Are Controls the Answer?

Are Controls the Answer?Author(s): Hendrik S. HouthakkerSource: The Review of Economics and Statistics, Vol. 54, No. 3 (Aug., 1972), pp. 231-234Published by: The MIT PressStable URL: http://www.jstor.org/stable/1937983 .

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ARE CONTROLS THE ANSWER? Hendrik S. Houthakker

W E shall not know for many months if AVIV~the introduction of direct controls over wages and prices in late 1971 was followed by a significant slowdown in the trend of price and wage increases. Even if inflation will moderate somewhat, as is likely, economists will still be debating for years whether this can be attributed to the controls or whether it is simply the delayed result of considerable slack in the economy. But whatever the outcome of this future academic debate, some form of direct control is likely to be with us for some time. The establishment of direct controls on August 15, 1971 was popular among the public at large and subsequent opinion polls indicate that this program, despite its uncertain performance to date, has not become a political liability. The controls are only likely to be abandoned if they seriously hurt some important pressure group without visible offsetting benefits elsewhere, but this has not happened so far. Although some discontent among West Coast longshore- men gave most of the labor representatives on the Pay Board a pretext for walking out, most union members, and even the departed leaders themselves, are apparently quite willing to live with continued controls. The Price Commission has so far managed to avoid widespread criti- cism, except on the issue of food prices over which the Commission has only limited juris- diction.

Aside from public reaction, another reason for thinking that controls will not disappear soon is that inflationary pressures are likely to become more intense as the economy comes closer to capacity operation. If there is a case for controls when unemployment is around 6 per cent, it will be even stronger if unemployment drops to a more sustainable level. Unlike the control programs imposed in wartime, the present program has no natural termination point. The view that the present controls will be effective mainly by bringing about a reversal in inflationary psychology is not likely to be substantiated unless inflation can be curtailed much more drastically than official pronounce-

ments suggest. A reduction in the inflation rate from 4 per cent to 3 per cent, while welcome, will scarcely allay widespread apprehension about large budget deficits and rapid monetary expansion. In fact, the belief that sheer psychology, as opposed to expectations based on experience, plays an important role in the inflationary process does not appear to be sup- ported by any evidence. Unless real output can be made to grow at a much higher rate than has so far been achieved, the rapid growth in the money supply combined with the usual lags virtually guarantees the preservation of inflationary pressures well into 1973, if not longer.1 A recent Brookings study (Schultze et al. 1972, especially chapter 13) suggests that the Fed- eral budget will not be a restraining influence either.

If this prognosis for controls is correct, the question is what they will actually achieve. Even if attained, the modest reduction in the inflation rate officially set as a goal pro- vides only weak justification for this drastic departure from our generally successful economic traditions. There is some indication that the Pay Board and Price Commission will serve less as a means of curtailing inflation than as watchdogs over big business and big labor. The three-tier classification of business firms by the Price Commission is one indication in this direction, and it has been further reinforced by the recent exemption of most small enter- prices from price and wage controls. The Pay Board and the Construction Industry Stabiliza- tion Committee already spend most, if not all, of their time on organized labor.

There is indeed a case for better supervision of the labor unions. In the last few years we

'In this connection it should be noted that in recent decades the growth rate of money GNP has on the average exceeded the growth rate of the money stock by about 3 percentage points. Thus, the recent year-to-year growth rate of 6 to 7 per cent in M, could sustain a growth rate in money GNP of 9 to 10 per cent, far more than the pro- spective growth rate in real GNP. It is true that the 3 per cent difference could conceivably be attributed to interest rate effects, but in the absence of a clear turn-around in inflation, a drastic fall in interest rates is not in the cards.

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232 THE REVIEW OF ECONOMICS AND STATISTICS

have come closer to the situation already reached in the United Kingdom (prior to the recent legislation), where the unions could obtain wage increases not only regardless of productivity, but also regardless of the state of the labor market. Our labor laws appear to be inadequate to deal with this problem, which has greatly complicated the preservation of full employment. The power of the unions may therefore have to be constrained in other ways. Although the Pay Board and the Construction Industry Stabilization Committee have so far demonstrated only limited effectiveness in deal- ing with excessive wage increases, they may learn in due course. Perhaps the introduction of an official link between unemployment and wage changes (an institutionalized Philips curve) would lead to better results.

However this may be, systematic government intervention in collective bargaining may be necessary pending a general restoration of competition in the labor markets and elsewhere. The great danger of regulatory bodies, as experience in other areas suggests, is that they will come under the control of the sector they are supposed to regulate. The departure of the labor members of the Pay Board does not necessarily remove this danger; it may indicate, on the contrary, that they were satisfied the Pay Board would be responsive to the unions even without their overt participation. Any tendency on the part of the Pay Board to favor organized over nonorganized labor will no doubt make union membership more attrac- tive and thus make the unions even more powerful. While this result may be partly offset by employers substituting nonunion for union labor, discriminatory wage controls are not likely to improve the working of the labor market.

For somewhat different reasons much the same is true if the Price Commission concen- trates on big business. The danger here is not so much that large firms will have undue influence over the Commission; for one thing there are far more large firms than large unions, and their interests are more diverse. The danger is on the contrary that the Price Commission will reduce the profit margins of the more efficient firms (who are usually among the

larger ones) to such an extent that marginal firms (who are often small) will be squeezed; even if the latter can avoid bankruptcy, they will then have difficulty attracting capital. In view of the increasing emphasis on profit controls, this danger is by no means theo- retical. Many economists (including at least one in this symposium) believe that price controls should be confined to large firms, and recent political trends also favor this emphasis. There may well be more immediate effect on prices if firms with large profits are forced to roll back their prices, but their less profitable competitors will, by the same token, see their market share or their profits (and probably both) vanish. Those who want to use controls as an instrument against big business will thus have gained a Pyrrhic victory at best.2

Presumably not all qualified observers will agree with my assessment of the short-term results of price-wage controls as modest at best, and of the long-term results as harmful. Only time will tell. But unless my fears are ground- less, continued controls do not appear to be the answer to inflation, at least from an economic point of view.3 Let us therefore con- sider alternatives.

One alternative that does not need much attention is the milder "incomes policy" prac- ticed in the United States during the middle

2 The foregoing analysis, which starts from the existing differences in profitability among the firms in an industry, clearly needs to be spelled out in much more detail than is possible here. In particular, it is necessary to distinguish three types of industries: those where a few large firms account for virtually all the supply, those where there are some large firms but small firms are important in the aggregate, and those where even the larger firms do not have significant market power. In the first type, profit controls and the resulting threats to market shares are likely to result in collusion (with or without government aid) to preserve the status quo; as Richard McLaren, then Assistant Attorney General in charge of the Antitrust Divi- sion, pointed out last year, many of the antitrust cases of the 1920's and 1950's originated in war-time controls. The second type of industry, which is probably the most com- mon in the United States, is the one envisaged in the text. In the third type, where concentration is low to begin with, emphasis on the larger firms is not likely to do much for the price level.

'From the political point of view the New Economic Policy was a tactical masterstroke in that it outflanked the opposition, though by the same token it raised serious questions concerning the Republican posture on the role of government in the economy.



WAGE-PRICE POLICY 233

1960's and also widely adopted abroad. While much less disruptive than direct controls, this milder approach has not had any lasting results (see, for instance, Ulman and Flanagan, 1971).

There is considerably greater promise in what may be called a "procompetitive strategy," under which the government attempts to make the factor and product markets more responsive to overall fiscal and monetary policy. Such a strategy would involve legislative re- forms in the areas of labor, antitrust, transportation, energy and agriculture, in addition to liberalization of import restrictions.

The advantages of competition for the efficient allocation of resources have, of course, long been recognized, but its benefits for economic stability are no less important. In markets where competition is restricted, prices tend to be not only too high, but also too sticky. In competitive markets prices respond more promptly to changes in supply and demand, and this is especially important for the success of anti-inflationary policies. Although aggregate demand was curtailed significantly between late 1968 and early 1970, prices and wages were not affected as much as similar experiences (most recently in the late 1950's) suggested. Wages continued to rise despite considerable unemployment, and prices followed suit, despite a fall in profits. As far as the labor markets are concerned there is admittedly little direct evidence of a change in structure which would have made them less responsive to unemployment. Nevertheless better response could have been obtained by policies aimed at racial dis- crimination, apprenticeship requirements, hir- ing halls, product boycotts and other restrictive practices. Such measures were especially needed in the construction and transportation industries, where wage increases were largest.

In several important product markets measures could have been taken to let declining demand show up in lower prices rather than in lower output. Some of these measures relate to imports, which are often the most potent source of competition in oligopolistic markets. Thus, if so-called voluntary quotas on steel ex- ports from Japan and Europe had not been negotiated in 1968 the behavior of steel prices would have been quite different. Similarly,

the adoption of the Cabinet Task Force report on oil imports would have had a major impact on petroleum prices. The substantial increase in dairy support prices in March 1971 was contrary to anti-inflationary policy. So were the readiness of the Interstate Commerce Com- mission to grant general freight rate increases, and the efforts of the Civil Aeronautics Board to prevent overcapactiy from depressing do- mestic airfares; these in turn encouraged the carriers to agree to the large wage increases demanded by the unions involved.4 Many more cases could be cited (including a few where competition was promoted and prices fell as a result, notably in international avia- tion), but on balance they would not change the conclusion that the government has generally been prepared to help politically powerful sectors in keeping prices up. This was one reason why the losses of output and employment implicit in the anti-inflationary policy followed up to mid-1971 were largely in vain. In fact the perverse response of these protected markets to the decline in aggregate demand may have aggravated these losses.

The principal lesson from this experience is that a procompetitive strategy is politically costly since it tends to offend powerful and well-organized interest groups. However, a strategy of controls cannot succeed either unless it hurts somewhere. As was pointed out earlier, the controls have not so far inflicted much pain, but neither have they done much to reduce inflation. The political advantage of controls is that the pain can be directed to the less vocal sectors. This is presumably why the wage boards have been willing to give prefer- ential treatment to certain unions and why little or nothing has been done to restrain farm prices. It remains to be seen whether this selective approach will yield the desired results.

There is still another alternative: to let inflation take its course, thus avoiding the costs inherent in an effective procompetitive or controls strategy. The many studies of the effects

'The Price Commission has been willing to give blanket approval to ICC and CAB decisions; in fact it is thus assuming the long-neglected responsibility of regulating the regulators.



234 THE REVIEW OF ECONOMICS AND STATISTICS

of inflation 5 suggest that the U.S. economy has developed fairly good adjustment mecha- nisms for the rather mild inflation we have ex- perienced until now. Wages and prices go up- ward in tandem; long-term interest rates fully reflect the rate of change of prices; most trans- fer payments are adjusted periodically. For most Americans who own any property at all their main asset is a house, whose value rises at least as fast as the general price level, and their main liability is a mortgage contracted long ago and fixed in money terms; they clearly stand to gain by inflation. Of course there are flies in this ointment. The gains of home- owners are matched by the losses of thrift in- stitutions, but expedients have been found to take care of this. More seriously, inflation through the Pigou effect leads to a rise in per- sonal savings,6 and this complicates the attain- ment of full employment. Moreover it is con- ceivable, though by no means certain, that inflation has a tendency to accelerate if left alone.

Of the three options before us -controls, competition, and benign neglect my own preference as an economist and citizen is clearly for the second, the only one that is consistent with established economic analysis. The sudden switch to controls one year ago resulted from an unwillingness to bear the short-term political costs inherent in a more constructive approach. But in economic policy the hard choices cannot be avoided, and the consequences of controls, even if they reach their primary objective, may not be very appealing either. We must all hope that the present policy will work, but at the same time we must remain on the alert for indications that it will ultimately do more harm than good.

'For a good summary see Morley (1971). 'This is the most likely explanation of the high savings

rates that have surprised so many observers of the economy. These rates are not surprising if savings are viewed as the planned accumulation of assets, and if the desired money value of assets is related to money income. As shown by Houthakker and Taylor (1970, chapter 7) the savings rate is then an increasing function of the growth rate of money income. The savings functions estimated there (on the basis of data preceding the current bout of inflation) have continued to track well.

REFERENCES

Houthakker, H. S., and L. D. Taylor, Consumer Demand in the United States: Analyses and Projections with Applications to Other Countries, 2nd edition (Cam- bridge, Mass., Harvard University Press, 1970).

Morley, S. A., The Economics of Inflation (Hinsdale, Ill., The Dryden Press Inc., 1971).

Schultze, C. L., E. R. Fried, A. M. Revlin, and N. H. Teeters, Setting National Priorities: The 1973 Budget (Washington, D.C.: The Brookings Insti- tution, 1972).

Ulman, L., and R. J. Flanagan, Wage Restraint: A Study of Incomes Policies in Western Europe (Berkeley: University of California Press, 1971).



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Are Controls the Answer?