Ours is a period of extensive allegations about the social irresponsibility of big business and big labor. As professional economists we want to put in a plea for a balanced record by focusing on the social irresponsibility of big government and its apologists. In a time when everything is being exposed, we want to contribute our part by unmasking wage-price controls and the "guilt triangle" theory of inflation.
Wage-price controls are an attempt to adjust the economy to the cause of inflation. Price controls "work" only by interrupting the normal functioning of markets. When the normal functioning of markets is interrupted, economic inefficiencies result. Thus, the "success" of controls varies directly with the number of economic inefficiencies that the controls create. A fundamental tenet of economics equates economic inefficiencies with economic failure. This article explains the "success through failure" paradox inherent in any system of wage-price controls, and argues that the existence of corporate and labor monopolies is not the cause of inflation. Inflation has its origin not in monopolies, but in money creation by the government. Wage-price controls have their origin not in inflation, but in an effort to subordinate private interests to the interests of government.
SUCCESS THROUGH FAILURE
The first principles of economics show that wage-price controls can succeed only by causing economic failure. It is a law of economic science that the only equilibrium price is the price at which all buyers can find a seller and all sellers can find a buyer. At the equilibrium price the market is said to clear. Even a monopolist prices his product such that the market clears. In an inflationary economy, the average of all equilibrium prices will rise. Some individual prices will increase by more than the average, others will increase by less than the average, and others may even decrease. Differences in the rate and direction of change of individual prices will result from particular technical advances and shifting consumer tastes. On the average, however, equilibrium prices will be increasing. But in the absence of controls all markets will clear.
Given these unalterable facts, what impact can wage-price controls have on an inflationary economy? If the controlling agency sets individual prices such that each market clears, then the agency is simply duplicating the market system: The price level (the average of all equilibrium prices) will continue to increase. In this case it is obvious that the control agency is a redundant input into the economy's production and distribution process. Therefore, the controllers will try to "do something" about the inflation by fixing individual prices at levels that are artificially low; that is, below equilibrium or market clearing levels. As a result shortages will emerge in the controlled markets. In other words, the only way controllers can avoid being a redundant input is to set prices such that all buyers cannot find sellers. Shortages in the controlled markets will result in rationing, black markets, preferential allocation by sellers, and many other discriminatory means of allocating a limited supply among competing buyers.
This is a perversion of the function of government. The government's price control officials will find that their success is directly related to the amount of rationing, black markets, and other forms of discrimination which they create. Even Communist economists understand this! For example, Tibor Liska, a Hungarian, has written:
In the case of free price movements, not even the most reckless floating of money can result in a general shortage, as prices may always rise to a higher level in order to absorb the growing quantity of money. In open inflation, the balance of demand and supply is attained again and again at a constantly increasing level of prices. But if, in order to avoid an inflation in prices, prices are fixed by the state via administrative measures, the total money demand can exceed the total money price of the goods supplied. This means waiting in more and more lines trying to purchase goods. From the lines getting longer and longer, the situation would soon become that only those heading the line would be able to buy anything for their money if the state did not intercede with some kind of ration system. That is, the state must determine what firms are to be allowed to purchase what resources and what consumers are allowed to purchase what goods.
Every economist knows that the state has no rational criteria by which to make such decisions and that the state's efforts to ration goods and resources result in wastage and loss of real national income. Aside from these economic costs, such a way of running an economy greatly reduces our individual liberties, it amounts to an economic police state.
THE REAL CAUSE OF INFLATION
What is consistently overlooked by advocates of wage-price controls is that the level of prices measures the rate at which money is exchanged for commodities. Consequently, there cannot be a rise in the price level unless the amount of money in the economy rises relative to the commodities available for purchase. In spite of all the recent theories and new jargon, the above statement is incontestable. If prices are to continue to increase through time, the supply of money must continue to increase relative to production. The growth rate of the money supply is determined by the government. The rate of growth in production depends primarily on the growth in quantity and quality of capital and labor inputs. Since the latter growth rate is to a great extent outside the purview of the government's (or anyone's) control, inflation can only occur if the government carries out an expansion of the money supply which is too rapid relative to production.
THE GUILT TRIANGLE
This simple but accurate description of the cause of inflation stands in vivid contrast to the "guilt triangle" theory of inflation, an erroneous theory extremely popular today. Two corners of the "guilt triangle" are "big business" and "big labor." Government officials place the blame for inflation on both business and labor for raising prices and wages. Arthur Burns, Chairman of the Federal Reserve Board of Governors, in testimony before the U.S. Congress, stated that "the structure of our economy—in particular, the power of corporations and trade unions to exact rewards that exceed what could be achieved under conditions of active competition—does expose us to upward pressure on costs and prices that may be cumulative and self-reinforcing" (FEDERAL RESERVE BULLETIN, February 1973). A Democratic administration may place more of the blame on business while a Republican administration may attribute more of the guilt to labor unions.
Labor unions plead innocence, saying that if business had not raised prices, labor would not have had to demand wage increases above increases in productivity. Business counters labor's argument by claiming that it was labor's exorbitant wage increases which forced them to raise prices. Each tries fruitlessly to benefit at the expense of the other, and these accusations repeat themselves over and over despite the fact that a continual rise in the price level cannot occur unless the government injects money into the economy at too rapid a rate.
Arthur Burns, the Chairman of the organization which has created the money that has caused the inflation, argued in his statement to Congress that the danger of a cumulative and self-reinforcing price spiral is so close at hand and of such proportions that "the very future of the American economy depends on getting better control of our stubborn inflationary problem. Early extension of the Economic Stabilization Act, and its effective implementation by the administration are essential." To imply that inflation can be stopped through wage and price controls is to argue that it is rising wages and prices which are the cause of inflation. This is as unsophisticated an explanation of inflation as a meteorologist claiming that the reason it rains is that drops of water fall to the ground!
By placing the blame on the private sector and by generating accusations of guilt between business and labor, the government divides and conquers. If labor and business do not soon realize that their common enemy is big government and unite against it, they will lose their autonomy.
The third hapless corner of the "guilt triangle" is private investment and consumption expenditures. Since wage-price controls cannot cure inflation, but only suppress it, sooner or later individual private expenditures must come under fire by government officials. When this point is reached apologists of big government suggest a tax increase as an antiinflationary policy. The purpose of a tax increase is to reduce private expenditures relative to government expenditures. In other words, private after-tax incomes must decline in order that government expenditures can continue to grow. An increase in taxation is not an antiinflationary policy, but a mechanism for redistributing national income from private to public spending. Thus, the argument for a tax increase as an antiinflationary policy is merely a convenient guise for the real purpose of ideologues who think that private spending is excessive relative to public spending. If private individuals, whether Democrats or Republicans, do not soon realize that big government is their common enemy, they will lose their incomes.
Implicit in the "guilt triangle" theory of inflation is the idea that prices are somehow forced upon consumers by socially irresponsible business firms and that wages are forced upon business firms by socially irresponsible unions. This erroneous theory neglects the fact that in a market economy trades cannot be forced. Trades are voluntary transactions. Anyone who enters into a trade does so because he believes that the trade will improve his situation. To complain that trade "forced" such and such a price is ludicrous. No one will enter into a trade that makes him worse off. Prices simply reflect the choices that people make.
Also implicit in the "guilt triangle" theory is the idea that private spending decisions are socially irresponsible whereas government spending decisions are always socially responsible. It is a disturbing commentary on the success of government propaganda that this idea is so prevalent during a time when it has become increasingly clear that government has purposes of its own that are independent of any public interest or any political party. The "guilt triangle" theory of inflation is a mask for the self-interest of government which can only expand by discrediting the efficacy of private interests.
MONOPOLIES AND THE PRICE LEVEL
Some economists, such as Professor Houthakker of Harvard University, have used the controls-inflation issue to argue for the elimination of business and labor monopolies (BARRON'S, 8 November 1971). The monopoly issue is a red herring. Arguments that connect the elimination of monopolies with antiinflationary policy support the government's "guilt triangle" theory of inflation. Although monopolies might contribute to a higher price level by restricting output, monopolies cannot inflate the economy. The presence or absence of monopolies does not affect the government's ability to create money.
Consequently, if proposals such as Houthakker's were adopted, their only effect on the price level would be to cause a one-time decline resulting from a one-time increase in output. After the elimination of monopoly, just as before the elimination of monopoly, the price level would be determined by the rate of change in the money supply relative to the rate of change in output.
Once monopolies were eliminated, two corners of the "guilt triangle" would be eliminated, leaving private consumption and investment expenditures as the government's only scapegoat. Thus, the full brunt of the government's "antiinflationary policy" would fall on private disposable incomes. Since Americans are unwilling to vote higher taxes on their incomes in order for the government to grow relative to the private sector, the game plan of the "progressive intelligentsia"—the handmaids of big government—is to achieve an increase in taxation under the guise of fighting inflation.
The "progressive intelligentsia" have no vision of economics and politics as the balancing of rival interests. Theirs is a highly simplified outlook: On the one hand is the public interest, identified with big government, self-evident and beyond questioning by an upright person; on the other hand are private interests, selfish, sinister and illegitimate.
Instead of exercising restraint over its own spending and money-creating activities, the government seeks to impose controls on what it sees as selfish and sinister private interests in order to harness them to its purposes. The fundamental freedom of buyer and seller to agree upon price can be destroyed, and private after-tax incomes decreased, without making any dent in the real cause of inflation.
Dr. Paul Craig Roberts is a research economist at the Hoover Institution on War, Revolution, and Peace at Stanford University and has published two books and numerous articles, including "Who Are the Imperialists?" which appeared in the August 1973 REASON; Dr. Gary Santoni is a professor of economics in Kansas; and Dr. Norman Van Cott is a research economist at the U.S. Department of Labor.
This article originally appeared in print under the headline "Unmasking the "Guilt Triangle" Theory of Inflation".