Midnight Money Analysis


It would seem safe to claim that few professional economists would be apt to affirm the use of price and wage controls as the means of calling a halt to price inflation. The standard argument against the imposition of price controls is straightforward enough: when official prices are below the prices that would have prevailed on a free market, shortages will appear in the legal, visible markets. Scarce resources will be hoarded; production bottlenecks will occur; production will decline; goods will be diverted into black markets. (Defenders of the methodology of scientific neutrality should not use the phrase "black markets." I much prefer "alternative zones of supply.") So much for the textbook presentation.

The argument states that price controls attack only symptoms, leaving underlying causes, be they fiscal or monetary in nature, basically unaffected. This judgment has been overly hasty. There is one very important aspect of the debate over controls that has been neglected in the literature. People cheat. The bigger the stakes, the greater the costs of not cheating. Admittedly, this is difficult to prove empirically: the bigger the stakes, the higher the risk; the higher the risk, the greater incentive for secrecy. After a time, presumably, the less efficient cheaters tend to be removed from the marketplace, leaving even more successful cheaters, who in turn leave fewer traces.

Leaving traces is the heart of my economic analysis, or rather, not leaving traces. As monetary inflation continues, the disparity between the legally fixed prices and the hypothetical market prices tends to increase. The opportunities for profit in illegal arbitrage operations also increases. Assuming that the political authorities are concerned about enforcing the structure of legal prices, more of the state's resources will be devoted to ferreting out cheaters.

The obvious place to start searching would seem to be the checking accounts of the nation's entrepreneurs. The Supreme Court has upheld the legality of photographing checks, so the data are available. The more efficient cheaters understand the implications of photographed checks. Credit cards, of course, leave even more traces than checks. The obvious alternative money for use in alternative markets is cash. For the purpose of exposition, let us designate cash as Midnight Money, or MM1 (since M1 refers to checking accounts plus currency in circulation).

As demand for MM1 increases, there will be pressures on the commercial banking system to provide the needed funds. No doubt the Federal Reserve System, established in 1913 to provide the nation with a truly elastic currency, will respond to the increased demand. The problem, of course, is the structure of fractional reserve banking. Withdrawals of MM1 that are not offset by redeposits elsewhere in the commercial banking system reduce the banking system's ability to create new deposits, since legal reserves are reduced by the very act of withdrawal. If a bank must retain a 15 percent reserve for all demand deposits, the permanent removal of one cash dollar, assuming banks are fully loaned out, would involve a shrinking of M1 by as much a $6.67, (1/15 = 6.67, minus the dollar still in circulation.) If the dollar were removed from a savings account, the contraction would be that much greater, given the lower reserve requirements for time deposits.

Thus, we can conclude that the effect of price controls is to create shortages; shortages give rise to alternative zones of supply (illegal); participants in these zones seek to cover their trail, and therefore prefer to make exchanges in cash; and the public's willingness to withdraw cash from the fractionally reserved banking system reduces the system's overall reserves, forcing them to contract both M1 and M2. (M2 equals M1 plus net time—savings—deposits.) This, quite obviously, is deflationary. Hence, it is safe to conclude that price and wage controls do help to reduce price inflation.

As far as I am able to determine, this is the only theoretical justification for imposing controls to reduce price inflation. Yet I have not seen a single reference to MM1 in the literature, nor have I heard a single pro-controls politician or economist use it in support of his proposed system of controls. Since MM1 analysis is the very heart of any serious proposal to reduce price inflation by means of price controls, I hope that my contribution will be seen for what it is.

Gary North received his Ph.D. in history from the University of California at Riverside. He edits the biweekly Remnant Review economics newsletter and is the commentator on the Gold and Inflation Report, a telephone advisory service.