RF Summer 2005 FINAL.ps - 7/12/2005 13:52 PM FEDERALRESERVE How Not to Stop Inflation BY MILTON FRIEDMAN 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 wage 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 shortages of If inflation does consist in a rise of ing down particular wages 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 Richard Nixon 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.