depended on gasoline were in no better position to obtain it than people wanting it for the most marginal purposes. Again, it was just a question of who got there first or who had the right friends.

Rent-controlled apartments are distributed in just the same way. If meat were placed under price control, it would not be long before it too was distributed in this way. The distribution of any good subjected to price controls becomes chaotic just as soon as the controls produce a shortage.

4. Chaos in the Geographical Distribution of

Goods Among Local Markets

We already know that price controls prevent an area that has an urgent need for a product from obtaining it by bidding up its price in competition with other areas. When price controls are joined by shortages, a further major element of chaos is introduced. Under the combination of price controls and shortages, not only is the price of a good prevented from rising, but also, paradoxically, it is prevented from falling.

Where a shortage exists, an increase in the supply of a good, or a decrease in the demand for it, does not reduce the price; it merely reduces the severity of the shortage. Where a shortage exists, an additional supply merely makes it possible for someone to buy at the same—controlled—price who previously could not do so; likewise, a decrease in demand merely means a reduction in the number of those contending for the supply who must go away empty-handed. The price does not fall in such circumstances because it is already too low, as a result of price control.

The significance of the fact that prices can neither rise nor fall is that if price controls and shortages exist in various local markets, producers are in a position to sell a larger quantity in every such market without any reduction in the price in that market or, therefore, in the profitability of sending supplies to it. All that they have to do is find an additional supply of the good to send. What this situation makes possible, in essence, is that producers can send their goods practically anywhere, in widely varying proportions, and it doesn’t matter to them. If they send too little to some areas, the price controls in those areas prevent prices and profitability from rising and halting the drain. Meanwhile, in the areas into which they are sending too much, shortages prevent prices and profitability from falling and stemming the inflow. In a word, the geographical distribution of a good simply becomes random and chaotic, disconnected from the consumers’ needs and purchasing power.

Consider the following case, based on the experience of the gasoline shortage. The price control on gasoline created a shortage in the whole northeastern region of the United States. Almost every state and locality in that region had its own individual shortage. In this context, it largely ceased to matter to the oil companies how their gasoline was distributed among the various areas in the region. Suppose, for example, that they sent a million gallons less a month to New Jersey and a million gallons more a month to Connecticut. It didn’t matter to them. The price of gasoline in New Jersey and the profitability of sending it there could not rise even if New Jersey received hardly any gasoline at all. Price controls prevented it. At the same time, the price of gasoline in Connecticut and the profitability of sending it there could not fall—until the shortage in Connecticut was totally eliminated. Of course, just the reverse could have occurred. A million gallons less a month could have been sent to Connecticut, and a million gallons more a month could have been sent to New Jersey. Price control would have prevented any rise in the price and profitability of sending gasoline to Connecticut; and, so long as it existed, the shortage would have prevented any fall in the price and profitability of sending gasoline to New Jersey.

This indeterminacy introduced by price controls explains how some areas can suffer relatively mild shortages, and other areas very severe shortages, and how their positions can easily be reversed. The significance of this is that price controls not only create shortages, but make it a random matter how the burden of those shortages is distributed. In the gasoline shortage, for example, it would have been possible for the various areas to share the burden of the overall shortage in any proportions. All might have suffered more or less equally, or some particular areas might have borne almost the entire shortage, while others suffered almost none at all, or any intermediate situation might have existed. The actual chaos that did exist fully accords with this principle.

Precisely how the burdens are distributed is the result of accident. In the gasoline shortage, the main accidental

factor was that the Northeast happened to be the region most heavily dependent on imports, and so it bore the far greater part of the nationwide burden—given the fact that price controls prevented the people of the region from bidding up the price of gasoline and thus making the shipment of replacement supplies profitable. Within the Northeast, further accidental factors played a role, such as the very time of the year when the controls were imposed. To understand this last point, imagine that the controls are imposed in the summertime. In the summer, there is a large demand for gasoline in many resort areas. As a result, the wholesale price of gasoline in these areas is at a seasonal high in relation to the wholesale price in many city areas. It is high enough to cover such special summertime costs as may be entailed in having to bring in supplies from more distant refineries than is necessary at other seasons, when the local demand in the resort areas is smaller. The imposition of controls freezes this seasonal price relationship and carries it forward to the fall and winter, when there is a different pattern of demand, and when there should be a different set of gasoline price relationships to reflect it. Given the perpetuation of the summertime price relationships, what happens is that gasoline continues to be heavily supplied to the summer resort areas—perhaps to the point of pushing the price there somewhat below the level permitted by the controls. As a result, no shortage whatever exists in these resort areas. The entire shortage is concentrated in the cities. If the controls are imposed in the wintertime, instead of the summertime, then, of course, the reverse situation develops.

Further chaos in distribution can be caused by such things as small bureaucratic adjustments in the price controls. For example, it is quite possible that after the controls are imposed, the officials in charge may make some minor adjustments here and there, such as for the purpose of rectifying the kind of seasonal problems I have just described. In doing this, they can unleash major movements in supply which they may not be aware of causing. Imagine, for example, that they decide to permit, say, a penny a gallon rise in the price of gasoline in one particular major city. If this small rise makes this particular city a relatively more profitable market than other markets, the various distributors will want to sell more heavily in this city; and as long as a shortage exists in the city, they can do so without any reduction in the newly increased price and profit margin. The effect will be that this particular city will tend to be supplied very heavily, perhaps to the point of totally eliminating its local shortage, while supplies will simply disappear from other markets to the same extent.

Frankly, it is impossible to know all the different factors that might suddenly unleash major movements in supply. The essential point is that under price controls and shortages, movements in supply have no effect on price and profitability until a local shortage is totally eliminated, at which point the local price and profitability will begin to fall and the further movement of supplies to that area will stop. Short of that point, massive movements of supply are possible in response to very small differences in profitability. Anything that can create such differences can cause such movement.

5. Chaos in the Distribution of Factors of Production Among Their Various Uses

The discussion of random geographical distribution applies equally to the distribution of factors of production in limited supply among their various uses. If a shortage exists of all the different products that a factor of production is used to produce, then there is a ready and waiting market for more of each such product. More of each such product can be sold without causing any reduction in its price or profitability, until the shortage of that particular product is totally eliminated. All that it is necessary for producers to do is find a way of getting more of any such product to the market.

In this situation, the allocation of a factor of production among its various uses becomes utterly chaotic. A factor of production can be withdrawn from the production of any of its products and added on to the production of any other of its products. The price and profitability of the product in reduced supply cannot rise to halt the decrease in supply. The price and profitability of the product in expanded supply cannot fall to stop the increase in supply, until its particular shortage has been totally eliminated.

Again, the oil shortage provides an excellent illustration of the principle. During the oil shortage there was a shortage of all the different oil products: gasoline, heating oil, jet fuel, propane, kerosene, etc. In these circumstances, it essentially ceased to matter to the oil refineries what they produced. If they took a million barrels of crude oil away from the production of gasoline and added it on to the production of heating oil, they could sell the additional heating oil with absolutely no reduction in its price or profitability, because of the shortage of heating oil. And if they did the reverse—if they took a million barrels of crude oil away from the production of heating oil and added it on to the production of gasoline—they could sell the additional gasoline with absolutely no reduction in its price or profitability, because of the shortage of gasoline. Of course, the price and profitability of the product being cut back could not rise—its price was controlled.

The result was that the production of the various oil

products was made random and chaotic. Practically any combination of products was possible. The only limits were those set by the possible total elimination of particular shortages. For example, gasoline production might have been expanded at the expense of heating oil production up to the point where the gasoline shortage came to an end and any further increase in the supply of gasoline would have forced a reduction in its price. At that point, the whole burden of the combined shortage of gasoline and heating oil would have been borne by heating oil. Or, of course, the reverse could have occurred. Heating oil production might have been expanded at the expense of gasoline production up to the point of eliminating the shortage of heating oil and throwing the whole burden of the combined shortage on gasoline production.

Either of these extremes or any intermediate situation was possible, and not just with regard to gasoline and heating oil, of course, but with regard to all oil products. Any of them might have been produced up to the point of no shortage, or any of them might have suffered a drastic reduction in production. Moreover, the position of the various products could suddenly have been reversed—with the relatively abundant ones suddenly becoming short, and the short ones suddenly becoming relatively abundant. Furthermore, if we add in the existence of geographical chaos, the situation could have been different in different parts of the country at the same time—for example, a severe shortage of gasoline and little or no shortage of heating oil in New Jersey and just the opposite in Connecticut.

The chaos that existed during the oil shortage fully accords with this description. And the same kind of random, accidental factors determined what actually did occur as in the case of geographical chaos. For example, the time of the year when the controls happened to be imposed played an important role in determining to what extent the overall oil shortage fell on heating oil or on gasoline. Controls imposed in the summertime tend to cause relatively abundant supplies of gasoline and a severe shortage of heating oil. This is because they impose the freeze at a time when the price of gasoline is high in relation to the price of heating oil, with the result that it is profitable to go on producing gasoline and not profitable to step up the production of heating oil even after the summer ends.

Conversely, controls imposed in the wintertime tend to cause a relatively abundant production of heating oil and a severe shortage of gasoline. Since our controls were originally imposed in August of 1971, it is not surprising that the first major petroleum product to develop a shortage was heating oil, which occurred in the late winter and early spring of 1973, months before the Arab embargo. (Subsequently, the government took special steps to assure the supply of heating oil, and thereafter the burden of the oil shortage fell more heavily on gasoline and the other petroleum products.)

As in the case of geographical chaos, bureaucratic adjustments in the controls can cause sudden major shifts in supply among the various products of a factor of production. By making the production of any one particular product of a factor of production somewhat more profitable than the others, for example, the officials administering the controls can bring about a sudden expansion in its production up to the point of totally eliminating its particular shortage, while, of course, correspondingly worsening the shortages of other products of the factor in an unpredictable way. And if they suddenly reduce the profitability of a particular item, they can make the supply of it disappear and other items show up in its place, again, in an unpredictable way.

Anything that produces even slight changes in the relative profitability of the various products of a factor of production, whether a bureaucratic change in the price-control regulations, or anything else, can produce major changes in supply when shortages exist. As just one example, imagine that the uncontrolled price of some of the chemical additives used to make gasoline changed. If the prices of these chemicals rose, the profitability of gasoline might suddenly be reduced below that of other oil products. Since the price of gasoline could not rise as its supply was cut back, while the price of other oil products would not fall as their supply was increased, it would now pay to shift as much crude oil as possible away from gasoline production to the production of all other oil products. Conversely, if the price of the chemical additives fell instead of rose, then gasoline production would suddenly become more profitable, and a massive increase in gasoline production would probably occur at the expense of the production of all other oil products.

A principle that emerges from this discussion is that price controls and shortages create tremendous instability in supply. The supply of everything subjected to controls is subject to sudden, massive, and unpredictable shortages.

Hoarding

The chaos in supply caused by controls has a further important consequence, one that I have already noted in other connections, but which deserves some additional elaboration and stress here. This is the fact that shortages and the fear of shortages cause hoarding. If a person cannot count on being able to buy something when he wants it, because, overnight, it may disappear from the market, then he had better try to buy it when he can, so that he will have it available when he needs it. The effect

of this is that price controls and shortages artificially expand the demand for everything even more. Price controls not only expand the quantity of goods demanded by virtue of artificially holding down prices, but also by virtue of creating shortages and then the need to hoard, to cope with the shortages. The demand price controls create for the purpose of hoarding is a demand that does not exist even potentially in a free market—i.e., it is not even a submarginal demand—because it would serve no purpose whatever in a free market. But under price controls and shortages, hoarding becomes a matter of survival and greatly adds to demand.

The effect of this is that the irrationality of price controls goes beyond even what I have previously described. In the second part of the last chapter, I explained how price controls prevent the most vital and urgent employments of a factor of production from outbidding its most marginal employments. I explained, for example, how they prevented truckers delivering food supplies from outbidding housewives wanting gasoline for marginal shopping trips; how they prevented the operators of oil rigs needing oil products from outbidding homeowners seeking oil to heat their garages. Actually, the situation is even worse. Under price controls, the most vital and urgent employments of a factor of production are prevented from outbidding not only its most marginal employments, but, from the standpoint of a free economy, employments that could not even qualify as submarginal; that is, employments for hoarding purposes.

Under price controls and shortages it is entirely possible for people to be unable to get to work, to be without food, or even to freeze to death, not only because they are prohibited from outbidding the marginal employments of the oil, or whatever factor of production it may be, but because products are being hoarded by other people in fear of this very kind of possibility happening to them. The consequence is that price controls and shortages not only sacrifice men’s wellbeing and very lives to the unearned, fleeting gains of other men, but, very largely, to a hoarding demand created by price controls themselves. In effect, men are sacrificed to the controls themselves.

6. Shortages and the Spillover of Demand

The effect of a shortage of any particular commodity is to cause the unsatisfied demand for that commodity to spill over and add to the demand for other commodities.

We have already had a glimpse of this principle earlier in this chapter, in our discussion of people ending up having to buy more expensive models of goods as the result of the unavailability of less expensive models. For example, as we saw, the man who wants a sixteen-inch black-and-white television set may end up having to buy a nineteen-inch color set, because there is a shortage of the sixteen-inch sets and he cannot obtain one; so he settles for this substitute.

This principle applies not only to close mutual substitutes, such as different models of the same good, but also to goods which are totally dissimilar in their nature and function. For example, if our prospective buyer of a television set cannot find any model television set that satisfies him, he will eventually decide to buy some other kind of good. He may decide to buy a suit or to apply the sum he wanted to spend for a television set to the purchase of a better car or to any one of thousands of things or combinations of things. In this way, the money that price controls prevent from being spent in one channel is diverted to another channel.

This diversion of demand, it should be realized, takes place almost immediately. For example, even if our prospective television set buyer decides to add the price of the set to his savings, in the hope of being able to find the set later on, still, the demand for other things will rise almost immediately. This is because he will almost certainly deposit his savings in a bank, which will lend them out. As a result, a borrower will be put in the position of being able to buy something with the money our man had wanted to use for a television set.

The effect of this diversion or spillover of demand depends on whether or not price controls apply to the second-choice goods that people turn to. If these goods too are controlled, then the effect tends to be a worsening of the shortages of these goods. I will not elaborate on this consequence, however, until we begin our discussion of universal price controls, in the next part of this chapter. If price controls do not apply to the second-choice goods, then the effect of the spillover of demand is simply to drive the prices of uncontrolled goods still higher and to make the profitability of their production in comparison to that of the controlled goods still greater.

This principle concerning the effects of the spillover of demand in a partially price-controlled economy has a number of important implications.

Why Partial Price Controls Are

Contrary to Purpose

First, the principle shows that “selective” or partial price controls, that is, price controls imposed merely on certain goods only, are contrary to any rational purpose the government might have in imposing them. 31 The government imposes controls on the goods which it believes are the most vital. It imposes the controls because it believes they will enable people to obtain these goods who otherwise could not have obtained them

because of too high a price. The government leaves uncontrolled those goods whose production it considers to be relatively unimportant. The effect of this policy, however, is to destroy the production of the very goods the government regards as vital, while encouraging the production of the goods it considers unimportant. This occurs because the price controls restrict or altogether destroy the profitability of producing the controlled goods. At the same time, the shortages the price controls create cause demand to spill over into the markets for the uncontrolled goods and thereby make their production still more profitable.

For example, the government might control the price of milk on the grounds that it is a vital necessity, and leave uncontrolled the price of ice cream and soft drinks on the grounds that they are trivial “luxuries,” not worthy of its attention. The effect of this policy is to reduce the profitability of milk production in comparison with these and all other uncontrolled goods. As a result, it brings about a fall in the production of milk; this, together with the increase in the quantity demanded of milk resulting from its too low price, creates a shortage of milk. The effect of the shortage of milk is to cause the unsatisfied demand for milk to spill over into the markets for uncontrolled goods, including, of course, ice cream and soft drinks, whose relative profitability is then further enhanced. 32 The effect of the government’s action, therefore, is to destroy the production of milk, which it regards as necessary and vital and wants people to have, and to promote the production of such goods as ice cream and soft drinks, which it considers unimportant.

Clearly, it would be less illogical if the government imposed controls on the things it considered unimportant and whose production it did not mind seeing destroyed, and left free the production of goods it considered vital. Nevertheless, governments do not do this, and again and again—in the early stages of a war, for example—they impose controls that undermine the production of necessities, while the socalled ash-tray industries and the night clubs and the cabarets flourish. For temporarily at least, these lines of business are left uncontrolled, on the grounds of being unimportant, and are therefore able to benefit from the spillover of demand caused by the shortages of necessities.

How Price Controls Actually Raise Prices

A second implication of the principle that shortages cause a spillover of demand and a rise in the prices of uncontrolled goods is that selective or partial controls cannot hold down the general price level. The expectation that they can is based on the erroneous belief that the problem of inflation consists in the rise of this or that group of prices and can be solved by prohibiting a particular group of prices from rising. The fact is that such controls hold down the prices of some goods only by making the prices of other goods rise all the more.

Indeed, the effect of partial price controls is actually to raise the general price level. Partial controls have this effect, because while they leave aggregate demand and spending unchanged, they reduce the efficiency of production and, therefore, the aggregate amount of production and thus supply. We have seen that they can destroy vital industries, such as the electric power industry and the oil industry, on which the production of all other industries depends. In the course of destroying an industry, they reduce the quality of its products and the service associated with them, thereby raising maintenance and replacement costs for the buyers of the products. We saw also that controls cause resort to unnecessarily expensive models and methods of production, and lead to a system of cost-plus pricing. And we have seen that they create utter chaos in the geographical distribution of the products of a controlled industry and in the combination of the various products that such an industry produces; this disrupts all subsequent production that depends on these industries, and thus reduces aggregate supply. In all these ways, therefore, partial price controls actually raise the general price level.

The Absurdity of the Claim That Price Controls

“Save Money”

A third, closely related implication is that the supporters of price controls are badly mistaken in claiming that any particular price control “saves people money,” and in arguing that the repeal of any given control will “cost” people this or that amount of money. This may be true in the short run for some individuals, who are lucky enough to obtain the goods they desire at below-market prices. But it is never true in the aggregate. In the aggregate, a control saves people money only in the sense of making them spend less for the controlled goods. At the same time, it makes them spend more for the uncontrolled goods. In the aggregate, they do not spend any less money. They do, however, receive fewer goods. Clearly, whatever saving or gain some buyers may have by virtue of controls is always at the expense of a greater loss to other buyers.

Indeed, in view of the fact that controls tend to destroy the controlled industries, the only kind of longrun “saving” they can achieve for anyone, including the people who might temporarily gain from them, is a rather bizarre one. It consists in preventing a person from spending the money he wants to spend for the goods he wants to buy. In this sense, the drivers who could not obtain gasoline at the controlled prices “saved money” on gasoline. Instead of having the gasoline they desperately wanted

and which they valued far above the controlled price, they had money left over to spend on other things which they wanted much less. Such savings are obviously absurd and contrary to purpose. They are comparable to making a person save money by not buying food or medicine, or anything he values more, so that the may have money for something he values less—if he is alive to spend it. Yet this is the only kind of “saving” that controls can achieve in the long run, and it is the only kind of saving they achieve right from the very beginning for whoever suffers from the shortages they create.

As will be shown in the next part of this chapter, total or universal controls—price controls on all goods—may be said to “save people money” in an even more bizarre way than partial controls. By virtue of creating a shortage of everything, and thus making money simply unspendable, universal controls enable people to save money in the sense of having it available for such purposes as papering their walls or lighting their fires with it. And as production declines under universal controls, and the volume of spending that can take place at the controlled prices accordingly drops further, the money that people “save” in this absurd way grows greater.

It follows from our discussion that in the aggregate the repeal of price controls would not cost people anything. If universal controls exist and are repealed, people would spend more money, but this greater spending would represent an exchange of otherwise useless paper for valuable goods, whose production would be greatly increased as a result of the repeal of the controls. If partial controls exist and are repealed, then the effect is a shift in the pattern of spending away from the previously uncontrolled goods to the newly uncontrolled goods. The prices of the former would tend to drop while the prices of the latter would tend to rise. But since the effect of the repeal is an increase in total production and supply, the general price level must tend to fall. For the same total demand with a larger total supply means a lower price level. The repeal of any partial control, therefore, must always tend to reduce the general price level by virtue of its effect of increasing production. It is only the repeal of a control, therefore, not the imposition of a control, that can truly be said to save people money.

Applications to Rent Controls

The principle that shortages cause the unsatisfied demand for controlled goods to spill over into the market for uncontrolled goods and to raise their prices has special application to rent controls as they have existed in places like New York City over most of the period in which they have been in force.

Such rent controls are partial price controls in an even more restricted sense than we have considered up to now.

They are partial controls not only in the sense that they apply only to specific goods, but also in the further sense that they apply only to part of the supply even of these goods. For example, in New York City all housing completed since January 1974 is totally exempt from rent controls. Prior to August 1971, all housing completed since February 1947 had been free of controls, and certain still earlier housing, considered “luxury housing,” had also been exempted. (All this previously uncontrolled housing is now subjected to controls in the form of government limitations on annual rent increases.) Perhaps even more important has been the fact that while rents have been controlled in New York City, they have generally been uncontrolled in the surrounding suburban counties and in most of the rest of the country. Nor have the prices of houses been controlled anywhere.

As a result of the fact that rent control has had only partial application, large numbers of people in New York City have been able to escape its effects. Those who could afford them have been able to find uncontrolled apartments or, in many cases, buy houses, co-ops, or condominiums in the city. Those who could not afford to live in New York City have been able to find places to live outside the city.

i. Internal Passports and Compulsory

Assignment of Boarders

Before considering further the effects of the diversion of demand caused by partial rent controls, it will be well to project the consequences of controls applied to all of these alternatives. In other words, let us project the consequences of a fully price-controlled housing market on a regional and national scale. We will see that some of the potentially most disastrous effects of rent controls have been avoided because of the relatively limited scope of the controls.

If the entire housing market were controlled, housing would be artificially cheap in all of its forms and everywhere. The quantity demanded of all types of housing would therefore exceed the supply. This would be true all across the country. As a result, there would be a shortage of living space and no way around it. People would simply be unable to find space in New York City, and they would be unable to find it in the surrounding counties or anywhere else in the country. There would be people desperate for living space with absolutely no way to obtain it. They would need apartments and houses but with no better chance of finding them than they had of finding gasoline at the height of the gasoline shortage.

What might happen in such circumstances? The answer is two things worth thinking about: The government would contemplate the restriction of the internal freedom of migration. And it would contemplate the assignment

of boarders to private homes and apartments.

As to the first point, it would soon become obvious that in the circumstances of a pervasive housing shortage, the influx of additional people into any area would have the effect of making the local housing shortage worse. Each area would therefore become anxious to keep out as many new arrivals as possible on the grounds of their worsening the local housing shortage. Each area would try to set up barriers to in-migration and try to prevail upon the federal government to keep people where they were. As to the second point, the argument would be made that people cannot be left to sleep in the streets and that in the “housing emergency,” or whatever it might be called, it was necessary for those fortunate enough to have space, to share it with those not fortunate enough to have space.

This state of affairs has actually existed in many countries. For example, it was no accident, but precisely for reasons such as these, that the government of Soviet Russia deliberately restricted the number of inhabitants of its various cities and controlled the internal movement of the Russian population through a system of internal passports. 33 The Communist sympathizers and apologists who boasted about how inexpensive housing was in the Communist countries—extremely limited and wretched housing, it should be noted—did not realize that precisely this was what created a nationwide housing shortage in those countries. They did not realize that the low rents they were so proud of virtually necessitated restrictions on the internal movement of people—even apart from all other factors working in the same direction in the Communist countries. In addition, of course, as the result of the low rents and the consequent housing shortage, families could not take their privacy for granted in the Communist countries. Millions of families were forced to live in communal apartments. Often, two families had to share a single room, separated from each other only by a curtain—just as depicted in the movie Ninotchka.

Fortunately, in the areas of the United States where rent control has existed, such as New York City, people have been able to escape such disastrous effects, because the controls have been confined to a very limited part of the overall housing market. But, even so, the consequences have been severe.

ii. How Rent Controls Raise Rents

Let us pass over quickly the consequences of partial rent controls as they affect the part of the housing supply subjected to them, and then focus on the consequences as they affect the part of the housing supply that is left free of controls.

We know that controls create a shortage of the housing to which they apply because people scramble for apartments at artificially low rents. We know that this fact, coupled with the lack of capital on the part of landlords that results from restricted profits, causes the quality of such housing to decline, in the process unleashing a spiral of mutually reinforcing hatreds between tenants and landlords. Ultimately, as the costs of operating buildings continue to rise, because of inflation, the effect of rent control is to cause widespread abandonments of buildings by their owners. Such abandonments have been going on for many years in New York City. As a result of rent control, there are growing areas in New York City— in the South Bronx, for example—that have been reduced to the status of a primitive village, with people living without electricity and having to fetch their water from public fire hydrants. (Such facts are reported every so often in The New York Times.)

As for the uncontrolled rental housing, we know that the shortage of rental housing that is under controls causes the unsatisfied demand for such housing to spill over and enlarge the demand for uncontrolled rental housing. This phenomenon and its consequences must be examined more closely.

The controls on rents bring space within the reach of people who otherwise could not have afforded it. That is their purpose and that is what they achieve. But to whatever extent the controls make it possible for some people to obtain space who otherwise could not have obtained it, they simultaneously reduce the space that is available for other people, who could have afforded to rent that space in a free market. These other people, of course, must then make their demand for space in a market that is less well supplied. The result is that rents on uncontrolled space in the area rise.

As far as the market is concerned, in addition to causing a diversion of the demand for housing, partial rent controls are equivalent to a reduction in the supply of rental housing. They take part of the rental housing stock off the market by giving it to people who could not afford the market rents. This leaves less of a supply of rental housing for the market and, consequently, increases rents on the diminished supply that is available for the market.

Perhaps the best and clearest way to understand these points is to think once again of the conditions of an auction. So imagine that an auctioneer is holding up two units of the same good. Imagine further that there are three bidders for these units. One bidder, imagine, is willing to bid a maximum of $300 for one of these units, if necessary. Another bidder is willing to go as high as $200, if necessary. The third bidder, assume, can afford to bid no more than $100—that is his maximum limit in the bidding. In a free market, the price at which these two units will be sold will be above $100 and below $200.

The price will have to be above $100 to eliminate the weakest bidder. It will have to be below $200, in order to find buyers for both units. It will tend to be the same for both buyers because there is usually no way to discriminate between them. Let’s assume the actual price turns out to be $150: too high for the weakest bidder, yet low enough for both of the other bidders.

The weakest bidder has been excluded from this market. What must happen if we begin to feel sorry for him? Suppose people begin to feel so sorry for him that they get a law passed that orders the auctioneer to give him one of the units of the supply at a price he can afford— say, $50. In that case, he gets his unit at $50. But now, as a result of this, instead of the auctioneer having two units to auction off in the market, he has only one; the supply available for the market has fallen. And this one unit will now have to sell at a price somewhere above $200 and below $300—say, $250. It has to be high enough now to eliminate the middle bidder instead of the weakest bidder. All that has happened is that one party has gotten part of the supply at an artificially low price and has caused the price on the remaining supply to go high enough to eliminate another party. The party eliminated could have afforded the market price if it were determined by the full available supply. But he cannot afford the market price as determined by the artificially reduced supply. Deprived of the supply that would have been available to him in a free market, his demand is diverted into a competition with the other remaining bidder, which competition, in the nature of the case, he must lose.

This auction example does not differ in any essential respect from the case of partial rent controls. Partial rent controls give part of the supply of housing to some people at below-market rents. To whatever extent these people could not have afforded as much space in a free market as they obtain under rent control, they leave that much less space available in the uncontrolled market. Consequently, rents in the uncontrolled market must rise that much higher—in order to level down the quantity demanded to equality with the reduced supply that is left for the market. For example, if the total rental housing supply in a city is one million rooms, and rent control results in giving half of those rooms to people who could not have afforded them at freemarket rents, then rent control correspondingly deprives other people of those rooms who could have afforded them at freemarket rents. In the process it makes the rents on the uncontrolled half-million rooms rise so high that that diminished number of rooms is all that people will be willing and able to rent in the uncontrolled segment of the market. In other words, rent control makes the open-market rents balance demand and supply at a supply of half a million rooms instead of a million rooms. People are eliminated from the market who could have afforded market rents as determined by the full supply of rental housing. These people cannot afford market rents as determined by the artificially reduced supply of rental housing that results from rent control. Just as in the auction example, when deprived of the supply that would have been available to them in a free market, their unsatisfied demand is made to spill over into a competition with buyers who are able to outbid them for the reduced supply.

Obviously, the larger is the proportion of the housing stock under rent control, the higher must be the rents on the correspondingly diminished supply that remains for the open market. If this principle is understood, it should not be surprising that, for example, New York City, which has the largest proportion of rental housing under controls of any major city in the United States, also has, for that very reason, the highest rents in the nation on housing that is available for the open market.

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The fact that partial rent controls act to raise rents on the uncontrolled part of the housing supply is reinforced by the fact that they increase the costs of providing rental housing. This occurs because the existence of controls on some housing today implies that the housing that is presently free of controls may later on be brought under controls. The threat of being brought under rent controls in the future makes it necessary for landlords of presently uncontrolled buildings to recover their investments more rapidly. For example, instead of looking forward to recovering their investments over a fifty-year period, say, the threat of rent control being imposed may make them want to recover their investments over a ten-year period, or even a five-year period, to be safe. This represents a great jump in the costs of providing new rental housing, and helps to explain why high rents on uncontrolled buildings do not result in corresponding new construction.

Insofar as rent control comes to be regarded as a regular institution, to be imposed at any future time the government may desire, the effect is to make today’s tenants in uncontrolled buildings pay for the spoils of tomorrow’s prospective beneficiaries of rent control. This artificial increase in the costs of new housing, it should be realized, is also one of the reasons why today’s socalled luxury housing is often inferior in many respects to housing constructed in earlier decades. The reason is that it is not genuine luxury housing, but rather cheap housing that must be rented at luxury rates in order to offset the prospective losses that are expected to be caused by rent controls in the future.

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Ironically, even if, however unlikely, rent controls were not expected to be extended to housing that is

currently free of them—indeed, if they were expected ultimately to be repealed—partial rent controls would still prevent the premium rents on uncontrolled housing from being eliminated by means of the construction of new housing. In a free market, it is true, rents tend to equal the costs of constructing and maintaining housing plus only as much profit as is required to yield the going rate of profit. Under partial rent controls, however, the rents on the uncontrolled portion of the market tend permanently to exceed this level, and exceed it the more, the larger is the proportion of the housing stock under controls. It is not only that the larger the portion of the housing stock under controls, the smaller is the supply remaining for the market, which is sufficient reason for the rents on the uncontrolled supply to be correspondingly high. But also the premium profits which such rents might be thought to offer for the construction of new housing are largely nullified by the consequences of the potential repeal of rent control no less than by the prospect of the extension of rent control. Consider. If the supply of uncontrolled housing were increased to the point that the rents on such housing were no higher than costs plus an allowance for the going rate of profit, the danger would exist that if rent controls were ever repealed, rents in the open market would then be driven below cost plus the going rate of profit. For the repeal of rent controls would throw back on the market all of the housing diverted from the market to tenants paying below-market rents. If open-market rents were already no more than equal to cost plus the going rate of profit, this increase in the supply available for the market would drive them below that point.

Thus, so long as they are in force, partial rent controls raise rents on uncontrolled housing, whether landlords expect them to be extended to the uncontrolled housing or to be removed from the housing to which they presently apply.

It follows from the preceding discussion that when partial rent controls are repealed, not only do rents in the open market fall, but the construction of new housing becomes much more profitable at any given level of open-market rents. For the repeal of the partial controls reduces the threat of new housing later on being subjected to controls, and thus extends the period of time over which investments in housing can be recovered. At the same time, the repeal eliminates any fear hanging over the market concerning the possible adverse effects of repeal on profitability. Thus, unless the decline in open market rents is quite drastic, the effect of the repeal of partial rent controls is not only lower open-market rents, but also a surge in the construction of new housing at those lower rents.

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The repeal of partial rent controls and the decline in open market rents that it brings is also accompanied by further substantial reductions in the costs of providing new rental housing, apart from that of a longer period of depreciation and correspondingly smaller annual depreciation charges. The decline in open-market rents on newly constructed buildings and thus in the market value of such properties is accompanied by a decline in the amount of taxes that such buildings must pay at the prevailing rates of property tax. Further declines in property tax on such buildings can occur by virtue of a fall in property tax rates, which is made possible by the rise in rents and property values, and thus property tax collections, in the case of the housing that had previously been controlled.

It is implicit in what I have just said, incidentally, that another of the destructive effects of rent control is a rise in property tax rates. This results from the destruction of the rent-controlled properties’ ability to pay rising taxes in pace with inflation. Thus, the rates are increased on the properties left free of controls and on owner-occupied housing. Also, as the property tax declines as a source of revenue, local sales taxes and income taxes are imposed. They too, and all the unpleasantness that accompanies them, must be laid at least in part at the door of rent control.

iii. The Case for the Immediate Repeal of Rent Controls

The fact that partial rent controls increase the rents on uncontrolled housing is not recognized by the general public. The result is that the higher do partial controls drive rents, the more necessary do people believe rent controls to be; the more desperately do they cling to the existing controls and the more eager they are to urge the extension of the controls. They fear that the repeal of the existing controls would raise all rents to the level of the presently uncontrolled rents, and they believe that the uncontrolled rents are enormous because they are not controlled.

Our discussion shows that the best solution to the problems created by rent controls would be the immediate and total abolition of rent controls, accompanied by constitutional guarantees against their ever being reimposed. This would both immediately reduce rents in the open market and bring about the greatest and most rapid possible increase in the supply of rental housing.

Calling for the immediate abolition of rent control raises the question of what is to become of many of the people who presently live in rent-controlled apartments and who would have to move if rent control were all at once repealed. (In order to have some term to describe these people, let us refer to them as the “beneficiaries” of rent control—provided it is understood that they are

beneficiaries in a short-run sense only, and not genuine beneficiaries.)

Our previous discussion provides the answer to the question of what would happen to these people. In essence, the answer is that they would simply have to change places with an equally large but generally unrecognized class of victims of rent control.

Two facts about the immediate repeal of rent control must be kept in mind: not only would it raise rents to the beneficiaries of rent control, but also, as we have seen, it would simultaneously reduce rents in the open market, because the space presently occupied by the beneficiaries of rent control would be added to the supply in the open market.

What would happen in response to these changes in rents is two related sets of developments, the one affecting the beneficiaries of rent control, the other the victims. Let us consider the effects on the beneficiaries first.

In the face of a jump in their rents, some of the beneficiaries of rent control might have to share apartments or even single rooms with other people, in order to economize on rent. Others might have to move in with relatives. Still others might decide to move to remoter areas of the city, where rents were cheaper, or to leave the city altogether. It should be observed that none of the former beneficiaries of rent control would have to sleep in the street as the result of the rise in the rents they had to pay; they would simply have to occupy less space or live in less favorable locations. These points must be stressed, in view of the hysteria that is often evoked in projecting the allegedly dire fate of these people as the result of the repeal of rent control. 34

Now consider the fact that the apartments vacated by the former beneficiaries of rent control would not remain empty, but would practically all be occupied. For the rents on those apartments, though too costly for the rent-control beneficiaries, would represent a decline in the rents charged in the open market, and would thus come within the reach of new tenants. To use the same figures as in our auction example earlier in this discussion, assume that initially a beneficiary of rent control was paying a controlled rent of $50, while rents in the open market were $250. Now, with the repeal of rent control and the addition of the previously rent-controlled apartments to the supply available in the market, rents in the market fall from $250 to $150. A rent of $150 is too expensive for the former rent-control beneficiaries. But it represents a reduction in rents in the open market and brings apartments within reach of people who could not afford them at the $250-a-month rents caused by partial rent controls.

Let us focus on the new tenants who would occupy the previously controlled apartments. Let us try to figure out who they would be and where they are now. These are people who could afford their own apartments in the city at $150 a month, but not at $250 a month. At $250 a month, they find it necessary to share apartments (or single rooms), to live with relatives, or to live in remote areas of the city or out of town altogether. In other words, they find it necessary to do all of the things the beneficiaries of rent control might have to do if rent control were repealed. Perhaps some readers of this book may know some of these victims of rent control, though they probably have not thought of them in that light before. The victims are young people who must live with roommates, young couples who must live with in-laws, families that cannot afford to live in the city, and so on. These people represent the class of rent-control victims, though they are almost all unaware of that fact and see no connection between rent controls and their own plight. They are fully as numerous as the class of rent-control beneficiaries, and they are already suffering the same kind of hardships as the rent-control beneficiaries would suffer if rent control were repealed.

In fact, these victims of rent control are suffering vastly more hardship than the beneficiaries of rent control would suffer. For if rent control were repealed, the total supply of housing would quickly begin to expand and its quality would improve. In places like New York City, the supply would increase almost overnight, because the abandonment of buildings would cease, and many previously abandoned buildings would be restored. The hardship of the former beneficiaries of rent control would be temporary, because rental housing would once again become an expanding, progressing industry. As time went on, more and more of the former beneficiaries of rent control would be better off than they ever could have been under rent control. In the long run, everyone would be better off. The real answer to the question of what would happen to the present beneficiaries of rent control if rent control were repealed, therefore, is this: In the short run and at the very worst, they would suffer no more, and probably less, than what the victims of rent control have already been suffering for many years. In the long run, what would happen to them is simply more and better housing.

Furthermore, it should be stressed that in the long run, the very idea of someone being a beneficiary of rent control is a self-contradiction. The gains of the beneficiaries of rent control are made possible by the consumption of their landlords’ capital. The tenant who is able to afford a better car, say, or an extra vacation, because of the artificially low rent he pays, is buying that car or vacation at the expense of part of a new apartment building somewhere, and ultimately he is buying it at the

254 CAPITALISM expense of the upkeep of the very building in which he lives. The day comes when he wants to move and finds no decent place to move to, because he and millions of others like him have consumed the equivalent of all the new apartment buildings that should have been built. For they have consumed their landlords’ capitals and destroyed the incentives for building. Finally, the day comes when they have consumed the equivalent of a new boiler or wiring system or plumbing system that their own building needs, and their landlord has neither the means nor the incentive to try to replace it. Then they live in cold, in darkness, and without running water. This is already the fate of tens of thousands of people in Harlem and in the South Bronx, as I have indicated. There is no reason why it could not happen to all rent-controlled housing in the country, given further inflation and more time. The only “gains” from rent control are the gains of consuming the capital invested in housing and then being left without housing. People do it because the housing belongs to the landlords, not to them. But in the long run, the loss is theirs, because they are the physical beneficiaries of the stock of housing. When they destroy the property of the landlords, they destroy the property that serves them.

How Repeal of Our Price Controls on Oil Reduced the Price Received by the Arabs

A further application of the principle that partial controls raise prices of goods that are free of controls concerns oil prices. It follows from this principle that our price controls on oil, which were in force from 1971 to 1981, raised the price received by the Arabs, and that their repeal immediately operated to reduce the price received by the Arabs. It follows further that a major effect of repeal was to undo the diversion of billions of dollars a year away from our oil industry to the Arab oil industry. The effect of this, in turn, was an expansion in the American oil industry and a still further drop in the world price of oil received by the Arabs. In other words, it follows that the dramatic decline in the world price of oil experienced in the 1980s can be directly traced to the repeal of price controls on oil in the United States.

In 1980, domestically produced crude oil in the United States was controlled at an average price of approximately $10 per barrel. Imported crude oil was uncontrolled and sold at about $34 per barrel, which was the price the Arabs received. Since the spring of 1974, the prices of the various oil products produced in the United States, such as gasoline, heating oil, and so forth, had been controlled on the basis of the weighted average of the uncontrolled price of imported oil and the controlled price of domestically produced oil. Since about half of our crude oil was imported and half was domestically produced in 1980, the prices of oil products were set on the basis of an average cost of crude oil of approximately $22 per barrel. Roughly speaking, the prices of oil products were set high enough to cover not only this weighted average cost of crude oil, but all the other costs of producing and distributing oil products and a more or less competitive rate of profit on the capital invested in refining and distribution. Such product prices did not differ radically from prices that would have existed had the free market price of crude oil been $22 per barrel.

In order to see how this arrangement benefitted the Arabs and how its repeal brought back billions of dollars a year to our oil industry that had been diverted to their oil industry by price controls, all we have to do is think through the consequences of repealing our controls. Following repeal of our controls, the price of domestically produced oil immediately had to rise above $10 a barrel. But the effect also had to be that the price of imported oil, and, therefore, the price received by the Arabs, fell below $34 a barrel. To understand just why, imagine for the moment that the price of domestically produced oil simply rose all the way to $34—the same price as the Arabs had been receiving. If that happened, the cost of producing oil products would have had to be based on an average price of $34 a barrel of crude oil rather than on the previous average of $22 a barrel. The prices of oil products would therefore have had to be raised correspondingly. But observe. At such higher prices, the quantity of oil products that could be sold would have been less, and, therefore, the quantity of crude oil that could be sold would also have been less. The only way to counteract this loss in sales would be if the prices of oil products did not rise by so much. The only way that that was possible was if the average price of crude oil did not rise by so much. But this implied that the price received by the Arabs actually had to fall. For in a free market our oil must sell for just as much as theirs; yet, we have just seen that their price of $34 was too high for an average cost of crude oil—it would significantly have reduced the quantity of oil products and thus of crude oil that could be sold. Thus, our price could not have met theirs at $34 a barrel. Our price and their price had to come together at some lower average figure.

Observe further. In order for the same quantity of crude oil to be sold in this country as was sold prior to the repeal of price controls, it would have been necessary for the Arabs’ price to meet ours at $22 a barrel—the previous average price of crude oil. For any higher price than $22 required a rise in the price of oil products, which had to reduce the quantity of oil products that could be sold in this country and therefore the quantity of crude oil that could be sold in this country.

Indeed, one may raise the question of why the effect

of repeal was not actually to leave the price of oil products unchanged in the United States and simply reduce the price of Arab crude oil and raise the price of our crude oil to the previous average price of $22. The reason these results did not occur was because one of the effects of decontrol was a reduction in oil imports into the United States. The price of $34 for imported oil prevailed throughout most of the world. The price of imported oil could not fall to $22 here while it was any higher elsewhere. What happened was that as the price of imported oil fell in this country, in the direction of $22, less of it was sent here and more of it was sent to other markets. The result was that the United States reduced its import of oil and the price of imported oil settled at an amount above $22. For a time, bolstered by cutbacks in their own production, the Arabs were able to maintain the world price at $29 per barrel.

But subsequently, in the face of the pressure of growing supplies of crude oil produced in the United States, the world price of oil collapsed, despite all efforts of the Arabled OPEC cartel to maintain it.

Thus, temporarily, the consequence of repeal was a rise in the average price of crude oil in the United States and a rise in the price of petroleum products in the United States. But the rise in price to American consumers was much less than the rise in price to American producers; much of the rise in price received by our oil companies was financed by a fall in the price received by the Arabs and other foreign suppliers. For example, when the price of crude oil temporarily settled at $29 per barrel, the cost base of oil products for American consumers was increased by $7 per barrel (from $22 to $29), while the price received by our oil companies was increased by $19 per barrel (from $10 to $29). The rise in price received by our oil companies was financed in part by a $5 drop in the price received by the Arabs and the other foreign suppliers (from $34 to $29). 35

Furthermore, as shown, this rise in domestic prices was merely a short-run effect, for oil production in the United States became substantially more profitable. Domestic oil production immediately begin to expand, and as it did so, the world price of oil began to fall sharply. Temporarily it declined to as low as $10. Currently, despite years of continued inflation, the price is approximately $18 per barrel. 36

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The preceding analysis can be presented in simpler, more dramatic terms in the light of the auction example I have used to explain why partial rent controls raise rents on the portion of the supply that remains uncontrolled. 37 Thus, one can conceive of the supply of oil consumed in the United States between 1971 and 1981 (the respective years in which the price control on crude oil was imposed and finally repealed) as consisting essentially of two units: the half produced in the United States and the half produced outside, by OPEC and other foreign suppliers. The U.S. government compelled the half produced in the United States to be sold at a below-market price and thus more or less considerably to come within the reach of otherwise submarginal buyers, leaving correspondingly less of the supply of domestically produced crude oil available for the market. In effect, it compelled Exxon, Chevron, and Texaco to sell their unit of oil to the submarginal buyer for less than $100, which left only one unit of supply available for the market, namely, the unit produced by Qadafi, the Ayatollah Khomeini, and Saddam Hussein, which unit could then be sold for a price of between $200 and $300. That was the essence of the situation. More precisely, in reducing the supply of American oil that a free market would have made available to American buyers, it forced American citizens into a competition for the remaining supply of oil in the market, a needless competition that many American citizens necessarily lost, and from which America’s enemies in the Middle East greatly profited.

As I have indicated, such a policy might have been understandable if the U.S. government had been run by officials in the service of Libya, Iran, and Iraq. What its existence actually demonstrated, of course, was not that our officials were traitors in the service of foreign powers, but that they were men and women who, while intending to serve the American people, were intellectually unqualified to do so and, as a result, wreaked great harm upon them.

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Given such incredible ignorance and destructiveness on the part of the U.S. government, it should not be surprising to learn of a further unnecessary tragedy inflicted on many American oil producers when the price control on domestically produced crude oil was finally repealed. Not content with simply repealing its price control and desisting from further acts of destruction against the oil industry, the U.S. Congress, acting on malice and greed, decided to confiscate a major part of the profits of American oil producers that resulted from their ability to receive a higher price of crude oil. In 1981, it enacted the socalled windfall-profits tax on crude oil as an accompaniment of the decontrol of oil prices. This was an act of malice in that its deliberate, overriding purpose was to limit as far as possible the ability of the oil companies to profit from the rise in price—for no other reason than simply that they should not profit. It was also an act of mindless greed insofar as its primary purpose having been accomplished, its subsidiary purpose was the enrichment of the U.S. Treasury without knowledge of, or concern for, the consequences.

256 CAPITALISM

The effect of this tax was that instead of billions of dollars of revenue simply being diverted from the Arab oil industry back to the American oil industry, a major portion ended up being diverted to the U.S. Treasury. The effect of this in turn was that the American oil industry lacked an equivalent number of billions of dollars of internally generated funds with which to undertake its expansion. Instead, it had to turn to outside sources of funds and borrow heavily. Then, when the collapse in oil prices came, instead of losing back what would have been previously earned “windfall” profits, American oil producers lost borrowed money. And thus many of them went bankrupt who, in the absence of the windfall-profits tax, would not have gone bankrupt, because they would merely have lost back previously earned profits.

A major consequence of this unnecessary tragedy is that the American oil industry today is smaller and less capable of expansion than it would otherwise have been, and thus less capable of further reducing the price of oil.

PART C

UNIVERSAL PRICE CONTROLS

AND THEIR CONSEQUENCES

1. The Tendency Toward Universal Price Controls

Price controls tend to spread until all prices and wages in the economic system are controlled—i.e., partial price controls lead to universal price controls.

Universal price controls existed in Nazi Germany. The equivalent of universal price controls exists under socialism, as for example in the former Soviet Union and its satellites. Universal price controls existed in the United States in World War II. They also existed very briefly under President Nixon, when he imposed a ninety-day freeze on all prices and wages in August 1971. They could easily come into existence again in this country, and this time on a longterm basis, in response to any significant worsening of inflation.

The reason partial price controls lead to universal price controls is their destructiveness. We have already seen how partial price controls destroy the industries to which they apply, while causing the uncontrolled industries to flourish. If the government wants to prevent the destruction of the industries it initially brings under controls, it has only three alternatives: It can repeal its controls on those industries, it can subsidize their losses out of the treasury, or it can control the prices that constitute their costs of production. If the government refuses to repeal its initial controls, and if it is unable or unwilling to pay the necessary subsidies, then its only alternative is to extend its price controls to the prices that constitute the costs of the industries concerned. But then the same story repeats itself, and the government finds that it must bring under controls the prices that constitute the costs of these industries, too, and so on, with the list of controlled prices steadily lengthening. 38

For example, consider the case of the oil industry when it was under price controls. The combination of controlled selling prices and rising costs of exploration and development resulting from inflation, meant that the domestic oil industry was progressively being destroyed and was ultimately headed for extinction. In order to prevent these outcomes, the government either had to repeal the price controls on oil (which, fortunately, it did), or subsidize the oil industry to the extent of billions of dollars a year to offset the rise in its costs, or extend its controls to include the prices that constitute the oil industry’s costs, such as the price of steel pipeline and the wages of oil field workers. If it had decided to control these prices, then it would have had to go still further. It would have had to extend its price controls not only further backwards, but in every direction. For example, if it had controlled the price of steel pipeline, then it would have had to extend its controls to all other steel products, such as I-beams, steel sheet, steel cans, and so on, as well as to the price of iron ore, coke, the wages of steel workers, and so forth. If it did not, the effect of its price control on steel pipeline would simply have been to make that one steel product less profitable than the others, and so to destroy its production.

Similarly, if the government had controlled the wages of oil field workers, it would have had to control wages in other occupations, into which the oil field workers might have gone, or into which potential oil field workers might have gone. Obviously, the government would quickly have had to seek to control all wages, because all the different occupations are interconnected. Finally, as the government controlled wages and other prices that constitute costs, it would have had to extend its controls forward to whatever remaining products may have previously escaped controls. Otherwise, the controls on costs would merely have served to make such products more profitable and thereby encouraged their production at the expense of the controlled products.

In this way, price controls have the potential to spread through the economic system like a cancer travelling through the human body’s lymphatic system. All that it takes for this to occur is for controls to reach the point that the government, while still convinced that the controls are necessary, becomes unable or unwilling either to tolerate their effects or to use subsidies to mitigate their effects, and thus turns to the extension of controls to deal with the problems created by the controls already in force.

2. Universal Price Controls and Universal

Shortages

The first point which must be understood concerning universal price controls is that they create universal shortages, in which the shortage of each good compounds the shortage of every other good. Under universal price controls, not only does a shortage exist of each good, but also the excess demand for each good spills over and adds to the excess demand for every other good. As illustration, consider again the case of the man who wants a television set but cannot find one at the controlled price. If television sets are the only controlled good, he can find his second choice, a new suit, say. But now, under universal price controls, the suit will probably be as hard to find as his television set. As a result, he must be prepared to settle for his third choice, or, indeed, for his fourth, fifth, or still lower choice, if it is all that is available to him. Eventually, in fact, he will be willing to settle for any good that is of greater physical utility to him than the otherwise useless paper money—that is, he will be willing to settle for virtually anything at all.

It should be realized that paper money is of less physical utility than the least valuable good. It does not even make good wallpaper or provide a good fire. The only reason that people do not rush to trade it in for matches or pins or any other physically more useful commodity is that they expect to be able to obtain still more valuable goods for it later on—perhaps later that day, the next day, the next week, or whenever. Price controls and shortages undermine this expectation. They destroy the desire to hold money and eventually make people willing to accept virtually anything in exchange for it.

In these conditions, our man’s unsatisfied demand for a television set is simultaneously an unsatisfied demand for a new suit and simultaneously an unsatisfied demand for goods of still lower choice—it is an unsatisfied demand for anything and everything. And so it is with the unsatisfied demand of everyone else. Thus, it comes about not only that there is an excess demand in the entire economic system, but also that the whole of it is poised ready to strike at whatever goods may be available from any industry. The excess demand facing each industry comes to be not only the unsatisfied demand of those for whom its products are the first choice with the money in question, but also the unsatisfied demand of those for whom its products are the second, third, fourth, and still lower choices. In this way, the excess demand of the whole system comes to exert its pressure against every point in the system. In addition, this excess demand is everywhere further compounded by an enormous hoarding demand for each good.

This discussion, it should be realized, is an actual description of conditions as they existed in Soviet Russia. In Soviet Russia, there was a shortage of everything. The only exceptions were goods they managed to produce that were of negative utility, such as pots that ruined the taste of food, or clothes that shrank out of all relation to their original size. Apart from such exceptions, everything was chronically in the same state of shortage as gasoline was in this country in early 1974 and in the spring of 1979. In his book The Russians, Hedrick Smith, who for some years was the head of The New York Times’ Moscow Bureau, tells of waiting lines up to a mile long; and of one, to sign up to buy rugs (a once-a-year event in Moscow), that was comprised of between ten and fifteen thousand people lined up four abreast in the winter snow and that lasted for two solid days and nights. Smith reports that Russian women normally spent fourteen hours a week waiting in line just to buy food. He writes that women normally carried shopping bags called “just-in-case bags”—meaning bags for just in case they happened to find something that was for sale and worth buying. The briefcases that Russian men were generally seen carrying served the same purpose. 39 I cannot resist quoting one passage because it so eloquently describes the condition of a willingness to buy anything:

Yet despite such ordeals the instinctive reaction of a

Russian woman when she sees a queue forming is to get in line immediately—even before she knows what is being sold. Queue-psychology has a magnetism of its own. Again and again, I have been told by Russians that anyone’s normal assumption on seeing people up front hurrying to get in line is that there must be something up there worth lining up for. Never mind what it is. Get in line first and ask questions later. You’ll find out when you get to the front of the line, or perhaps they’ll pass back word before then. A lady lawyer told me she once came upon an enormous line stretching all through the Moskva Department Store, and

when she asked those at the end of the line what was on sale, “they said they didn’t know or else snarled at me and told me not to interfere. I walked up 20 or 30 yards asking people and no one knew. Finally, I gave up asking.” 40

Shortages of this type come to exist whenever universal price controls are in force for any extended period of time.

Excess Demand and Controlled Incomes

It is necessary to deal with a difficulty that many people have in understanding how excess demand can exist under universal price controls. Many people reason in the following way: The main source of demand for consumers’ goods, they say, is incomes, especially wages. But under universal price controls, everybody’s wages, interest, dividends, and so on are controlled. Therefore, people ask, how can demand be rising and a problem of

excess demand be created?

The answer to this question is that excess demand is created by virtue of an expansion in the quantity of money, and that the limitation of incomes is irrelevant.

In order to understand this point as clearly as possible, consider the case of a hypothetical small economy with $10,000 of total spending, 1,000 units of supply, and a general price level of $10 per unit. Assume that the $10,000 of spending in this economy is the result of $10,000 of incomes. Assume further that when price controls are imposed in this economy, incomes are frozen at a total of $10,000. Nevertheless, demand in this economy can grow progressively more excessive—in the following way. Assume that the government decides to spend $1,000 out of newly created money. The price of what the government buys is controlled at $10 a unit. Consequently, the government buys 100 units of the economy’s supply. This leaves 900 units of supply for the citizens. These 900 units are controlled at a price of $10 per unit. This means that the most it is possible for the citizens to spend in buying them is $9,000. Nevertheless, the citizens want to spend $10,000—their incomes. Clearly, the citizens have $1,000 of unspendable income. What has happened is that the government’s spending of $1,000 out of newly created money has displaced $1,000 of spending by the citizens and has made $1,000 of the citizens’ incomes back up on them as surplus, unspendable funds.

This phenomenon can grow progressively worse from year to year. We have just seen the government spend $1,000 and the citizens spend $9,000. This means that businesses have taken in $10,000 of sales revenues and in the second year are again able to pay out $10,000 of incomes. But now, these $10,000 of incomes are added on to $1,000 of surplus unspendable income from the year before. This year, therefore, the citizens would like to spend $11,000 rather than $10,000. If the government again spends $1,000 out of newly created money, the citizens will again be able to succeed in spending no more than $9,000. Thus, there will now be an excess demand of $2,000, and in the third year it will be $3,000, and so on. In this way, the shortages grow worse from year to year. It is not too long before people are ready to buy anything.

This example, incidentally, helps to show why price controls do not create severe shortages in the very moment they are introduced. When the controls are first imposed, the existing prices are the proper prices. In fact, they may even have been raised somewhat in anticipation of the controls being imposed. It takes time for these prices to become outmoded—both by continuing inflation and by all the other forces acting to bring about changes in supply, demand, and cost. The longer the controls remain in force, the more serious their consequences become, because the more out of line do the controlled prices become in relation to the potential freemarket prices that would exist if the controls were repealed.

3. The Destruction of Production Through Shortages

The government’s purpose in imposing universal price controls is to assure an adequate rate of profit to the vital industries it initially brings under controls. For this reason it imposes controls on the prices that constitute the production costs of these industries. It extends controls to the selling prices of all other industries in order to restrain their rate of profit in relation to that of the controlled industries.

It should be realized that it is perfectly possible under universal controls for all industries to be guaranteed not only approximately equal rates of profit, but rates of profit that by historical standards are relatively high in nominal terms. This is possible because the government controls all the prices that constitute costs, including wages, which are the fundamental element in costs. Nevertheless, no matter how high the nominal rate of profit the government allows, vital industries are still destroyed, and production is disrupted far more seriously than under partial price controls.

What destroys production under universal controls is the consequences of the shortages they create.

In Part B of the present chapter, we saw a variety of ways in which shortages disrupt production under partial controls. I will briefly recount them because all of them apply under universal controls. 41 (It should be recalled in this recounting, by the way, that anything that acts to raise costs implies a decline in production. 42 )

(1) Shortages make buyers impotent and thereby remove the incentives of sellers to provide good quality and service. As a result, quality and service decline and the costs of maintenance and replacement increase.

(2) Shortages of means of production, such as a material, often force sellers to reduce quality and service and make it necessary to resort to more expensive substitute methods of production.

(3) Shortages encourage sellers to concentrate on the production of unnecessarily expensive models as a disguised way of raising prices.

(4) Shortages create a positive incentive to using more expensive methods of production if the government allows the pass-through of higher costs and makes the incurrence of higher costs a source of higher profits. (5) Shortages result in delays in production.

(6) Shortages cause hoarding and the construction of additional storage facilities.

PRICE CONTROLS AND ECONOMIC CHAOS 259

(7) Shortages cause the waste of time in searching for supplies.

(8) Shortages create chaos in the geographical distribution of a good among local markets—for example, gasoline during the oil shortage.

(9) Shortages create chaos in the distribution of a factor of production among its various uses in production—for example, crude oil in the production of the various oil products.

Under a system of universal price controls and universal shortages, these elements of chaos apply to all industries, instead of just a few industries. In addition, they apply more strongly to each industry than if that industry were the only industry under price controls, or if price controls were confined to it and just a few others.

First of all, the excess demand confronting each industry is far greater than under partial price controls, because it is compounded by the excess demand for all other products, as we have seen. The greater severity of the shortage of a product under universal controls creates correspondingly more severe problems in connection with that product. As just one illustration, consider the case of cotton and cotton products. If the prices of cotton and cotton products were the only controlled prices in the economic system there would be a problem of using too much cotton to produce shirts, say, and not enough to produce other cotton products, or vice versa. Because, similarly to what we saw earlier in this chapter in the case of crude oil, there would be a shortage of each cotton product. 43 Thus more of any one cotton product, such as shirts, could be produced at the expense of the others without reducing its price and profitability, until its particular shortage was totally eliminated. Yet if shirts, cotton, and the other cotton products were the only controlled goods, the increase in shirt production would be limited by the fact that people could spend their money on other goods. Beyond a point, people would be willing to buy additional shirts only at prices that made any further increase in shirt production unprofitable, however low the price of raw cotton might be controlled.

But if everything is controlled, and people find no other goods available on which to spend their money than shirts, there is no reason why they would not buy enough shirts to have two or three new ones to wear every day, if there were that many available. People would be willing to go on buying more shirts just so long as extra shirts had a physical utility greater than that of paper money. They would be willing to buy them as a source of cleaning rags, buttons, pins, or whichever, that otherwise might be unobtainable. They would buy them merely to hold as a store of value for the future, because holding them would be better than holding the otherwise unspendable paper money.

The principle that emerges is that under universal controls it becomes practically impossible to eliminate the shortage even of an individual good by means of expanding its production, because each good is confronted with the excess demand of the whole economic system.

There is a second reason why the elements of chaos connected with partial controls must apply more strongly under universal controls. This is the fact that each industry must suffer the consequences of shortages in its capacity as a buyer. Indeed, it must suffer them in everything it buys. For example, under universal controls, not only does chaos reign for the customers of the oil industry, but the oil industry itself now encounters the same chaos in its own purchases of pipeline, drilling equipment, trucks, tankers, and labor services. Whatever problems the oil industry had before are now intensified. And, of course, in accordance with the principle we just developed, the excess demand confronting the oil industry is radically expanded by the spillover of unsatisfied demand from every other fuel and chemical for which petroleum products could substitute; it is also expanded by the sheer desire of people to own any storable physical good in preference to unspendable paper money.

Not only do universal price controls spread chaos through the whole economic system, and intensify it at every point, but they add a wholly new dimension to the chaos, that we have not previously encountered. Namely, they create chaos in the allocation of capital and labor, the two elements of production required by every industry. This chaos exists because the shortages of consumers’ goods create a ready and waiting employment for more capital and labor in every industry. As a result, the distribution of capital and labor among the various industries is made random. Capital and labor are made to stand in the same relation to all the different industries that we have seen crude oil or raw cotton stand in relation to their respective products. What this means is that capital and labor can be withdrawn from any industry and placed in any other industry, and there is no effect on the rate of profit anywhere. If capital and labor are withdrawn from any industry, price controls prevent prices and profits in that industry from rising. If additional capital and labor are invested in any industry, shortages prevent prices and profits in that industry from falling— all that happens is that the shortage in the industry is reduced. For example, if capital and labor are withdrawn from making paper and transferred to making pots, price controls prevent the price and profitability of paper from rising, while shortages prevent the price and profitability of pots from falling.

The consequence of this state of affairs is that production from industry to industry becomes utterly chaotic.

Not only can any product of crude oil be randomly expanded at the expense of any other product of crude oil, not only can any product of cotton be randomly expanded at the expense of any other product of cotton, but any product anywhere in the economic system can be randomly expanded at the expense of any other product anywhere else in the economic system. The chaos is total.

Let us consider the significance of this. Assume the consumers would prefer to have more shoes and fewer shirts. Under price controls, they cannot bid up the prices of shoes and increase the profitability of shoe production. At the same time, as a result of universal shortages, they will not decrease their purchase of shirts, because they have no alternative use for the money. In fact, in this situation it is perfectly possible that capital and labor could be withdrawn, unchecked, from shoe production, which the consumers want more of, and added on, unchecked, to shirt production, which they want less of— that is, that the exact opposite of the consumers’ wishes could occur. For if this perverse result did occur, price controls would prevent the price and profitability of shoes from rising to stem the withdrawal of capital and labor from the shoe industry. At the same time, the existence of a shortage would prevent the price and profitability of shirts from falling to stem the inflow of capital and labor into the shirt industry.

Indeed, this perverse result is not only possible, but fully as likely as that the consumers will get the result they want. Under universal price controls, there is no longer any connection between the consumers’ preferences and business firms’ profits or losses. In an economy in which there are universal shortages, the consumers are ready to buy anything. And that makes it possible for businessmen to produce anything. I leave it to the reader’s imagination to think of what kind of deterioration in quality and service can take place in this kind of situation, and of all the other inefficiencies that can exist.

It should already be clear that the extent to which this perverse process can be carried, of consumers getting goods they want less at the expense of goods they want more, has no limits under universal price controls. No matter how bad the shortage of a particular good becomes as the result of a decrease in its production, price controls prevent its production from becoming more profitable. No matter how much the production of a particular good is increased, its shortage is so severe that practically no amount of additional production will eliminate it, because its shortage reflects the spillover of unsatisfied demand from the whole economic system.

In this way, universal price controls have the effect of flooding people with shirts, while making them go barefoot, or inundating them with shoes, while making them go shirtless; of giving them enormous quantities of writing paper, but no pens or ink, or vice versa; of giving them food, but no clothing, or clothing, but no food; of giving them toothpaste, but no soap, or soap, but no toothpaste; indeed, of giving them any absurd combination of goods. Moreover, at any moment, the positions of the goods can be reversed, with the relatively abundant ones suddenly disappearing, while the ones previously impossible to find suddenly appear in comparative abundance.

These conditions are not a mere theoretical projection. They were the normal, chronic conditions of Soviet Russia ever since the Communist Revolution. There was no connection in Soviet Russia between production and the desires of the consumers, and practically everything produced for the individual consumers in Soviet Russia was, in the words of Hedrick Smith, “simply junk”. 44

This kind of chaos in production is the source of drastic declines in production.

Merely giving consumers unbalanced combinations of goods is itself equivalent to a major decline in production, for it represents just as much of a loss in human wellbeing. For example, imagine that a dozen shirts represents the same physical volume of production as three new pairs of shoes, in terms of the capital and labor that must be employed to produce them. Suppose further that what a person wants each year is a dozen shirts plus three pairs of shoes. If he ends up having to settle for two dozen shirts and go barefoot, he is much worse off than if he could have gotten eight shirts and two pairs of shoes, or even just four shirts and one pair of shoes. The same overall volume of physical production becomes equivalent to a smaller volume of physical production by virtue of its being improperly proportioned among people’s different wants and needs.

However, this kind of chaos in production does not merely cause chaotic combinations of consumers’ goods. It also causes chaotic combinations of capital goods. And in so doing, it reduces the economic system’s overall physical ability to produce.

An economic system’s ability to produce does not depend merely on the quantity of its capital goods, but, no less, on the proper apportionment of that overall quantity among the various specific types of capital goods. If, for example, the steel industry is unduly expanded at the expense of the coal industry, say, the economic system’s subsequent ability to produce will be impaired: not only the extra steel mills, but part of the existing steel mills may be inoperable for lack of fuel. In the same way, if the coal industry is unduly expanded at the expense of the steel industry, not only the new coal mines, but part of the previously existing coal mines may be inoperable because of a lack of steel products such as

PRICE CONTROLS AND ECONOMIC CHAOS 261 structural supports and drills. An economy’s overall ability to produce must be thought of in terms analogous to the functioning of an organism. It depends on the smooth coordination and adjustment of all of its parts. Like a human body, whose total performance cannot exceed the power of its brain, heart, lungs, or any other vital organ, the overall performance of an economic system cannot exceed the power of any one of a large number of vital industries. If some are unduly expanded at the expense of others, the effect is to reduce the functioning of the whole. Indeed, every malproportion has serious consequences.

Consider the devastating effects on production not only of disproportions among whole major industries, like steel and coal, but of disproportions within the output of individual industries—for example, the production of too many trucks to haul farm products and of not enough tractors to harvest them. Consider the effects on production of disproportions in the production of just a few key products here and there—like ball bearings, lubricants for machinery, spare parts, even ordinary screws, and so on. A shortage of any one of these items, or a shortage of one special type of these items, such as ball bearings of a particular size, must cause a widespread paralysis and the grossest inefficiencies in production. And, of course, improper geographical distribution of these or any other inputs has equally devastating consequences for production; for the mere existence of a thing is of no value if its location prevents the producers who need it from obtaining it. The same is true if anything is unavailable for production because it is being hoarded. These declines, of course, are all further compounded by the declines that result from producers just not having to care any longer about the quality of their products or about economies in producing them.

Again, this chaos is not a mere theoretical projection, but an actual description of the chronic conditions of Soviet Russia. In Soviet Russia, hydroelectric stations were built without generators and without the existence of industries to supply; wheat could not be harvested because the necessary tractors had not been built, or, if they had been built, they lacked spare parts, or were in the wrong place, or quickly became inoperable; factories could not operate because they lacked materials; new buildings and new machines were worthless, because of shoddy construction due to lack of care or lack of the necessary materials. 45

Now the declines in production resulting from all of these causes tend to be self-reinforcing and cumulative. For in the course of production, capital goods are physically consumed; i.e., materials and fuel are used up, and machinery and buildings wear out. If production is to be maintained, the capital goods consumed in production must be replaced. The only source of replacement, however, is production itself; i.e., the capital goods consumed in production in an economic system can be replaced only out of that system’s production. But if that production declines sufficiently, because of economic chaos, then it will not be possible to reproduce the capital goods consumed in production. As a result, the stock of capital goods will fall. Once that happens, production must decline further, because it will be carried on with fewer capital goods. If the smaller supply of capital goods is used as inefficiently as was the larger supply, because of continuing chaos in production, it will not be possible to replace the smaller supply of capital goods either. Thus, once again production will decline. This process, of less production causing fewer capital goods causing less production, can go on until the economic system is carried back all the way to the level of barbarism.

To make this process more concrete, just think of the fact that in the course of production such things as steel mills, cement factories, freight cars, and so on are wearing out and must be replaced. The only way to replace them is out of the economy’s current production. If that production declines sufficiently, because of economic chaos, then it will not be possible to replace them. The result will be that in the future, production will have to be carried on with fewer steel mills, cement factories, and so on. And then even the smaller number of steel mills, etc., will not be able to be replaced, because, given the continuation of chaos, the output that is obtained from them will be too low. 46

---

Special consideration must be given to the shortage of labor that universal price controls create. For the labor shortage introduces a second powerful factor making for a self-reinforcing, cumulative decline in production.

Under universal controls, every industry is eager to employ more labor, because whatever extra products it can produce with more labor will be snapped up by goods-hungry buyers. In addition, the labor shortage is intensified by the declines in efficiency that price controls create, because these declines in efficiency mean that it takes more labor on the average to produce a unit of goods. As a result of the labor shortage, employers are even led to “hoard” labor, that is, keep it on the payroll in idleness or semi-idleness in order to have it available when they need it. This, of course, only intensifies the labor shortage.

What is of special importance is that the labor shortage not only exists because of an excess demand for labor, but it also very soon becomes compounded by a falling supply of labor. The supply of labor begins to fall as a result of the shortages of consumers’ goods. These shortages destroy the incentive to work. As people accu—

mulate surplus, unspendable income, it begins to occur to them that they need not earn money they cannot spend. They lose the incentive to advance, because earning more money is useless to them. They cease to care about being fired, because not only can they immediately find another job if they wish it, but the loss of income they cannot spend does not affect them. They begin to do their jobs badly. They become willing to settle for lower-level, less demanding jobs that pay less. They quit their jobs altogether and live off their forced savings for extended periods before taking another job. All of these things represent a decline in the supply of labor. Of course, they also cause a major decline in production and thus in the supply of consumers’ goods. This decline in the supply of consumers’ goods resulting from the decline in the supply of labor makes the shortages of consumers’ goods still worse and thereby further reduces the incentives to work, which, of course, causes even worse shortages. And so it goes, until in fairly short order production must come to a total halt.

Again, it is worth noting that the economy of Soviet Russia was characterized by a labor shortage, in which factory managers “hoarded” labor in order to be sure of fulfilling their quotas under the official economic plan. The shortages of consumers’ goods in Russia also contributed to the labor shortage. 47

The Prosperity Delusion of Price Controls:

The World War II “Boom”

Something that is truly remarkable about universal price controls is that, at least in their earlier stages, they can create a delusion of prosperity, even while production is becoming chaotic and on is the road to collapse. The reason for this is that under universal price controls any businessman can find a ready and eager market for any merchandise, no matter how poorly it is produced. All he has to do is produce something of greater physical utility than paper money. In the process, he can even make large nominal profits, simply by virtue of the government having controlled at an appropriate level the prices that constitute his costs. By the same token, the labor shortage makes it possible for any worker to obtain immediate employment in any occupation for which he is even remotely qualified. To those who confuse going through the motions of production with real production, and who confuse the earning of mere paper money with the acquisition of real, physical wealth, this situation looks like prosperity. What they see is that business is humming, everyone is employed who cares to be, and everyone is making money.

Just this situation characterized the United States during World War II. The combination of massive inflation to pay for the war, and universal price controls to hide the symptoms of the inflation, quickly produced widespread shortages, including a labor shortage. Most people mistook this situation for prosperity.

Nevertheless, despite a superficial appearance of prosperity, the real standard of living of the American people fell drastically during World War II. It fell to a level far below the worst years of the depression. In the worst years of the depression, three-fourths of the American labor force were employed, and everyone who was working could buy anything he wanted commensurate with his earnings. During World War II, no one could buy a new car, a new house, or a new major appliance of any kind: the government prohibited their production altogether. In addition, many of the most common, everyday goods simply became unobtainable or obtainable only with great difficulty—such as chocolate bars, chewing gum, sugar, meat, nylon stockings, gasoline, rubber tires, and so on. The goods that were obtainable badly deteriorated in quality—everyone recognized the difference between what they called “prewar quality” and “wartime quality.”

People believed they were prosperous in World War II because they were piling up large amounts of unspendable income—in the form of paper money and government bonds. They confused this accumulation of paper assets with real wealth. Incredibly, most economic statisticians and historians make the same error when they measure the standard of living of World War II by the largely unspendable “national income” of the period.

The controls did not last long enough in this country to wreck the economic system. Their effect was further mitigated by the fact that we entered the war with mass unemployment and a large amount of idle plant capacity. The absorption of these factors into production made it possible to offset much of the wastes and inefficiencies resulting from the controls. They constituted a kind of temporary reserve fund, as it were, out of which much of the costs of the controls were met.

Also, during the war, people were highly motivated by considerations of patriotism, and were not only willing to tolerate the hardships imposed by the war, but actually to work harder and longer. Many of them reasoned that if the soldiers at the front could risk their very lives in the defense of civilization, they could do with fewer goods and put in an extra effort at work. Finally, no one regarded the controls as a permanent institution— everyone looked forward to a quick end to the war and to the opportunity to spend after the war.

Such things, however, can at best only delay the full consequences of universal controls. In the circumstances of the present and of the foreseeable future, moreover, no such mitigating factors are present.

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4. Socialism on the Nazi Pattern

In an effort to deal with the chaos it creates through price controls, the government adopts further measures: it seizes control over production and distribution.

For example, during the oil shortage of 1973–74 a new government agency—the Federal Energy Administration (now the Department of Energy)—was established. This agency had the power to tell the various oil companies how much of each of the various petroleum products they were to produce and to which industries, firms, and regions they were to distribute those products. Thus, government officials decided how much refining capacity should be devoted to producing gasoline, how much to producing heating oil, jet fuel, propane, kerosene, and so forth. In the process, government officials decided which industries dependent on the various petroleum products would obtain supplies, and to what extent. They decided the distribution of each individual petroleum product among its various uses, such as how much gasoline would go to truckers, how much to bus lines, and how much would be left for passenger automobiles. They decided which firms in each industry would get how much of the product allotted to that industry. For example, in the airline industry, they decided that each airline would get 80 percent of the jet fuel it had consumed in the previous year. They decided which geographical areas would get how much of each product. For example, they decided how much gasoline went to New Jersey and how much to New York. And they were about to decide how much gasoline and heating oil went to each individual consumer—for example, the plan to give every licensed driver over eighteen a fixed monthly ration of gasoline by issuing coupons with the picture of George Washington on them.

In addition, government officials made it their business to look into the methods of production employed by the users of oil products. For example, they began to try to force electric utilities to switch from burning oil to burning coal, in order to reduce oil consumption. (Often, these were the same utilities that only a short time before the same government had forced to convert to oil, under the influence of the ecology movement.) As part of this process, they reduced highway speed limits, which must be viewed as an interference with methods of production insofar as it applies to trucks and buses or any form of travel for business purposes.

All of these further interferences were an unavoidable response to the chaos in the oil industry, given the fact that the government was not prepared to abandon its controls over oil prices. Price controls and shortages had made the output of the oil industry and the subsequent distribution of that output utterly chaotic. The government took control of production and distribution in the oil industry in an effort to deal with this chaos.

Now under a system of universal price controls, such as existed in World War II, the government is led to seize control over the production and distribution of every commodity. The government thus comes to decide not only all prices and wages, but how much of each item is produced, by what methods, in what locations, and to whom it is distributed. The government fully controls all the inputs that each firm receives, how it combines those inputs into outputs, and what it does with the outputs.

There is only one appropriate name to describe this state of affairs of full government control over production and distribution. And that is socialism. In seizing control over all production and distribution, the government fully socializes the economic system.

The reason the system must be called socialism is because, in fact, the government exercises all of the powers of ownership. The meaning of ownership is the power to determine the use and disposal of property. If the government determines what a firm is to produce, in what quantity, by what methods, and to whom it is to sell its output and at what prices, then it is the government that determines the use and disposal of the firm’s property. The government, therefore, becomes the real owner of the firm—the de facto owner. The nominal owners recognized by the law—that is, the firm’s stockholders (and also the board of directors chosen by the stockholders, and the managers appointed by the board of directors)— are reduced to the status of government functionaries, compelled to carry out the government’s orders. The fact that the stockholders may be allowed to continue to draw dividends is irrelevant. The status of these stockholders is essentially no different than if the government had openly nationalized their property and given them government bonds on which they received interest.

This system of de facto socialism, carried out under the outward guise and appearance of capitalism, in which the legal forms of private ownership are maintained, has been aptly characterized by von Mises as socialism on the German or Nazi pattern. 48 The Germans under Ludendorf and Hindenburg in World War I, and later under Hitler, were the foremost practitioners of this type of socialism. (The more familiar variant of socialism, in which the government openly nationalizes the means of production and establishes socialism de jure as well as de facto, von Mises calls socialism on the Russian or Bolshevik pattern, after its leading practitioners.

It cannot be emphasized too strongly that Nazi Germany was a socialist country and that the Nazis were right to call themselves National Socialists. This is something everyone should know; yet it appears to have been overlooked or ignored by practically all writers but von

264 CAPITALISM

Mises. In Nazi Germany, the government controlled all prices and wages and determined what each firm was to produce, in what quantity, by what methods, and to whom it was to turn over its products. There was no fundamental difference between the Nazis and the Communists. While the Communists in Russia wore red shirts and had five-year plans, the Nazis in Germany wore brown shirts and had four-year plans.

There is a further point that must be made about the use of the term “socialism.” Socialism means an economic system based on government ownership of the means of production. On the basis of this definition, not only must Nazi Germany, a country usually not recognized as socialist, be categorized as socialist, but other countries, usually thought of as being socialist, must not be categorized as socialist—for example, Great Britain, Sweden, and Israel when they were under the rule of socalled labor governments.

In these three countries, the economic system has always been characterized by private ownership of the means of production—not only de jure, but de facto private ownership. This private ownership, to be sure, has labored under all sorts of restrictions and prohibitions, but still it has been private ownership, and production in these countries has been carried out primarily at the initiative of private owners for the sake of private profit. The philosophy of the ruling political parties of these countries may have been socialism and socialism may have been their ultimate goal, but their actual practice, up to now, has not been socialism. The correct description of these economies is von Mises’s expression “hampered market economy,” and that description applies to the economy of the United States, too. For the sake of brevity, such an economy can be referred to as a “mixed economy,” provided it is understood that what is meant is an economy based on private ownership of the means of production but more or less severely hampered by an extensive list of socialistically motivated acts of government intervention.

In this last connection, it should be realized that the existence of isolated socialized industries, such as the postal service and the railway network, does not warrant characterizing a country as socialist. So long as such industries operate in the context of a market and market prices based on a foundation of private ownership of the means of production and the profit motive, they represent, in effect, merely a blemish on an otherwise capitalist body. The existence of such industries belongs under the heading of socialistically motivated acts of government intervention and properly serves to categorize the economy of a country as a hampered market economy, but not as a socialist economy. 49

The only truly socialist countries in the world today are Communist China and the other remaining members of the Communist bloc, such as Cuba and North Korea. Perhaps several of the East European countries, the surviving “republics” of the former Soviet Union, and possibly some of the socalled third-world countries should also continue to be classified as socialist. But no other countries are in fact socialist. Indeed, to the extent that growing market activity now exists in virtually all of the East European countries and the various former Soviet Republics, the classification even of these countries as socialist becomes increasingly dubious. More and more, their status appears to be that of primitive market economies, in which economic activity takes place in the absence of clearly defined or legally protected private property rights, but nevertheless on the basis of individual initiative, motivated by private profit. Hopefully, within the next few years, no existing country will warrant being described as socialist. Indeed, it appears that in at least one major province of Communist China, de facto private ownership of the means of production and a market economy more advanced than those of most former members of the Communist bloc, have already come into existence.

Notes

1. The quantity theory of money is elaborated at length on pp. 503–506. The demonstration that it is the only possible valid explanation of a sustained, significant rise in prices occupies the whole of pp. 895–922.

2. See above, p. 152.

3. This equation and its implications are developed and elaborated below, pp. 505–506 and 897.

4. Actually, I will show later that falling supply can practically never be the cause of a sustained significant rise in prices and that at no time can it be the cause of the full complex of symptoms that people complain of in discussing inflation, such as the enormously greater number of prices rising compared with the number of prices falling and the effects on the relationship between debtors and creditors. In addition, I will show that falling supply is itself usually a consequence of rapid inflation. Concerning these points, see below, pp. 897–907.

5. For the explanation of this phenomenon, see below, pp. 519–526.

6. On these points, see below, pp. 895–922, which show conclusively why the quantity theory of money is the only valid explanation of an inflationary rise in prices, and why any element of truth in any alternative explanation of rising prices serves only to confirm the quantity theory of money.

7. Statistics of the money supply are published every Friday in

PRICE CONTROLS AND ECONOMIC CHAOS 265

The New York Times and The Wall Street Journal. Historical statistics are available from the Board of Governors of the Federal Reserve System, Washington, D.C. The Federal Reserve Bank of St. Louis regularly publishes data showing the trend of growth in the money supply on a shortterm and longterm basis.

8. For a further, related discussion of the effects of price controls on natural gas, see George Reisman, The Government Against the Economy (Ottawa, Ill.: Jameson Books, 1979), pp. 130–132.

9. Cf. above, p. 191.

10. On these points, see John Stuart Mill, Principles of Political Economy, Ashley ed. (1909; reprint ed., Fairfield, N. J.: Augustus M. Kelley, 1976), pp. 706–709. See also above, p. 192 and pp. 217–218, n. 19

11. For the rebuttal of those fallacies see above, pp. 192–194. 12. New York Times, April 28, 1978, pp. 1, D9.

13. The explanation of why inflation reduces or altogether eliminates the real rate of return on capital is provided below, pp. 930–938.

14. Indeed, as previously pointed out, the hysteria of the ecology movement has caused the government of the State of New York to deprive its citizens of the benefit of an actually existing, brand new major atomic power plant—the Shoreham plant on Long Island. See above, pp. 66–67.

15. New York Times, January 29, 1977, p. 22.

16. For a discussion of the various ways in which inflation reduces the real rate of profit, see below, pp. 930–937.

17. See below, pp. 931–933. In the case of inventories, there is some relief in that it is possible for businesses to choose to calculate their costs for tax purposes on the basis of the cost of the inventory acquired last rather than first—i.e., the socalled “Lifo” system (last in, first out) rather than the customary “Fifo” system (first in, first out). In the case of fixed assets, however, there is no such palliative.

18. See Ludwig von Mises, Bureaucracy (1944; reprint ed., New Rochelle, N. Y.: Arlington House, 1969), passim.

19. See Ludwig von Mises, Socialism (New Haven: Yale University Press, 1951), pp. 40–42, 500–504; reprint ed. (Indianapolis: Liberty Classics, 1981). See also below, pp. 296–300, which greatly elaborate on the points just made.

20. See above, pp. 228–230.

21. New York Times, April 11, 1974, pp. 49, 55.

22. Reported improvements in fuel economy are largely the result of compelling manufacturers to produce smaller, lighter-weight cars.

23. It is closely associated with what I described earlier as the Eloi mentality. See above, pp. 110–112.

24. Cf. above, pp. 23–26.

25. For a rebuttal of the closely related charge that a free economy lacks freedom of competition and freedom of entry, see below, pp. 375–376. For further discussion of the concepts of freedom and freedom of competition and a refutation of the related tissue of fallacies that constitute the doctrines of “oligopoly,” “monopolistic competition,” and “pure and perfect competition,” and of the charge that a free economy lacks “price competition,” see below, pp. 425–437. See also the discussion of the concept of freedom on pp. 21–27, above.

26. As will be seen, under universal price controls, it is possible for the controls to build in a substantial rate of profit. Even so, potential competition would not be a factor, because in the context of universal price controls, the shortages are so severe that even if new suppliers could enter any given industry, the effect would not be to eliminate the shortage faced by the customers of that industry. At the same time, the effect would be to make shortages elsewhere in the economic system more severe. On these points, see below, p. 257.

27. New York Times, February 5, 1974.

28. These results are reinforced by the fact that the more economical models, being more popular and therefore selling faster, tend to carry lower profit margins in a free market than do the higher priced models. For example, $1 million of capital invested in a fast-moving inventory of low-priced models may generate $2 million of sales revenue in a year, while the same sized capital invested in a slow-moving inventory of high-priced models may generate only $1 million of sales revenue in a year. In order to earn the same rate of profit on capital, say 10 percent, when invested in either inventory, it is only necessary to have a 5 percent profit margin on the low-priced models, while a 10 percent profit margin is required on the high-priced models. If price controls are imposed and costs rise by any given percentage, the reduction in profit margins will be more severe in the case of the low-priced models. For example, a 5 percent rise in costs will just about totally eliminate profits on the low-priced models, while it will roughly halve them on the high-priced models. This too tends to cause the discontinuance of low-priced models ahead of high-priced models.

29. For a more forceful demonstration of this point, see below, pp. 254–256.

30. See above, pp. 205–206.

31. I am indebted to von Mises for this point and for the example used to illustrate it. See Ludwig von Mises, Human Action, 3d ed. rev. (Chicago: Henry Regnery Co., 1966), pp. 762–764; Socialism, pp. 532–534; Planning For Freedom, 4th ed. (South Holland, Ill.: Libertarian Press, 1980), pp. 73–75. 32. The additional expenditure on the uncontrolled goods is equal to the funds that the sellers of milk are prevented from receiving by virtue both of the artificially low, controlled price of milk and the reduced production of milk.

33. Because the Soviet Union was always nothing more than an illegitimate extension of Russia—the Russian Empire—I follow the practice of referring to it simply as Russia or Soviet Russia, though in view of the recent breakup of this empire, it is sometimes necessary to distinguish Russia from the former Soviet Union as whole.

34. Of course, the government is capable of forcing people to sleep in the streets, by prohibiting landlords from providing housing in the limited size and quality people can afford. Where they are local, such prohibitions are accompanied by a spillover effect of their own, which makes conditions worse in areas free of such restrictions. On these points, see below, pp. 384–385. 35. It should not be forgotten, of course, that a major portion of the increase in price paid to the American oil companies was not actually received by them but was taken by the government in the form of the socalled windfall-profits tax.

36. This is written in the fall of 1993.

37. See above, pp. 250–252.

38. See above, n. 31 of this chapter, the reference to von Mises. 39. See Hedrick Smith, The Russians (New York: Quadrangle

266 CAPITALISM

Books, 1976), pp. 62–65, and Robert G. Kaiser, Russia (New York: Atheneum, 1976), pp. 46–48. 40. Smith, Russians, p. 65.

41. See above, pp. 239–247.

42. On the significance of cutting costs and, by implication, of raising them, see above, pp. 179 and 212. 43. See above, pp. 245–246.

44. See Smith, Russians, pp. 60–61. 45. See Kaiser, Russia, pp. 315–356. See also Hedrick Smith,

The New Russians (New York: Random House, 1990), p. 210. 46. For a discussion of the role of economic efficiency in capital accumulation, see below, pp. 629–631 and 634–636.

47. See Kaiser, Russia, pp. 16, 324; Smith, Russians, p. 267. 48. See Ludwig von Mises, Human Action, pp. 717–719, 758– 759, 764; Socialism, pp. 533–534; Planning For Freedom, pp. 4–5, 22–27, 30, 72–78; Omnipotent Government (1944; reprint ed., New Rochelle, N. Y.: Arlington House, 1969), pp. 55–58. 49. See von Mises, Human Action, pp. 258–259, 716.