Blaming the Victims; R. Higgs

Putting metaphors aside, I am say ing that they have a theory about the nature and causes of inflation that suggests guidelines can be an effective anti-inflation policy. It is not a very coherent or well articuRobert Higgs Is Professor of Economics at the UnI versity of Washington. He Is popular as a lecturer on economic and monetary affairs. His writings Include numerous .rtlcles .s well .s books on The Trans 'ormation 0'the American Economy, 1865-1914, and Competition and Coercion. lated theory, but its main elements can be·discerned fairly readily in the statements emanating from the President himself, from the Council on Wage and Price Stability (COWPS), and from the Council of Economic Advisers (CEA). The Official Line The fundamental assumption of the government's theory is that competitive market forces have lit tle or nothing to do with the deter mination of prices and wages. ((The pay and price standards," the Presi dent's advisers say, ((are designed to be guides for decision-making agents who have discretionary power in wage and price determination."1 They believe, in other words, that firms can set whatever prices they want and, in conjunction with the unions, whatever wages they want.

Alfred Kahn, the chairman of 397 398 THE FREEMAN July COWPS, and his fellow enforcers obviously believe that this dis cretionary power resides especially within the largest corporations and labor unions, for those institutions have been the focus of their monitor ing efforts from the very beginning. The notion that large firms and unions possess significant power to resist competitive market pressures is known to economists as the administered-price theory. The President's men clearly embrace this theory root and branch. From the administered-price theory of price and wage determina tion, it is but a short step to the cost-push theory of inflation. The government economists have taken this step. In this year's Report of the Council of Economic Advisers, one finds repeated assertions that dur ing the current expansion the econ omy, even in 1978, has not yet ex perienced excessive aggregate de mand for its output. Idle plant and labor, it is said, have been ample to accommodate increases in the econ omy's rate of output. 2 Rather than the pressure of excess demand driv ing up prices, the government economists see cost increases, par ticularly increased costs of labor, pushing prices up. H[T]herise in unit labor costs," it is alleged, was ~~a major factor in the acceleration of inflation" in 1978.3 By combining the assumption of discretionary market power, the administered-price theory, and the cost-push theory of inflation, the government economists arrive at the concept of a wage-price spiral as a characterization of the causal structure of inflation. In this view, large firms and unions conspire to push up wages excessively; the firms then pass the increased labor costs along to final consumers and other purchasers in the form of higher product prices, thereby creating in flation. In response to this inflation, which reduces real wages, the unions subsequently return to the bargaining tables with even more outrageous demands. The economy is propelled through successive rounds of inflation kept in motion by the powerful but socially irresponsi ble actions of the large companies and unions. The rest of the economy, with its smaller firms and mostly nonunionized workers, falls pas sively into line with the patterns set by the large firms and unions.

The wage-price spiral is the gov ernment's accepted view of the basic inflationary process, but the Presi dent's men complement this basic conception with two auxiliary theories of inflation: the exogenous shock theory and the self-sustaining expectations theory. The exogenous shock theory has been especially popular of late. In his economic report to the Congress this year, the President relied on it almost exclusi vely to explain the 1979 THE GOVERNMENT'S THEORY OF INFLATION 399 recent increase in the rate of infla. tion. Mr. Carter identified severa.l important shocks: Cold winter weather affected food supplies and prices. Depreciation of the dollar in foreign exchange markets added to prices of imports and to prices of goods produced by U.S. firms that com pete with imported products. Costs of land and building materials were driven up by exuberant demands for new homes, and the rise of mortgage interest rates added to the costs of buying a home. At the same time, the cumulative effects of government legislation and regulation over recent years gave further impetus to cost pressures. A large part of the worsening of inflation last year, how ever, stemmed from poor productivity. 4 Of course, the most frequently cited exogenous shock of all is the effect on fuel and related prices when the OPEC cartel raises the price of oil.

All of these exogenous shocks are thought to be external to the normal functioning of the American econ omy but additive to its allegedly inherent wage-price spiral. They are seen as unfortunate accidents-Qur luck seems always to be bad-that make inflation even worse than it would be as a result of the internal wage-price spiral. Finally, the self-sustaining expec tations theory completes the gov ernment's overall conception of the inflationary process by suggesting that, once inflation has gone on for a while, people expect it to continue; and these expectations, all by theolselves, can then continue to push prices up year after year. In the words of the CEA, ~~Once under way, a high rate of inflation generates responses and adaptations by indi viduals and institutions that per petuate the wage-price spiral, even in periods of economic slack. . . . The formal and informal adaptations to a longstanding inflation exert a powerful force tending to sustain inflation even after the originating causes have disappeared."5 Those who regard economics as the dismal science will certainly find ample confirmation in this theory.

Fallacies of the Official Line Unfortunately, the entire edifice of the government's theories-the assumption of discretionary power, the administered-price theory, the wage-price spiral, the exogenous shocks, the self-sustaining expecta tions-all of it is the rankest non sense as an explanation of infla tion. There are a variety of pertinent reasons for rejecting the official line. Consider for a moment the as sumption of discretionary power. This unfortunate belief seems to have grown out of the common ob servation that many firms can in crease their prices somewhat with out losing all their sales. What the notion of discretionary power ne glects, however, is that, unless the demand for its product has in creased, a firm that raises its prices 400 THE FREEMAN July will experience a reduction in unit sales volume. Even the true monopolist, the single seller with the market all to himself, must con tend with the law of demand-and, of course, true monopolists are as rare as hen's teeth. Clearly, even firms in highly concentrated indus tries must, and do, compete for the customer's favor. Despite what Pro fessor J. K. Galbraith and a host of lesser known polemicists have as serted, it simply is not true that large firms can raise their prices at will without suffering any con sequent reductions in sales. Even if this ever had been the case, we can be confident that business managers would long since have taken advan tage of such a marvelous opportu nity for adding effortlessly to their profits. The idea that large firms possess bottomless reservoirs of dis cretionary pricing power is prepos terous in its logic and without any basis in fact.

The closely related theory of ad ministered pricing is similarly flawed. George Stigler and James Kindahl, in the most painstaking and carefully designed study of in dustrial prices ever conducted, found that industrial markets, in cluding those with only a few large firms, are not ««unresponsive in their pricing to changes in general busi ness conditions";6 that is, the price data refute the administered-price theory. Economists have also tested the relationship between industrial con centration and the rate of price in crease among industries. Both in the late 1960's and in the decade ter minating in 1977, they have found that the correlation between concen tration and price increases is nega tive; that is, the industries with a few large firms have had smaller average increases in prices than the industries with many small firms. 7 George Shultz, the former Secre tary of the Treasury who occupied an important administrative posi tion during the period of President Nixon's price controls, has pointed out that between 1971 and 1974 prices rose most rapidly in sectors with many small firms (e.g., agricul ture), in sectors dominated by the government (e.g., health services), and in sectors heavily involved in international trade (e.g., petro leum).8 One can draw similar conclusions for the past 11 years by examining the broad components of the con sumer price index: since 1967 (index = 100), the greatest increases have occurred in the prices of home own ership (238.8) and medical care (227.0), both sectors that are domi nated by a multitude of small suppliers. Even increased fuel and utilities prices (218.5), which have been so profoundly affected by the actions of the OPEC cartel, have barely equaled the increased prices 1979 THE GOVERNMENT'S THEORY OF INFLATION 401 of food (217.8), which is supplied by tens of thousands of stores and mid·· dlemen and millions of farmers. 9 The administered-price theory, scientifically speaking, is a joke though not a very funny one.

Nevertheless, it is very popular among the general public, who are infected with a chronic .distrust of big business' motives and actions. And it is, if anything, even more cherished by politicians. As Shultz has said, ttThe politician . . . knows the political mileage to be gained by pushing around the big boys in the economy, whether or not it makes any economic sense."lO Without the assumption of dis cretionary power and the administered-price theory to sup port them, the cost-push theory of inflation and the notion of a wage price spiral collapse of their own weight. Inflation versus Relative Price Changes In any event, the cost-push theory, along with the exogenous shock theory, fundamentally mis construes the issue in question. In flation is a persistent, ongoing in crease in the average price of the economy's total output; or, looking at it from its other side, inflation is a persistent, ongoing decline in the average purchasing power of money.

Unfortunately, it has become commonplace for people to refer to any increase in the money price of a particular product, no matter how small or how transitory, as inflation ary. This confuses the price of a particular good with the average price of all goods. It is extremely important to understand that in any real economy some increases in the prices of particular goods would necessarily occur even if the overall price level were perfectly stable. Ob viously, such particular price in creases would change only the rela tive prices of particular goods; de clines in other individual prices would offset these increases, thereby keeping the aggregate price level constant. The fallacies of the cost-push theory can be illustrated well by a simple, hypothetical example. Sup pose a firm and a union enter into a conspiracy to raise the wage paid to the firm's workers far above the competitive level; the firm then raises the price of its product enough to offset the increased labor costs; but the total volume of money ex penditures in the overall economy remains the same. What will hap pen?

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

402 THE FREEMAN July The increased supply of workers elsewhere will tend to reduce the wage rate, lower production costs, and encourage enlarged production and therefore reduced product prices elsewhere. The ultimate outcome of these readjustments is that the con spiring firm to some extent prices itself out of the market;· its labor force shrinks, and some of its initial workers find work elsewhere at lower wages. The price of the firm's product does increase, to be sure, but prices elsewhere decrease. Inflation, most emphatically, does not occur. The truth is that as long as the aggregate volume of money expen ditures is held fixed, cost increases in particular firms or sectors, no matter what their origin, can cause only relative price changes. Such cost increases alone cannot cause in flation, which is a persistent, on going increase in the average price of all goods and services.

Recall the alleged causes of in creased inflation in 1978 as iden tified by President Carter. They in clude bad weather, dollar deprecia tion against foreign currencies, in creased demand for housing, and higher mortgage interest rates. Each of these can cause a change in relative prices, but none of them can cause inflation. The cost-push theory of inflation, from an intellec tual standpoint, is simply indefensi ble. It remains immensely useful for politicians, however, because it shifts the blame for inflation onto the private sector. But private citi zens cannot cause inflation, because they cannot regulate the volume of aggregate money expenditure. Whoever controls that bears the blame for inflation and holds the only key to stopping it. What Really Causes Inflation? Inflation occurs, by definition, when the economy's aggregate vol ume of money expenditure grows faster than its aggregate real out put. The excessive growth of money expenditures can have, again by definition, only two sources: either the velocity of monetary circula tion grows excessively or the money stock itself grows excessively (or both). Our current inflation is attributable almost entirely to ex cessive growth of the money stock.

Because the excessive growth of the money stock and the inflation it causes do not happen simultane ously, some people always fail to perceive the relationship. Increases in the money stock take some time before their effect on the volume of expenditure becomes significant. But once the actual lag is recog nized, the relationship is seen to be very close. By relating the rate of inflation in a given year to the a verage rate of growth of the broadly-defined money stock (M3) during the three previous years, one can chart a clear parallel relation1979 THE GOVERNMENT'S THEORY OF INFLATION 403 ship. During the 1970's, the only breakdown of this relationship oc·· curred in 1972; and, of course, that anomaly disappears when one ad·· justs the inflation data for the ef.· fects of the severe Phase II price controls in force in 1972. In short, inflation is not caused by cost-pushes, wage-price spirals, de·· preciation of the dollar on foreign exchange markets, regulatory con straints, minimum wage laws, or lagging productivity growth. Infla tion is a purely monetary phenome· non: when the purchasing power of the dollar falls steadily and persis, tently over many years,· it is because dollars have steadily and persis·· tently become more abundant in re lation to the total quantity of real goods and services for which they exchange. Inflation, in sum, is caused by excessive growth of the money stock. Period.

The Government's Responsibility As the Federal Reserve Systenl authorities can control the rate of growth of the money stock, they clearly are to blame for its excessive expansion. Of course, the executive and legislative branches of the fed eral government have put heavy pressures on the monetary au thorities to expand the money stock fast enough to ~~facilitate" the easy financing of the enormous, unpre cedented peacetime deficits in the federal budget. In general, however, the Fed has been an easy touch, quite responsive to these pressures. William Miller, the current chair man of the Federal Reserve Board, has been variously described as ~~cooperative," a ~~team player," and ~~a tool of the [Carter] administra tion."ll One wishes the central bankers had had more backbone. If they had, we would have found that mere deficits, in the absence of excessive monetary expansion, can not cause inflation. Clearly, the de ficits, working through the political process as it influences the Fed, en courage a loose monetary policy. But it is essential to recognize that it is the excessive growth of the money supply, whether to finance deficits or for some other reason, that causes inflation. Conversely, with a suffi ciently slow growth of the money stock, there can be no inflation, no matter what is happening to the federal budget, labor costs, regula tory standards, minimum wages, and so forth. To repeat, inflation is a purely monetary phenomenon.

It hardly needs to be added that once excessive monetary expansion has been halted, inflation cannot be kept alive merely by expectations of inflation. People will find that, in the absence of continuing monetary stimulation of aggregate expendi tures, the inflation they expected just doesn't happen. If they are ob stinate and continue to act as if infla tion is not abating, they will simply 404 THE FREEMAN July price themselves out of their mar kets in the same manner as the conspiring firm in the example above. It is far more likely, however, that they will adjust their expecta tions as the rate of inflation falls. Expectations cannot sustain an in flationary process unless they are validated by the actual course of inflation; and that validation can occur only so long as the growth of the money stock remains excessive. -FOOTNOTESlCouncil of Economic Advisers, Annual Report, 1979, p. 84; emphasis added.