RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM

FEDERALRESERVE How Not to Stop BY

EDITOR’S NOTE: High and rising in- et me turn to my topic for This analogy is suggestive but does flation can tempt policymakers to enact tonight, “How not to stop not go far enough. If you broke the inflation.” As you know, the word thermometer, that would neither quick “fixes,” such as and price L “inflation” has a great many different make it hotter nor do any other harm. controls. But as Milton Friedman argues in meanings and people attribute different It would just simply prevent a signal this speech, delivered in February 1966 to conceptions to it. What we mostly of the rising temperature from being the Detroit chapter of the University mean by it, and what I shall mean by it, seen. Prices partly do measure pres- is a rise in prices, in prices in general. sure, but they also affect the course of Chicago Alumni Association, such In the past year or so, we have been of events. Perhaps a better analogy is controls don’t get at the fundamental having a tendency for a rather wide- the following: When it gets too hot source of inflation — excessive expansion spread rise in prices. That tendency in this room, close all the outlets from of the money supply — and eventually seems to give every sign of intensifying the furnace while letting the furnace and increasing, so we have a real run full blast until it bursts. That is make the problem worse. While in effect, problem of inflation. more nearly a correct analogy to hold- the controls often result in of If inflation does consist in a rise of ing down particular and prices goods, and when they are removed, the prices — in the price of meat going as a means of stopping inflation. inflationary pressures that have been up, of wages, and of all sorts of things The question is, why is that a bad — then it seems most natural to say way to stop inflation? What harm does bottled up artificially tend to explode. that the way to stop it is to stop prices it do? In trying to suggest to you the Only five years after Friedman deliv- from rising. If you want to stop infla- answer to those questions, I want to ered this speech, President tion, let’s just pass a law saying that no talk about two main points. The first enacted a program of wage and price price shall rise. That will stop it. The point is to discuss what the source main theme of my talk tonight is of inflation is. If I were putting it as controls. The system was supposed to last to say that this tempting way to stop a topic for a Sunday sermon and only 90 days but proved to be far less inflation is the way not to stop it. could speak French, I would say, temporary, surviving in modified form for It will not in fact cure inflation, but instead of “Cherchez la femme” — nearly three years. The results were even if it did, it would be a cure that is “Cherchez la monnaie.” “Look for the worse than the disease. This approach money.” Inflation is always and every- predictable. The legislation was greeted is like saying that if it’s getting too where a monetary phenomenon. That with initial enthusiasm, but its problems hot in this room, the way to solve the is the first point I want to discuss. were quickly apparent. By the mid-1970s, problem is to break the thermometer. The second point I want to discuss inflation had reached double digits. In his is that while we ordinarily talk about Milton Friedman distinguishing between inflation and memoirs, Friedman wrote that Nixon’s deflation, between rising prices and decision to impose the controls “did far falling prices, there’s another distinc- more harm to the country than any of the tion that I think is even more later actions that led to his resignation.” important. That is the distinction between open inflation and sup- Friedman, who won the Nobel Prize pressed inflation, between an inflation in economics in 1976, taught at the in which prices are permitted to rise University of Chicago from 1946 to 1977 and an inflation in which prices are and is now a senior research fellow at the held down. While inflation is bad, it is far better to have it open than it is to Hoover Institution. This speech, which has have it suppressed. Suppressed infla- been edited for length, has never before tion is the case in which the cure is been published. The full text is available at worse than the disease, like pouring our Web site: www.richmondfed.org coal into the furnace while locking all places where the steam can get out until the furnace blows up. PHOTOGRAPHY: THE UNIVERSITY OF CHICAGO NEWS OFFICE

2 Region Focus • Summer 2005 RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM

Let me turn to the first point. The else to hold less. This is a game of to the wholesalers. The wholesalers common approach to inflation is to musical chairs in which the pieces of say, “Our costs have gone up so we think that inflation, being a rise in paper pass around. While each indi- must charge a higher price,” so they prices, results from a rise in costs. vidual separately can decide how charge a higher price to the retailers. With rare exceptions, every business- much to have, the community as a The butchers say to the housewives man and every ordinary person tends whole has nothing to say about how when next they come in, “We’re very to think that the reason why prices go many pieces of paper there shall be sorry to have to do this to you; it up is because they are pushed up to pass around. That’s determined isn’t our doing, but our costs have because costs go up. This may take by the Federal Reserve Board or the gone up so we have to charge you a the form of a so-called cost-push Treasury or by some central agency. higher price.” Everybody along this spiral or wage-price spiral or other Whatever that amount is, it’s shuffled chain, except way back at that auc- fancy terms, or it may take the sim- around from person to person. tion where there is nobody who has pler form of each man thinking he has I think that’s a very clear and any costs that he can look at in the to raise prices because his costs have straightforward example of how it is same sense, is honestly charging high- gone up. It is perfectly natural that that the way it appears to the individ- er prices because his costs have gone people should think this way because ual is the opposite from the way it up. And yet, taken altogether, the to each individual separately that is appears to the community. The same increase in prices clearly reflects the the way it looks. But the fact is that thing is true with respect to inflation. increase in demand at the final stage. this has almost never been the source The example I can give you which That is the way it is in the economy of inflation. It’s the external manifes- will bring this out most clearly is one at large. Every manufacturer says, “I tation of inflation, but not its source. which I have taken from a recent have to charge higher prices because Indeed, this illustrates a much textbook in elementary economics. my wages have gone up,” but the more general principle. What makes The authors, Armen Alchian and reason his wages have gone up is economics, in my opinion, a fascinat- William Allen, have a wonderful little because there’s been an increase in ing subject is that for almost any story in their book that will illustrate demand somewhere else which has led important proposition in economics, how it is that to each individual sepa- somebody else to try to bid his work- what’s true for the individual is pre- rately it looks as if what causes ers away from him, or he’s been trying cisely the opposite of what’s true for inflation is a rise in costs even though to bid workers away from somewhere everybody together. That’s why you to everybody together what causes it else. The ultimate source of the have so many widespread economic is an increase in demand, a monetary increase in price has been an increase fallacies. People generalize from their phenomenon. Let us suppose, they in monetary demand. individual experience, and yet that is say, that all of a sudden the house- And now we ask the question, precisely the opposite of what holds wives of America decided that they where does that increase in monetary for the community as a whole. Let me wanted to serve more meat on their demand come from? If there has been illustrate that in a very simple way, tables, and so come Monday morning any substantial increase in monetary which is also related to the problem of each one goes to the butcher and demand, it always has had the same inflation. Each one of us separately buys more meat. No butcher raises basic source. Somebody has produced thinks he can decide how many of his price. He just sells out his meat more money. The exact source of these green pieces of paper to keep in and then he orders a larger amount of additional money has varied from his pocket — subject, of course, to his meat from the wholesaler. The whole- time to time. In the period after 1896, total wealth. If any one of us wants to salers sell out and so they order the after William Jennings Bryan was keep $20 more in his pocket, all he has larger amount of meat from the defeated in the campaign for free to do is cash a check for $20 or sell a packer. The packer finds his inven- silver, prices rose in the United States bond for $20 or use $20 of his income tory going down and so he sends back from 1896 to 1913 by roughly 35 per- and keep it in cash instead of spending instructions to the cattle buyers at cent. That price rise came from an it or investing it in some other way. the auctions to buy more animals. increase in the quantity of money So each person separately thinks he Well, of course, there aren’t any more which occurred because some smart can decide how much money to hold animals to be bought, so what people had figured out how to apply in his pocket, and each one is right. happens is that the people trying to the cyanide process to extract gold Yet for the community as a whole, the buy them bid up the price of the ani- from low-grade ore. The resulting amount of currency to be held in mals. They report to the packing great increase in the production of pockets is a fixed number. There are houses, “We’re sorry we’ve had to pay gold brought about an increase in the only so many pieces of these green a higher price for the animals.” The quantity of money, which in turn pieces of paper that have been print- packing houses say, “Our costs have brought about inflation. ed. The way that you get more in your gone up so we must charge a higher To go back to my main theme, on pocket is by persuading somebody price,” so they charge a higher price that occasion, inflation reflected an

Summer 2005 • Region Focus 3 RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM

increase in the quantity of money, but therefore, we’ve got to get higher make it stronger there. Suppose you the particular reason why the quantity wages to have the same real income for succeed in keeping down, let us say, of money increased varies from time our employees. So you have a situation the price of steel which has attracted to time. On that occasion it increased in which the government, to blame so much attention. That would simply because of gold. In World War I and somebody else, attributes inflation to mean that the purchasers of steel have World War II, in the United States the a wage-cost spiral, and the business- more money left after buying steel quantity of money increased very rap- men and the labor union leaders than they would otherwise have had idly because government printed it to accept the blame and say, yes, we and they can now spend it on bidding finance the war. Go back to the great are guilty. Yet in fact, as I have empha- something else up. If you keep down price inflation in Europe in the 16th sized, the inflation arises from one the wage rate of labor under these cir- and 17th centuries and that came and only one reason: an increase in a cumstances, it just means that the because of the discoveries of specie in quantity of money. employers have more money to pro- the New World. There have been That is my first point. The next duce inflation somewhere else, so all many reasons why the quantity of point I want to discuss is the harm you are doing is shoving the inflation- money has increased, but inflation has that is done by trying to stop inflation ary pressure over. never occurred to the best of my by holding down wages and prices. But you may say, that’s only knowledge except as a consequence of The president, members of the because we haven’t gone far enough. If a more rapid increase in the quantity Council of Economic Advisers, and we really spread our net wide, if we of money than in output. other prominent public officials make held down every wage and every price, In modern times, the quantity of speeches about the terrible effects there’s no place for the inflationary money is under the control of govern- of inflation and about the urgent pressure to go. That’s true, but let’s mental agencies. In the United States, necessity for businessmen and labor look and see what the consequences it is determined by the Federal union leaders to exercise a social would be. The consequences of that Reserve Board, the Treasury, the mon- responsibility in holding down wages would be to destroy the price system etary authorities. And that means that and prices. Maybe the cause of infla- as a means of organizing economic if inflation is always a consequence of tion is an increasing quantity of activity and you would have to an increase in the quantity of money, money, but you may well ask, what substitute something else. What else the responsibility for inflation is harm would it do to try to stop it by would you substitute? If prices are not always governmental. But, of course, holding down those wages and those going to determine who buys how as you know, no human being likes to prices? much, something else must do it. take responsibility for things that are In the first place, one of the major Let me give you a historical unpleasant or undesirable and so no sources of harm it does is to lead example which perhaps makes my governmental official likes to stand up people and the government to mis- point most strikingly about the impor- in front of an audience and say, conceive the nature of the problem. tance of the distinction between “Mea culpa, I’m responsible for infla- If the businessmen and the labor open and suppressed inflation. It has a tion.” What always happens is that leaders accept the blame, the govern- very real parallel with strong implica- the governmental officials stand up ment goes on pouring coal into the tions for the United States although and say, if we have inflation it’s furnace, increasing the quantity of it’s a much more extreme case. The because of those rapacious business- money, and says that any resulting best example, because it’s almost a men and those selfish union labor inflation is not its fault. So you tend to controlled experiment, is a compari- leaders. If those people would only encourage a delay in adopting the son of experience in Germany after stop demanding more and more, high- remedy which alone can prove effec- World War I and World War II. As er and higher wages and higher and tive, namely, a slowing down in the you recall, after World War I in higher prices, there would be no infla- rate of growth in the quantity of Germany there was an inflation that tion. And the businessmen and the money. That’s only a minor reason really was an inflation. It was a hyper- wage union leaders, surprisingly why it is harmful. A second reason is inflation. A student of mine some enough, tend to accept the indictment that it isn’t going to stop inflation. It’s years back, Phillip Cagan, wrote a because of their misunderstanding like taking a great big balloon and classic study of hyper-, and of the elementary economic point thinking that by pressing one corner he defined a hyper-inflation as begin- I’ve been trying to present here. of it you are going to deflate the bal- ning when prices rose more than The businessmen tend to say that loon. All you do is push the air into 50 percent a month. In Germany the reason we have inflation is because the other part of the balloon. In the during the height of hyper-inflation, those selfish unions push up wages, same way, if you succeed in holding there were periods when prices were and the union leaders say the reason down some wages and some prices, all doubling every day. In fact, it got to we have inflation is because those that does is push the inflationary the point that employers were paying selfish businessmen raise prices and, pressure over somewhere else and their workers salaries three times a day

4 Region Focus • Summer 2005 RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM

— after breakfast, lunch, and dinner so they could go out and spend it before it lost value. That was really an infla- tion. Prices went up by amounts that you have to reckon by 10 to the 10th or 10 to the 20th, something like that. The hyper-inflation did tremen- dous harm of a social kind. It destroyed the German middle classes, and it undoubtedly laid much of the socio- logical basis for the subsequent emergence of Hitler. But from a pure- ly economic point of view, the striking thing about it is that, except for the last few months of the hyper- inflation, the level of economic activi- ty remained high. Inflation was open, prices were free to rise, there were no price controls of any kind, and, consequently, people were free to continue to do business. There were controls when there is that big a dis- Friedman (right) with President Nixon certain kinds of inefficiencies pro- crepancy between the market price and in the Oval Office in duced but you never had any major and the controlled price. 1971, the year the Nixon administration decline in the aggregate level of But Germany from 1945 to 1948 imposed wage and price controls. production. Indeed, as you may was an exception because there was an recall, 1920 to 1921 saw a worldwide American, a French, and a British occu- and pans for money and using the depression. In the United States pation army there, and they were money to buy the potatoes. And so prices fell by nearly 50 percent from enforcing the price controls. So you Germany with a very much smaller 1920 to 1921. Germany was almost the had about as well-enforced price inflationary pressure had an enor- only country in the world to escape controls as you could imagine. The mously greater reduction in its that depression. While the rest of the result was that, because this inflation economic output. Indeed, the action world was having a decline in output, was suppressed, the prices were not taken in response to this episode is the Germany was booming. There was an allowed to find their own level, and reason Ludwig Erhard is chancellor of artificial kind of a boom that had output in Germany was cut in half. Germany today. great social costs, but from the purely Walter Eucken, a German economist, One Sunday in 1948, Erhard, who technical point of view, the inflation wrote a wonderful article on this was economics minister then, released did not prevent the economy from experience in which he tells the story an announcement that all price operating. of workers in a factory making alu- controls were abandoned. He did it After World War II, Germany minum pots and pans who would work on Sunday because that was the was again faced with an inflationary in that factory for three days a week. day on which the Allied offices of problem, but it was an inflationary They would receive their pay in the military occupation were closed and problem of enormously smaller form of some of the pots and pans they so they couldn’t contradict his order. scope. Prices rose about fourfold. had helped to produce. They would Immediately, there was a very sizable Now that seems like a big inflation spend the rest of the week scouring the rise in recorded prices, but immedi- and it is. For prices to go up to 400 countryside trying to find a farmer ately also the price system started percent of their initial value is a sub- who was willing to trade them some operating again. That was the source stantial price rise. But it is negligible potatoes for those pots and pans. of the German economic miracle, as it by comparison to what happened The problem is, if you don’t let came to be called, which produced a after World War I. Yet that rise was prices rise, you destroy the system tremendous increase in the total out- not permitted to happen openly after which organizes the economy, the put of Germany over the next year or World War II. There was widespread price system which coordinates the two. There was no mystery about it. price control. Under those circum- activities of different people. You It had nothing to do with the capacity stances, price control can almost force people into the inefficiency of of the German people for hard work never be enforced. From the time of barter, or a man producing pots and or with any special wisdom of the the Roman Empire to the present, pans trying to find a man who has American occupation authorities or you cannot in general enforce price potatoes, instead of selling the pots with any assistance from us to them. PHOTOGRAPHY: COURTESY OF MILTON FRIEDMAN

Summer 2005 • Region Focus 5 RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM

It solely was a case of substituting from copper producers at home. sequently to 90 cents. Of course, this an efficient money system for an The next step is to impose export brought a tremendous inflow of silver inefficient barter system. quotas on copper. Now if you want to into the U.S. Treasury just as our price The money system is so important export copper, you are prohibited from fixing in wheat did. We kept the price that if you prevent it from operating doing so unless you can get a permit of silver at the same level and in the efficiently something else will come from the Department of Commerce. meantime prices in general more than along. In the period This is inevitable. If doubled. Hence, a very high price from 1945 to 1948 you are going to fix became a very low price and now, in in Germany, as Wage and price the price of copper, order to prevent the price of silver you may recall, then you will have from rising above $1.30, we’ve had to substitute monies controls destroy the to decide who shall sell silver out of these stocks. We’ve developed. Ger- buy copper at that had a and, as you know, we’ve mans started to system which organ- lower price, and so substituted Federal Reserve notes for use cigarettes as a izes the economy. it goes all down silver certificates, and sandwich coins form of money: cig- the line. for solid coins. So we know how to arettes for small We have so far produce shortages or surpluses. transactions and Cognac for big ones. in the United States had the most That’s what has been happening in That was when they really started talk- extensive experience with repressed the foreign exchange market. We’ve ing about the importance of having inflation in an area where it is been pegging the price of the dollar. adequate liquidity. And you may most destructive, namely, foreign The result has been a whole series of remember that there were stories in exchange. We have been pegging for direct interferences with individuals American newspapers of this time some years now the price of the and with trade. You know as individ- saying something like, “Look at these pound sterling in terms of the dollar, uals some of the minor irritants, crazy Germans. They just got beaten the price of francs in terms of the dol- things like the reduction of the duty- in the war and they are poor and lar, the price of gold in terms of the free allowance tourists can bring in. devastated. Yet they are willing to dollar, and so on. And we have had Much more important has been the pay $1.50 for a package of cigarettes. the usual consequences from price interest-equalization tax which has How silly can they be?” The answer, fixing. You know, economists may not established a differential exchange of course, is that they were no more know very much, but there’s one rate, a devalued exchange rate for silly than you are when you’re willing thing we know. We know how to pro- capital transactions. Also, there are to pay $10 for a piece of paper (a $10 duce either surpluses or shortages. oil import quotas, copper export bill) that’s only worth a penny as paper. You just tell us what you want. If you quotas, and I can’t begin to name the You don’t pay $10 for this piece of want to have a surplus, we’ll tell you host of specific quantitative controls paper in order to burn it or to write to set the price too high. Have a high that have been promoted by the notes on it. Neither were the Germans price on wheat and you’ll be sure attempt to peg exchange rates. paying $1.50 or $2 for a package of you’ll have wheat running out of your I mentioned foreign exchange cigarettes in order to smoke them. bins. If you want a shortage, we’ll tell pegging because that is a particularly That was money because prices in you to set a low price. Put rent con- important type. The example that terms of cigarettes were not con- trol on rental quarters in New York, comes to mind in this case as a trolled, and it developed as a very and you’ll be sure you will have a cautionary tale of where it can lead inefficient substitute money. shortage of dwelling units to rent at you to is India. India is a country The repressed inflation in that price. which has been having inflation over Germany was far more destructive of We’ve been doing pretty well in the the past decade or so, and it has been economic output and productivity case of silver with first creating a repressing it the way in which we than the open inflation after World surplus and then creating a shortage. have been trying to repress it here. War I. And this is true more generally. We’ve had it both ways in that case. The key in India is the exchange Let me come back to the United Incidentally, the story of silver is fasci- rate of the rupee. The official price States to see some parallels in very nating. In the 1930s, we had a silver of the rupee is 21 cents, 4.7 rupees to small ways. Not long ago, there was purchase program that, as it hap- the dollar. If the rupee was worth pressure on American copper produc- pened, was one of the main reasons 21 cents five or 10 years ago it is ers not to raise the price of copper. why China is communist today. I certainly not worth it now because The next step, of course, is that, since won’t go into that one right now, prices have gone up 30 or 40 or 50 copper is selling for a higher price except to note that under the silver percent. I’m not sure of the latest abroad than it is at home, everybody purchase program we raised the price figures. But India has tried to main- wants to export it and nobody wants of silver in one year from 25 cents an tain that exchange rate. The result is, to import it. People want to buy it ounce to 75 cents an ounce and sub- of course, that everybody wants to

6 Region Focus • Summer 2005 RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM

import and nobody wants to export. is to introduce enormous inefficien- nomic efficiency and from the point of So you then have quotas and exchange cies and to expand very greatly the view of the preservation of political permits on imports and subsidies on scope and extent of direct controls. freedom. If we are going to have exports. You have to ration imports This, in turn, has a further effect inflationary pressure we should have it of steel, copper, and so on. which is the final consequence I want open — let prices rise, let it go. Better The next stage is it becomes of to mention of trying to stop inflation yet, of course, would be to remove the great economic value to have an by holding down prices and wages. source of the inflationary pressure by import permit. Indeed, if you ask The effect is of a political character. slowing the rate of expansion of what has been the major source of We have had a number of episodes in money. new fortunes in the last 20 years in the past five or six years in which After the 1960 recession, itself the world, including the United there’s been an attempt to hold down largely produced by a sharp retard- States, there is no doubt it has been wages and prices. We had the ation in monetary growth, indeed an getting the ear of governmental offi- Kennedy confrontation with the steel absolute decline, the Federal Reserve cials to get special permits, whether industry in 1962. We had the more System did the right thing by increas- it be to have a single television recent episode with aluminum. The ing the rate of growth. They have also station or to have a permit to import interesting thing to me is the drastic done the right thing by maintaining a copper. In India this is very wide- change that occurred between the fairly high rate of monetary growth. spread. There’s enormous corruption first and the second episode in the This is the main source of our long and bribery involved in the exchange willingness of businesspeople who continued expansion. Unfortunately, permit system. Indeed, the major were potentially affected by it to however, they overdid a good thing obstacle to having a devaluation of speak out freely and express their sen- and expanded the quantity of money the rupee exchange rate or allowing timents about it. And I don’t blame at too high a rate. This has built into the rupee to go free is that there them. our society some pressures driving are now so many people who have There is no legal authority whatso- toward higher prices. We cannot elim- vested interests in the exchange rate ever whereby the president or any inate this pressure and stop the system because they have the import other official has the power to require inflation without paying a price. The licenses. the aluminum company or the steel danger is that if we try to do so, as we Exactly the same thing is true in company to hold down its prices or a sooner or later will have to, by curtail- this country. The permit to export union to hold down its wage rates. ing the growth of the quantity of copper is a valuable thing now. I There is no official authority, but money, that we will go too far, that we mentioned the TV and radio stations, there is lots of power lying around will overdo the reaction. Even if we and that’s a special example of the Washington. There are lots of extra- don’t overdo the reaction, there is no same kind of thing. Here you have legal pressures that can be brought way of bringing inflation to a halt sud- something that’s worth several mil- to bear. After all, there’s hardly a man denly. There is already built into the lions of dollars if you get it, and if you in the country who cannot now be economy forces for making price get it, you get it for nothing. Then subjected to great inconvenience by increases. people are surprised why there should having a tax official suddenly decide If you were to take the correct and always be charges of corruption and that his return needs extra careful proper measures, which is to slow bribery in connection with television scrutiny — and which return doesn’t? down gradually the rate of growth of and radio licenses. The threat of antitrust action is the quantity of money, there will for To come back to my main theme, not something which any business- a time be a continuation of inflation the effect of trying to hold down man is going to take lightly. There is a at the same time that we experience prices by suppressing individual wide range of governmental contracts some measure of recession and un- prices and wages is to eliminate the that are available. The attempt to hold employment. That is part of the price central governor of the economic sys- down particular wages and prices we are going to pay for having in the tem, the central method by which we produces a resort to extra-legal power, past three or four years stepped on organize our economic activity. If you which, in its turn, tends to spread and the accelerator too hard. But that will insist on doing that, you are going to to lead to a suppression of individual be far better and a far lower price than have to substitute something else. and personal and political freedom to continue along our present lines of You are going to have to engage in and to a great lessening of the willing- trying to conceal the inflationary and indirect controls. You ness of people to dissent. These are pressure by appealing to the social are going to have to decide who shall some of the consequences of the responsibility of business leaders and buy from whom and how much. attempt to stop inflation by holding labor leaders, reinforced by an appeal The effect, therefore, of trying to down particular prices and wages. to unnamed and unspecified exercise stop inflation by holding down I think they are extremely serious of governmental power. individual prices and individual wages both from the point of view of eco- Thank you. RF

Summer 2005 • Region Focus 7