The Futility of Price Controls

The Futility of Price Controls

By Roger LeRoy Miller and Daniel K. Benjamin

In The Economics of Macro Issues

In the modern world, inflation seems to be just about everywhere.  Among the 167 nations for which data are available, 164 (that’s 98.2 percent) experienced sustained inflation throughout the 1990s.  Sixteen of these countries, including Brazil and Russia, had inflation rates that averaged more than 100 percent per year during this period.  Although it looks like the first decade of the twenty-first century will have fewer members of the “100 percent club,” almost every nation will once again have another decade of sustained inflation.

Over the sweep of history, inflation has been less commonplace than today, but it is most assuredly not a modern phenomenon.  The ancient Greek philosopher Aristotle was aware of inflation, and long before the birth of Christ, ancient Rome was plagued by rising prices.  We now know that sustained inflation is, in the words of the Nobel Laureate Milton Friedman, “everywhere and always a monetary phenomenon.”  That is, sustained inflation in the long run is the result of growth in the money supply that exceeds the rate at which the economy can increase the output of goods and services.  This means that the cure for inflation is simple: reduce the rate at which the money supply is growing.

This cure for inflation has rarely been popular with governments, however, because they routinely have been the source of rapid growth in the money supply.  (In fact, issuing more and more money is one of the more popular means by which governments finance their activities, particularly during wars and other periods of fiscal stress.)  Instead, governments often have tried to control inflation by imposing legally mandated controls on prices.  Despite the popularity of these controls, the evidence is clear: they do not achieve their supposed objective of reducing the true inflation rate, but they have plenty of other consequences, none of them productive.

The Sweep of History

Although the Egyptians and Babylonians had tried them hundreds of years before, the first well-documented system of price controls was instituted in 301 C.E. by the Roman emperor Diocletian.  His price-control edicts set schedules for 890 different price categories, more than 200 of which covered food items.  Anyone caught disobeying the emperor’s edict was dealt with severely – death by drowning.  According to the historian Lactantius, writing in 314, there was

…much bloodshed upon very slight and trifling accounts; and the people brought provisions no more to market since they could not get a reasonable price for them, and this increased the dearth so much that after many had died by it, the law itself was laid aside.

Price controls were resurrected in medieval Europe, with a “just price” code based on the “intrinsic value” of goods.  Some years later, the New World colonies tried their hand at controls.  In 1636, the Puritans decreed that those who violated wage and price limitations were officially classified with “adulterers and whoremongers.”

The high inflation experienced during the American Revolution led eventually to the imposition of price controls.  The Continental Congress decreed “that all manufactures of this country be sold at reasonable prices” and that “vendors of goods or merchandise will not take advantage of the scarcity of goods, … but will sell the same at rates we have been respectively accustomed to for twelve months last past.”  But such admonitions – supplemented by price controls imposed by most of the colonies – did not prevent inflation.  By November 1777, commodity prices were 480 percent above their pre-war average expressed in terms of paper money, or “continentals.”

The controls did, however, cause sometimes serious disruptions in the supplies of goods and services.  General George Washington had great difficulty acquiring army provisions at controlled prices, a problem that played a key role in the agony his troops endured at Valley Forge during the winter of 1777-1778.  Partly as a result, the Continental Congress urged the states to abolish controls, declaring in June 1778 that “It hath been found by Experience that Limitations upon the Price of Commodities are not only ineffectual for the Purposes proposed, but are likewise productive of very evil Consequences to the great Detriment of the Public Service and grievous Oppression of Individuals.”

Nonetheless, many local and state price controls continued.  At some town meetings, the names of those who charged more than the controlled prices were announced, and the guilty were condemned in newspapers.  Boston declared that those who violated price ceilings were enemies of their country.  By 1780, most controls were abandoned.

America’s most comprehensive attempt at controlling prices occurred during World War II.  Some years later, in the 1970s the Nixon administration instituted extensive wage and price controls, during the Vietnam War.  And throughout the country, state and local governments have tried to control the prices of a variety of individual goods.  For example, many states have laws prohibiting “price gouging” (usually invoked to control the price of gasoline or ice for refrigeration after natural disasters, such as major storms or earthquakes), and dozens of cities have controls on the rents that landlords may charge on apartments.

Why Impose Controls?

The most popular justification for imposing wage and price controls at the national level focuses on the importance of expectations.  The claim is that, either as a result of past inflation or in expectation of future inflation, firms raise prices.  These price increases lead other firms to expect more inflation, which leads them to raise prices, and so forth.  Imposing price controls, it is said, will break the “expectations cycle” and thus stop the upward pressure on prices.

Although this is a plausible argument, it glosses over the fundamental source of inflation.  After all, inflation is a generalized increase in the dollar prices of goods and services.  For it to occur, something must change the money supply (or the demand for money) relative to the supply of goods and services.  Looking at the historical record, the source of such change almost always has been excessive monetary growth.  Moreover, this excessive monetary growth almost always has been caused by government issuance of money to finance its expenditures.

But why impose controls rather than going after the root of the problem?  When price controls are imposed at the national level, there are a few possible explanations.  During wartime, the government necessarily reallocates huge amounts of resources from private consumption to the war effort.  Price controls can help promote patriotic unity by spreading the cost of that reallocation more evenly among people than if prices freely adjusted and wealth or income alone determined consumption.  Then, too, the controls sharply reduce the budgetary cost of the resource requirements of the war, making the full cost less obvious and thus politically more palatable.  (Note that price controls do not reduce the real economic cost of the war; in fact, they increase it because they force people to use more costly, nonprice means of allocating scarce resources, such as standing in line.)  The imposition of peacetime price controls by a national government is most often an attempt to distract voters’ attention from the real source of the inflation – namely, government spending far in excess of its political will or ability to levy explicit taxes.

State and local governments have no power to issue money, so they cannot cause – or stop – inflation.  But these governments do have the power and the inclination to reallocate resources among their citizens.  Price controls are one way to accomplish this.  For example, legal ceilings on the prices (rental rates) that landlords may charge on apartments reallocate wealth from landlords (who are few in number) to tenants (who are numerous).  This often yields votes for the politicians imposing these controls.

The Consequences of Controls

Price controls of the type we are discussing reduce actual prices below their equilibrium levels.  This implies that price controls must necessarily have three consequences:

The lower prices received by suppliers induce them to reduce the quantities of the goods supplied on the market.The reductions in the quantities of the goods supplied must raise the full cost of the goods to consumers, including both price and nonprice costs (such as waiting in line). Because scarce goods can no longer be rationed by prices, some nonprice means of rationing must arise, such as a decline in the quality of goods supplied or the emergence of lengthy waits in line for the privilege of purchasing at the controlled price.

We noted earlier that the price controls imposed by Diocletian led to reduced supplies of goods and the emergence of bloodshed as a rationing device.  Similarly, the price controls imposed by Pennsylvania during the American Revolution made it impossible for General Washington to properly feed and clothe his troops at Valley Forge.  And only a few years later, when the French Revolutionary government felt compelled to institute price controls, the effects were immediate.  As one commentator noted: “The butcher in weighing meats added more scraps than before … other shopkeepers sold second-rate goods at the maximum [price] … The common people complained that they were buying pear juice for wine, the oil of poppies for olive oil, ashes for pepper, and starch for sugar.”

Of course, governments try to prevent people from responding in these ways.  Yet policing the controls on millions of prices is an enormous task.  During World War II, the United States had approximately 60,000 paid price watchers and 300,000 to 350,000 volunteer price watchers.  The time and effort devoted to policing price controls use economic resources that are, by definition, not free.  And even so, no system of policing can be complete.  As one later administrator of U.S. price controls put it, “No matter how cleverly any group designs a control system, distortions and inequities will appear.”

The truth in this statement is illustrated by government attempts to control gasoline prices in the United States during the 1970s.  In 1973, several major Arab oil-producing nations refused to ship oil to the United States and other Western nations, in retaliation for Israel’s so-called Yom Kippur War with Egypt and Syria.  The result was a significant reduction in world oil supplies and sharp upward pressure on gasoline prices.  Again in 1979, oil-producing states, acting in concert through the Organization of Petroleum Exporting Countries (OPEC), decided to cut world oil supplies – which once more put strong upward pressure on gasoline prices.  The U.S. government tried to resist these pressures with price controls on gasoline – and the results were disastrous.

Faced with soaring input costs and unable to pass these costs on to consumers, gas-station owners sharply reduced their hours and limited the amount of gasoline that customers could buy at one time.  As consumers frantically sought fuel, lengthy lines formed at gas stations.  Some lines reportedly stretched a mile or more, and people had to wait hours for the opportunity to buy five or ten gallons of gasoline.

Some station owners tried to alleviate the problem by offering to fill up the customer’s gas tank before the station’s regular opening hours, if the customer would park in the station lot the night before – for a minor “parking fee” or, say, $25.  Drivers tried to help, too, by offering to buy one-gallon gas cans at four times their regular price – if they were full of gas.  But such behavior was deemed illegal by the government, and so the gas lines continued.  Not surprisingly, tempers began to flare.  One man who cut in line ahead of other people was beaten senseless by another driver wielding a metal tire iron.  Another driver who jumped to the head of a gas line pulled a gun when informed by the attendant that he would have to return to his assigned spot.  Reportedly, he got his gas – and was later arrested.  Interestingly, in Europe and Japan, where prices were generally allowed to rise in response to the reduced supplies, there were no lines, no special parking deals, and no reports of gas-station violence.

Do They Work?

The measured rate of inflation during World War II was certainly lower with price controls than it would have been without them.  But what do we mean by the rate of inflation?  If we mean the rate of increase in the consumer price index (CPI), that measure may have little to do with the actual rate of inflation.  During World War II, the CPI rose very little because in most cases any explicit, published rise in prices was illegal!  We had then what has been called a repressed inflation: inflation was actually going on, but it did not show up in the official, published price indices.  People had to resort to a variety of costly devices to obtain goods at the official, controlled prices; this drove the full cost of goods well above the level indicated by published prices.  When price controls were lifted after the war, the official price index caught up with the actual price index, and, for two or three years, published prices rose very rapidly.

This brings up one of the more peculiar aspects of price controls; the more effective they seem to be, the more likely they are to be ineffective.  We have already seen how price controls lead to declines in product quality and to costly alternative means of rationing the goods.  But in addition, sometimes the suppliers of the goods disappear altogether.  What does a price index mean when, during periods of price controls, many goods are not even available?  In fact, the true price of many items during periods of controls is actually infinite because they are unavailable.  What happens to the true cost of goods when the price of even one item goes to infinity?  Surely, General Washington’s troops must have pondered this question when they found themselves starving at Valley Forge in the winter of 1777-1778.