The Theory of Price Control: John Kenneth Galbraith's Contribution.

Abstract

Price controls have always aroused controversy. Before the Second World War, most economists saw them as either impossible to implement or unwise. Even during wartime it was widely believed that prices should remain as free as possible. Many economists saw benefits to price controls during the war, but also identified numerous costs to these controls. They also tended to favor limited price controls, applying to only those goods needed to fight the war. John Kenneth Galbraith was generally sympathetic to price controls during the war. He too supported limited controls, but then changed his mind and supported more extensive price controls during the Second World War. After the war, inflation tended to reappear long before full-employment was reached, even when production and employment were falling. From his wartime experiences, Galbraith tried to draw lessons for peacetime inflation. He proposed price and wage monitoring for a few hundred big companies and the unions with whom they negotiate.

Full text

The Theory of Price Controls:
John Kenneth Galbraith’s Contribution
STEPHANIE LAGUERODIE & FRANCISCO VERGARA
University of Paris (Paris-Est), France;
Association pour la diffusion de
l’e
´conomie politique, Paris, France
Price controls didn’t work in World War I, when they began as ‘selective’; they
didn’t work in World War II, when they were ‘comprehensive’ ...price controls
have never worked. (Murray Rothbard, 1995, emphasis added)
In World War II ... we controlled or sought to control all prices ... the General
Maximum Price Regulation was put into effect in April of 1942, and it worked.
(John Kenneth Galbraith, 1980, emphasis added)
ABSTRACT Price controls have always aroused controversy. Before the Second World
War, most economists saw them as either impossible to implement or unwise. Even
during wartime it was widely believed that prices should remain as free as possible.
Many economists saw benefits to price controls during the war, but also identified
numerous costs to these controls. They also tended to favor limited price controls,
applying to only those goods needed to fight the war. John Kenneth Galbraith was
generally sympathetic to price controls during the war. He too supported limited
controls, but then changed his mind and supported more extensive price controls during
the Second World War. After the war, inflation tended to reappear long before full-
employment was reached, even when production and employment were falling. From
his wartime experiences, Galbraith tried to draw lessons for peacetime inflation. He
proposed price and wage monitoring for a few hundred big companies and the unions
with whom they negotiate.
1. Introduction
Since the time of Adam Smith, one question that has raised great passion
and controversy among economists is that of government control over prices.
Are certain prices so special that government control over them is justified?
Can particular circumstances sometimes warrant a more extensive control
over prices?
Review of Political Economy,
Volume 20, Number 4, 569–593, October 2008
Correspondence Address: Francisco Vergara, Association pour la diffusion de l’e
´conomie politique,
Paris, France. Email: vergajofra@aol.com
ISSN 0953-8259 print/ISSN 1465-3982 online/08/040569–25 #2008 Taylor & Francis
DOI: 10.1080/09538250802308950

These questions are of special interest for at least two reasons. First, they
raise issues that appear again and again throughout history. Who is not worried
today about the price of health care and a university education, or about the
impact of rising food prices? Who is not concerned by the fact that exclusive
reliance on fiscal and monetary tightening, as a way of containing inflation, can
hurt the most vulnerable and slow down an economy?
But the subject is also of interest because the author we are commemorating,
besides having had extensive experience in the practice of price controls (from
1941 to 1943), also wrote a book that makes important contributions to this
debate (Galbraith, 1952).
1.1. The Classical Economists on Price Controls
Before we get to Galbraith, let us recall that the classical economists (from Adam
Smith to A.C. Pigou) were not doctrinaire laissez-faire advocates when it came to
the question of price controls. Smith did not believe that the free movement of
prices is always and everywhere the best policy. He thought that the government
should ensure that education is provided at a low price, affordable to all. ‘For a
very small expense the public can facilitate, can encourage, and can even
impose upon almost the whole body of the people the necessity of acquiring
those most essential parts of education. The public can facilitate this acquisition
by establishing in every parish or district a little school, where children may be
taught for a reward so moderate that even a common labourer may afford it’
(Smith, 1776, Vol. 2, p. 785).
Smithalsobelievedthat,intheEnglandofhistime,toomuchofsavingswere
being squandered in harebrained schemes and that a low legal maximum on the
rate of interest (an important price if there ever was one) could improve the allo-
cation of resources by making lenders prefer sober investors over reckless ones
‘who alone are willing to pay high interest’: ‘Where the legal rate of interest,
on the contrary, is fixed but a very little above the lowest market rate, sober
people are universally preferred, as borrowers, to prodigals and projectors’
(Smith, 1776, Vol. 1, p. 357).
As for Pigou, after a detailed discussion of several examples of successful
price controls drawn from British war-time experience, he draws some rather posi-
tive conclusions: ‘The fixing of maxima for a number of particular prices ... helps
a government to hold back the ultimate threat of galloping inflation. ... Govern-
ment restriction of particular prices is not then a policy either foredoomed to
failure or necessarily futile’ (Pigou, 1941, p. 118).
1.2. What is meant by Price Controls
‘Price controls’ does not necessarily mean government imposition of some precise
price at which given commodities must be bought and sold. This is just one option
amongmany.By‘pricecontrols’,authorslikeJohnKennethGalbraithmeantawide
variety of policies by which market prices that are causing problems can be modi-
fied or influenced. Price controls are thus a palette of measures among which the
policy maker can choose according to the particular problem he wishes to solve
570 S. Laguerodie & F. Vergara

oralleviate.Insome cases it will bealegalmaximumona given price (asproposed
bySmith fortherate ofinterest),in othersalegalminimum(as theminimumwage),
sometimes a minimum price at which the government promises to buy and a
maximum at which it promises to sell (as for certain agricultural commodities),
sometimes a temporary price freeze, and sometimes a maximum or minimum for
price changes. This is probably why the plural word ‘controls’ is often used.
The fundamental idea behind price controls is that if the free movement of
certain prices produces very bad consequences (as during a mobilization for
war), or if it makes it impossible, or very difficult, to attain some important
national goal (like full employment without inflation or access to food for every-
one), it is legitimate to keep an eye on these prices and eventually do something
that makes the situation better. Most economists agree on this point, butthen many
go on to exclude price controls from the policy options that are on the table. Not
Galbraith (1951, p. 15), who believed that ‘we cannot exclude from use any
weapon that is necessary ... it would be reckless to decide in advance that
price controls should not be used’.
Price controls are, of course, only part of the solution, and often just a tem-
porary expedient to buy time while a more comprehensive policy to solve the
problem is being put in place. To be effective, they generally have to be part of
a package that includes accompanying measures to ease the pressure of prices.
And this package must evolve with particular circumstances. Galbraith was
always clear about this. In 1941, for example, he writes about the war mobilization
effort: ‘Reasonably full use of resources without serious inflation can be achieved,
but ... we shall need a portfolio of measures appropriate to different stages in the
expansion process’ (Galbraith, 1941, p. 84, emphasis added). Nearly 40 years
later, referring to peacetime anti-inflation policy, he expresses the same sentiment:
‘Controls on wages and prices in the highly organized sector of the economy
are not ... the whole answer ... But they are part of any complete strategy’
(Galbraith, 1980, Introduction, n.p.).
The different methods by which a government can bring about compliance
with the price policies it chooses can also be very diverse – ranging from exhorta-
tion and moral pressure to legal restraints and penalties, tax incentives, selective
liberalization of imports for particular commodities, or selling of government
strategic stocks.
In this larger sense, such policies are actually much more common than one
would believe, though they are not usually called ‘price controls’. Open market
operations by the Federal Reserve, for example, can be considered as such a
policy since it is clearly intended to modify the interest rate that arises from the
market. New York Stock Exchange circuit breakers (by which trading is halted
when the Dow Jones falls more than 10%) and price limits (which prohibit
trading at prices below a pre-set limit during a price decline) are other, less
well-known ways of not allowing the free movement of prices to cause havoc.
Governments also use regulatory policy instruments, created to increase compe-
tition, in order to obtain lower prices by threatening companies with investi-
gations, litigation, disrepute and eventually fines and even dismemberment.
Finally, public utility fees, and the price of many government services are, of
course, often controlled.
The Theory of Price Controls 571

1.3. What is not meant by Price Controls
As often happens with words, the expression ‘price controls’ has become
associated, in many people’s minds with crude and counterproductive measures
that eventually make things worse. If the price of cereals becomes too high, for
example, a government that imposed an excessively low, non-remunerative
selling price on farmers, would probably discourage them from increasing food
production. Price controls are also not a policy to be applied in isolation, all by
themselves. A city government that just froze house rents (in face of a housing
shortage), without doing anything else, would eventually find itself with all
sorts of undesirable secondary effects and would probably not achieve its end
of promoting affordable housing. Such unwise forms of price controls have
undoubtedly been imposed by local and general governments afraid of popular
discontent, but they have never been proposed by economists like Galbraith.
Nevertheless, it is such measures that libertarian authors, from Fre
´de
´ric Bastiat
to Friedrich Hayek, love to argue against.
This is probably one of the reasons why the word ‘controls’ has a negative
connotation, and why it would be wise to find some other expression. Galbraith
was perfectly aware of this: ‘I have used the word “control” in the past so that
no one would think there was an easy-escape from firm government responsibility.
I now propose that we try a new designation, and speak of ... Incomes and Prices
Policy’(Galbraith,1978,p. 109). Even better,wecanuse a much lesscontroversial
expression and speak of ‘monitoring prices’.
1.4. Galbraith’s Book
In A Theory of Price Control, Galbraith recalls his experience as President
Roosevelt’s price controller during the Second World War, and tries to draw
some lessons that could serve for other, less extreme, circumstances. The book
marks an important turning point in the author’s life. Its lack of impact upon
the economic profession made him realize that if he wanted to influence policy,
it was better to write directly for the larger public and not waste time trying to con-
vince other economists: ‘I decided that henceforth I would submit myself to a
wider audience’ (Galbraith, 1981, pp. 174–175, emphasis added).
Galbraith thought A Theory of Price Control was one of his best books. None
ofhisotherpublications, he tellsus,combineshis theoretical knowledge withprac-
tical experience to such a degree (Galbraith, 1981, pp. 174–175). This opinion is
shared by some of his critics. George Hildebrand, who reviewed the book for the
American Economic Review, recognized that Galbraith: ‘brings to the task a fortu-
nate combination of high level administrative experience, and awareness of the
main theoretical issues’ (Hildebrand, 1952, p. 987). Yet Hildebrand (1952,
pp. 988–989) then adds the familiar arguments: ‘price controls do not prevent
inflation. They hide it ... they threaten the survival of a free society ... they are
not likely to work ... if by a miracle they were to work, the resulting distortions
would make little economic sense’.
For Milton Friedman, another great opponent of price controls, this book
makes Galbraith: ‘the only person who has made a serious attempt to present a
572 S. Laguerodie & F. Vergara

theoreticalanalysisto justifyhisposition[apositionfavorabletoprice-controls]...
I happen to think that the analysis is wrong, but at least it is a serious attempt to
provide a basis for a point of view’ (Friedman, 1977, p. 12, emphasis added).
Friedman would have us believe that price controls have only been proposed
by ‘practical’ men who made no attempt at theoretical justification (with the
exception of Galbraith who tried a theoretical argument but got it wrong). In
this he is perfectly mistaken. Some of the sharpest economic minds have
written on the subject and provided plausible arguments in favor of price controls
based on economic theory.
TheFirstWorldWarhadjustendedwhen Frank Taussig (1919) published his
‘Price Fixing as Seen by a Price-Fixer,’ an account of his experience as President
Wilson’s price controller during the conflict. Two years later, in 1921, Pigou gave
his own opinions based on his experience in Great Britain, dedicating a chapter of
The Political Economy of War to the issue of price controls. At the beginning of
the Second World War, Pigou rewrote his book (1941 [1921]) taking into account
his reflections on the subject during the inter-war period. Then there was John
Maynard Keynes (1940), who published How to Pay for the War, a powerful
pamphlet criticizing the laissez-faire policy adopted during the First World War
and proposing that something very different be done this time. Finally, Michal
Kalecki also addressed these issues.
1
The US entered the Second World War two years after Great Britain (in
December 1941) but, due to the massive expenditures related to preparation for
war, inflationary pressures appeared earlier. The problem attracted the attention
of Alvin Hansen (1941), whose opinions were close to those of Keynes.
Hansen’s views led Galbraith to respond with a critical comment in which he
disagreed with Hansen and Keynes (Galbraith, 1941). At the end of April 1941,
President Roosevelt put Galbraith in charge of price controls, where he remained
until May 1943. In the latter 1940s, Galbraith published several articles drawing
from his experience.
The discussion on price controls does not end with the Second World War;
each time that inflationary tensions reappear, so too does the debate over controls.
At the start of the Korean War, Tibor Scitovsky et al. (1951) wrote a tract,
Mobilizing Resources for War, for the Rand Corporation. This work analyzed
the interrelationships between inflation and war efforts, and reviewed the different
anti-inflationary policy options. A few months later Galbraith published A Theory
of Price Control, in which he summarized his experience and thinking on the
subject (Galbraith, 1952). The subject of price controls comes back again under
Presidents Kennedy, Johnson, Nixon and Carter.
2. Price Controls in Time of War
Before we focus on Galbraith’s contributions to the debate on wartime controls,
it is useful to look at some different opinions on anti-inflation policy and price
controls that were expressed during the Second World War.
1
Kalecki (1997) contains a collection of his articles on these subjects.
The Theory of Price Controls 573

2.1. The Timing of Price Controls
Before the Second World War began, it was widely believed that, because of the
high unemployment and excess capacity inherited from the Great Depression,
inflationary tensions would not arise as soon as they had during the First World
War, but only after a while, as full-employment was approached and excess
capacity disappeared. So, if price controls (or some other anti-inflationary
policies) were required, they would not be necessary right away. Here is how
Mordecai Ezekiel (1939, p. 1), a prominent economist in the Roosevelt adminis-
tration, put it: ‘This is one of the subjects on which economist generally, I believe,
do agree ... If you have some unused capacity in your economy, the result of
borrowing is not to put heavier pressure upon what you are already producing
but rather to call forth more production. You then may borrow, get increased
production for war purposes, and yet not drive up the price level’.
However, contrary to expectations, inflation started immediately. In the UK,
four months after war was declared, wholesale prices rose by 27%, and the cost of
living by 10%, even though unemployment had hardly fallen. In the US, inflation
shot up from a yearly rate of 3% (in July 1940) to 15% (in July 1941); but unem-
ployment was still above 10%, and the US would not enter the war for another five
months.
Keynes and Galbraith gave different (but not necessarily opposed) expla-
nations for this unexpected phenomenon. Keynes provided a macro explanation,
Galbraith a micro one. Let us start with Keynes.
To carry on an important war (as opposed to a short military expedition),
Keynes argued, a country could not draw on its stocks of ammunition and war
material; rather, it must expand its production of these items. The labor force
necessary for expanding war production could only come from the ranks of those
already employed elsewhere (in branches producing civilian goods), or from
the ranks of those who are not employed. In both cases excess demand for civilian
goods appears immediately – no matter how much unused capacity there is. In the
first case, excess demand arises because the production of civilian goods is reduced,
in the second case excess demand arises because the number of wage earners
increases without more civilian goods going to the market. As Keynes (1940,
p. 8) put it: ‘Even if there were no increases in the rates of money-wages, the
total of money earnings will be considerably increased by the greater number of
men engaged in the services and in civilian employments ... It follows that the
increased quantity of money available to be spent in the pockets of consumers
will meet a quantity of goods which is not increased’.
Excess demand then appears immediately, no matter how far we are from full
employment and full utilization of capacity; so whatever anti-inflationary policy
the government decides on, it must begin right away. ‘This analysis of how
inflation works is fundamental. ... But it is not yet understood by everyone ...
During the last war I was in the treasury. But I never, at that time, heard our finan-
cial problem discussed along these lines’ (Keynes, 1940, p. 70).
Kalecki was not very clear on this subject at the beginning of the war. In June
1940, he writes: ‘The fundamental problem of the war economy is ...to prevent a
violent rise in prices, which is bound to come, since the productive resources are
574 S. Laguerodie & F. Vergara

limited’ (Kalecki, 1997 [1940], pp. 7–9). A year later, he assimilated the point
made by Keynes: ‘The problem of inflation arises in wartime because the
volume of employment is maintained or even increased, whereas the output of
consumption goods falls considerably’ (Kalecki, 1997 [1941], p. 20). The fact
that productive resources are ‘limited’ no longer enters into the argument.
In the case of Kalecki, his first (erroneous) formula had little influence on
what he proposed. He in no way used it as an argument for postponing government
intervention until full capacity use was reached. On the contrary, he favored
rationing and price controls from the very beginning of the conflict, seeing
them as a way of preserving the interests of the working classes and sharing the
burden of the war more equitably.
Galbraith’s alternative explanation comes in critical comment on Hansen’s
(1941) paper ‘Defense Financing and Inflation Potentialities’, where Hansen esti-
mates that output and employment in 1940 were running at roughly 80% of poten-
tial capacity and concluded that ‘the fear of inflation is exaggerated’. ‘In taking
account of inflation potentialities, the situation differs from that of the first
World War ... there is very large productive capacity ... we approach the
problem of preventing wartime inflation from a stronger vantage ground than in
the first World War’ (Hansen, 1941, p. 6). His argument was that, during mobili-
zation, inflation can enter the system for two different reasons – because of bottle-
necks and because full employment has been reached. Each type of inflation
required a different policy to counter it. As full utilization of resources is
approached, it may be useful to control prices. But if the price of a given commod-
ity starts rising because of a bottleneck, the only sound policy is to concentrate
efforts on ‘breaking the bottleneck’; it would be wrong to block the corresponding
price increase and thus deprive oneself of ‘the important weapon of specific price
increases where these may help eliminate bottlenecks’ (i.e., by attracting capital
and labor): ‘If we succeed in avoiding, or at any rate in holding to a minimum,
bottleneck inflation ... we shall finally encounter, as we approach full employ-
ment, the problem of general inflation’ (Hansen, 1941, p. 6).
Galbraith starts his criticism by diplomatically suggesting that the comments
he is about to make are ‘supplementary to rather than at issue with’ Hansen’s argu-
ments. But then he questions not only the relevance of Hansen’s main distinction
but also his main proposal: ‘Professor Hansen distinguishes between rising prices
associated with specific bottlenecks and rising prices associated with an approach
to full employment ... I am not sure that complete rejection of the distinction
would not be wise’ (Galbraith, 1941, pp. 82–83). After more than ten years of
Depression, parts of the economy that can speedily expand production and
those that would rapidly experience bottlenecks are so intermingled that any dis-
tinction between the two is purely academic: ‘Full employment will have little or
norelationtotheappearanceofinflation...theimportantdecisionsinpricepolicy
and fiscal policy will have to be made long before full employment is reached’
(Galbraith, 1941, p. 83, emphasis added).
It seems only fair to mention Bernard Baruch here. Baruch identified specu-
lation as a third argument for starting price controls immediately. Once the fear of
war appears, businessmen anticipate that certain commodities will be in short
supply, and their price will rise. The perception that prices are likely to rise
The Theory of Price Controls 575

makes them bid up the price of existing stocks and future contracts for these
commodities. Prices thus start rising even before the excess income related to
war production (of which Keynes speaks) comes into existence (Adams, 1942,
pp. 111–142).
2.2. Which Anti-inflationary Policy?
Economists may have agreed that war mobilization produced excess demand and
inflationary tensions, but there was little agreement concerning what should be
done about these problems. It is here that Galbraith’s most original contributions
to the question of price controls are to be found. But to understand them it is
necessary to know what others thought about this issue.
The first policy that usually comes to the mind of a trained economist when
faced with excess demand is to let the market restore equilibrium. This is what the
free movement of prices is supposed to do.
Even if the price mechanism does this in times of peace, there are several
arguments against relying on it in times of war. Importantly, it takes too much
time. As Mordecai Ezekiel (1939, p. 9) wrote: ‘If you wait for a high price to
encourage manufacture to expand ... you may lose a great deal of lives before
that profit motive has brought the material needed’. To extend a famous remark
by Keynes, we could say that, if we rely on market forces in times of war, we
would be dead ‘in the short run too’. Pigou (1941, pp. 70–71) says essentially
the same thing: ‘In an intense international conflict, delay is extremely dangerous.
Time is of the essence of victory ... commandeering enables the transition from
peace production to war production to be effected much more speedily ... The
molding of industry into the shape proper for war needs therefore to be helped
forward by direct government coercion’. Likewise, Tibor Scitovsky et al.
(1951, p. 139, emphasis added) wrote: ‘The market mechanism takes time –
sometimes a considerable length of time – in effecting adjustments to changes
in supply or demand conditions. In fact, the slowness of the market mechanism
was the main argument advanced in World War II in favor of direct controls’.
Another argument against relying on the free movement of prices is that
when war mobilization takes place, excess demand arises not only for military
goods but for civilian goods also (for the reasons explained by Keynes). If
prices of civilian goods rise, the profits from making these goods will attract
investment away from military production, which is exactly what one wanted to
avoid. As Seymour Harris (1945, p. 30) noted: ‘uncontrolled prices may well
result in the movement of labor and capital to industries which can be dispensed
with in war-time’.
A last argument is that, during a war effort, the free movement of prices
will not restore equilibrium. As Keynes put it: ‘the Government having taken
the goods, out of which a proportion of the income of the public has been
earned, there is nothing on which this proportion of income can be spent ... if
prices go up, the extra receipts simply swell someone else’s income, so that
there is just as much left over as before ... that is an arithmetical certainty’
(Keynes, 1940, p. 61, emphasis added). And Keynes comes to the conclusion, a
position later challenged by Galbraith, that: ‘Some means must be found for
576 S. Laguerodie & F. Vergara

withdrawing purchasing power from the market ... This is the only way’ (Keynes,
1940, pp. 8–9, emphasis added).
Withdrawing purchasing power: taxes versus savings. It seems there are only
two ways of withdrawing excessive purchasing power from the market. The first is
raising taxes, what Scitovsky et al. (1951) call the ‘pay-as-you-go system’. It con-
sists of financing current military expenditures by current taxes. As Pigou (1941,
p. 73) explains, this system has practically never been relied on: ‘in a war on a
great scale, it is generally agreed that a policy of finance through taxation
alone, however excellent it might be in theory, is in practice out of the question,
for the simple reason that people would not stand it’ (emphasis added).
This is one reason the founders of political economy often favored such a
policy – they wanted the people to feel, in their pockets, the cost of the unnecess-
ary wars their sovereigns chose to wage. But here we are supposing that the war is
justified and necessary, so the task of the economist is exactly the opposite. It is to
make the pain of financing the war as imperceptible as possible.
A second way of withdrawing purchasing power is by increasing savings.
Voluntary savings can be increased by patriotic propaganda, by increasing incen-
tives to save, by making consumption more difficult, etc. But there is a big
problem with this approach. ‘The defect in a voluntary plan, of course, is that
its magnitude will necessarily be small compared with what might be achieved
by a compulsory plan’ (Hansen, 1941, p. 6).
There is another way ‘voluntary’ savings can deliver funds that the govern-
ment requires for its military needs – it is by allowing inflation. Keynes brilliantly
shows that this is a hidden way of transferring income from those who ‘try to
spend it’ to the hands of those who ‘will save it’. He explains how this comes
about: ‘allowing prices to rise ... merely means that consumer’s incomes pass
into the hands of the capitalist class’ (Keynes, 1940, p. 6). What happens to this
income, since the goods on which it could eventually have been spent on have
been taken by the Government? What will the capitalists do with it? ‘[P]art of
this gain they would have to pay over in taxes; part they might themselves
consume thus raising prices [of consumer goods] still higher ... the rest would
be borrowed from them, so that they alone, instead of all alike, would be the prin-
cipal owners of the increased National Debt’ (Keynes, 1940, p. 6, emphasis
added). ‘Thus it is quite true that, in the last resort, the amount of saving necessary
to balance the expenditure of the Government (after allowing for the yield of
taxation) can always be obtained by “voluntary” savings. But whether this is a
good name for it is a matter of taste. It is a method of compulsorily converting
the appropriate part of the earnings of the worker ... into the voluntary savings
(and taxation) of the entrepreneur’ (Keynes, 1940, p. 69, emphasis in original).
In sum, Keynes and Hansen both believed that voluntary savings (apart from
the unjust type just described) would be the better way to finance wars.
The problem, however, is that people do not seem to be up to the task of saving
voluntarily; so Keynes and Hansen both propose forced savings, although they
disagreed on the name. Keynes called it ‘deferred wages’. These would be placed
to the credit of their owner ‘as a blocked deposit in a friendly society or ... in the
Post Office Savings Bank carrying interest at 2.5%’ (Keynes, 1940, p. 44).
Hansen (1941, p. 6) preferred to call it ‘a tax on payrolls’ deducted from wages
The Theory of Price Controls 577

that would be credited to the wage earners ‘in the form of a blockedpostal savings
account’.
Galbraith’s ‘disequilibrium system’. Galbraith was not convinced by the
Keynes–Hansen policy of across-the-board withdrawal of purchasing power.
He was afraid that it would produce undesired side effects. First, by withdrawing
purchasing power to reduce inflationary pressures where there are bottlenecks
(rubber tires and scrap aluminum, for example), we also reduce purchasing
power where there is abundant idle capacity (food and tobacco). It is a method
of reducing demand for ‘scarce goods needed by the army’ that also reduces
demand for ‘non-scarce goods used by the people’.
Second, excess demand has a stimulating effect on production that it would
be a mistake to eliminate:
reducing the amount of spending too soon [as Keynes proposes] ... would
remove a very desirable pressure for expansion of capacity ... If we wait for
full employment before reducing the volume of spending [as Hansen proposes]
we shall already have had a good deal of inflation ... we must avoid premature
reduction of spending. It is not something to be done at the first sign of inflation.
It is not clearly desirable even when inflationary tendencies become relatively
wide-spread, for at such time, if my analysis is correct, there will still be import-
ant unused resources. (Galbraith, 1941, pp. 83–84)
We should control prices right away! As such, ‘this control ... will check
inflation without hampering expansion or curbing the consumption of commod-
ities or the use of services which are plentiful. In short, the real burden of the
armament effort can be reduced by price controls’ (Galbraith, 1941, p. 84).
ThatwasGalbraith’smainmessage,anditiswhattheUnited States did under
his (and Leon Henderson’s) guidance. In 1947, looking back with well deserved
paternal pride (for both the system and the name it goes under), he writes:
During the second World War, the United States ... developed a system for
mobilizing economic resources that, by commonly accepted standards of per-
formance,provedhighlysatisfactory ...[this system] I havetermedtheDisequi-
librium system ... an aggregate of money demand substantially in excess of the
available supply of goods and services ... was a distinctive and pervasive
feature of the system (not an unfortunate or evil by-product) ... I have used
this disequilibrium of demand and supply to name the system as a whole.
(Galbraith, 1947, pp. 287–288, emphasis added)
To be fair, we must recall that Kalecki opposed across-the-board withdrawal
of purchasing power a year before Galbraith. He feared that it was a policy that
unnecessarily reduced the consumption of things that were not needed for the
war effort: ‘reduction of enjoyment of services releases little in the way of raw
materials and labour ... If somebody’s compulsory savings are made by ... redu-
cing his dwelling space, or giving up the cinema – he does not, indeed, contribute
much to the war effort’ (Kalecki, 1940, pp. 7–9). He also feared that Keynes’s
policy would burden the poor more than the rich. The rich, he says, can comply
with the ‘forced savings’ that are required by reducing their ‘voluntary
savings’, without restraining their consumption. The poor don’t have voluntary
savings, they can only comply by reducing their consumption: ‘[we should]
578 S. Laguerodie & F. Vergara

establish a certain maximum for the consumption of the rich before compulsory
saving is imposed on the poor’ (Kalecki, 1940, pp. 7–9).
2.3. The Scope or Coverage of Price Controls
It was also widely believed, at the beginning of the war, that price controls (if and
when they eventually became necessary) need not be comprehensive – they
should only concern specific commodities. According to the consensus opinion,
Galbraith (1980, p. 5) tells us in his book: ‘price controls would be applied
[only] to commodities which the war had placed in especially short supply’
(emphasis added). Keynes also seems to have seen no extensive role for price
control: ‘some measure of rationing and price control should play a part in our
general scheme ... [a list of] a limited range of essentials ... should be drawn
up and the Government ... should do their best to prevent any rise in an index
number based on the cost of these articles’ (Keynes, 1940, p. 57, emphasis
added). The idea that price controls should be limited to specific items was
shared by Galbraith (1941, p. 84): ‘in the areas where resistances develop, as
they are now developing, we shall need specific price controls ... these specific
price controls must be the major reliance’ (emphasis added).
Both theoretical and practical arguments were advanced for the scope of
price controls. The more laissez-faire authors wanted to disturb the mechanism
of freely moving prices as little as possible because they believed this mechanism
would direct resources towards their most efficient uses (Anderson, 1938, pp. 3,
16; Enke, 1942, pp. 842–843). For this reason, among others, Ludwig von
Mises (1945, 1949) argued that controls should be minimized lest they set a
precedent and jeopardize the future of economic freedom and private property.
Galbraith was not impressed by such laissez-faire arguments, in large
part because he did not see the need for comprehensive price controls. As Leon
Henderson (Galbraith’s boss) explained before the House Committee on Banking
and Currency, on 17 September 1941: ‘ceilings on 75 to 100 of the principal
commodities and fabrications would be sufficient’ (Barber, 1996, p. 142).
The prevailing idea was that if (and when) the supply of a given commodity
became problematic the authority supervising prices should step in, study the
market in question, and propose a specific solution. One of the first problems
encountered were rubber tires: ‘By the summer of 1941, prices of lumber, scrap
metal, some textiles ... were under the pressure of rising military and civilian
demand. As the prices rose, we published schedules setting out the maximum
permissible [price] levels’ (Galbraith, 1981, p. 136).
But it rapidly became evident to Galbraith that they were on the wrong path.
Thenumberofcommodities posing problemsskyrocketed;andalthough the Office
of Price Administration expanded its personnel, the task of studying a growing
number of markets for problematic commodities and proposing a well thought
out price schedule for each of them, quickly became impossible. The politics of
‘piecemeal control’ (as Baruch and Harris called it) soon became unworkable:
each price fixing action took time; costs had to be obtained, meetings held and
the results deliberated ...The work in understanding issues in dispute, establish-
ing ceilings, according hearing and appeal to interested and aggrieved parties,
The Theory of Price Controls 579

staffing and otherwise managing the enterprise and answering to the Congress,
press, and public, was to be the most intense effort of my life ... we began to
realize for the first time what an unreasonably large number of products and
prices there were in the American economy ... I began to accept that I had
been very wrong. (Galbraith, 1981, pp. 136, 164, emphasis added)
And the problem seemed destined to become more serious over time. If the
price of commodities for which excess demand appears first (tires, lumber, scrap
metal) gets fixed, they stop rising; but the excess income still exists and simply
chases the remaining (and less numerous) commodities. As Harris (1945, p. 93)
explained: ‘Once the government has restrained prices ... over a significant
part of the economy, the pressure of excess demand became more serious, for
the area over which excesses of purchasing power could be spilled was gradually
being reduced’.
There was clearly a dilemma. Letting the market determine prices would lead
to inflation, but the government seemed unable to set prices with promptitude and
competence. Yet if only some of the prices were fixed, it just made the problem
worse for the price of the remaining commodities.
Towards general price controls. The solutioncameintheformoftheGeneral
Maximum Price Regulation (GMPR) of 28 April 1942, which imposed a ceiling
on all prices. Starting from that date, no seller would be allowed to charge, for
the same item sold to purchasers of the same class, more than the highest price
he had charged during the month of March 1942.
The new regulation reversed the earlier design for price control policy. In the
earlier system, the burden of proof had been on the Office of Price Administration:
if it wanted to impose a maximum price on a particular commodity, it had to give a
well thought out argument for doing so. Now the onus probandi would be on the
particular seller: if he wanted to raise his prices and charge more than he had
during March 1942, he had to give a convincing reason for doing so. Controls
over prices and wages became the rule; freedom from such regulation became
the exception. The new regulation made no pretense to deal with particular dise-
quilibria. According to testimony by Chester Bowles to Congress, overnight the
prices of 8 million products were fixed (Harris, 1945, p. 22).
There had, of course, been voices dissenting from the previous consensus that
controls were only necessary on the price of some goods. Baruch (who was chair-
man of the War Industries Board during the First World War) long opposed the
path that Galbraith and his colleagues were following. Testifying before Congress
in 1941 he warned: ‘I do not believe in piecemeal price fixing. I think you have
first to put a ceiling over the whole price structure ... and then adjust separate
price schedules upward or downward, if necessary, where justice or governmental
policy so require’ (Baruch, 1960, p. 287). George Adams (1942, pp. 111 –142) has
given an excellent account of the objections to Baruch’s opinions, and the answers
he gave.
In his memoirs, Galbraith recalls how Baruch’s propositions had been
received at the time:
We were horrified. All economists were horrified. An economist without a price
system is a priest without a divine being ... We had spent our lives learning
580 S. Laguerodie & F. Vergara

about prices and teaching others how they rose to encourage needed production;
how they fell to discourage unneeded production ... Under the Baruch plan all
of this admirable mechanism would be in limbo ... We could not accept the
Baruch system. (Galbraith, 1981, p. 134)
Rostow (1942, p. 486) confirms this: ‘The majority of economists ... opposed
such wide and drastic action.’
The solution of controlling all prices was not completely new, of course.
Germany imposed a general price-stop in 1936, but it was largely believed to
be a decision: ‘taken by men who were intellectually incapable of weighing the
alternatives ... to their unsubtle minds, it seemed the only way to prevent
inflation’ (Galbraith, 1952, p. 5). Whatever may have been the case with
Germans,themethodofusingageneralformula,insteadofdealingwith each indi-
vidual price, had also been applied by the British, during the First World War, to
commodities having great variety and numerous grades. Here is how Pigou (with
evident approbation) described this practice:
grades were often very numerous ... when there were a great many, it was
thought better to rely, not on a schedule of maximum prices, but on a general
order determining the relations between the prices that might be charged in
the future and those that had been charged in the past ... sellers of machine
tools [for example] were forbidden, except with the sanction of the Minister,
to charge prices higher than they were charging in July 1915. (Pigou, 1941,
pp. 119–120)
Finally, when general price controls were imposed by the Canadian government in
the autumn of 1941 and these controls seemed to be working, the taboo was
broken: ‘I had been up to Ottawa – writes Galbraith – it was obvious that they
were doing a better job of price stabilization than we were ... In March (1942)
I confessed error’ (Galbraith, 1981, p. 164).
In the end, Galbraith (1952, pp. 4, 7) tells us: ‘all of the highly organized bel-
ligerents emerged with comprehensive systems of price-fixing ... Events had
forced the step that economists, in the main current of economic theory, had so
long viewed as unwise or impossible, or both’ (emphasis added).
3. Why General Price Controls were Possible
and why it didn’t cause Chaos
As noted above, it was widely believed that it was beyond the ability of the
government to develop a comprehensive and coherent schedule of prices to
replace market prices because of the enormous number of goods, the great diver-
sity of varieties and qualities, and the many different localities and circum-
stances in which production was carried out. It was also believed that, if the
mechanism of freely moving prices were suspended, there would be catastrophic
results.
The experience of the Second World War shows that nothing of the sort hap-
pened. All developed belligerent countries applied general price controls during
the war but no country collapsed because of these controls. As for the US, from
1939 to 1944 its per capita GDP doubled in constant dollars (Madisson, 2003,
The Theory of Price Controls 581

p. 88), industrial production almost tripled, and it was possible to produce a
massive amount of war material while at the same time increasing civilian
living standards.
Drawing some lessons from war-time price controls, Harris (1945, p. 8)
writes: ‘Few will dispute the fact that price control in the United States has
been effective. Those who do not agree need only compare the rise of prices in
former wars – especially the first World War with those in the second World
War – to be convinced’. He furnishes a graph comparing price and production
performances during both wars for the first 52 months of the conflict (Figure 1).
The large gains in output during the Second World War are clear from this
figure. As Galbraith (1981, p. 171) put it: ‘That so much could be accomplished
with the market in partial suspense was deeply damaging to the established faith’.
This raises two questions. First, why the did the task of fixing thousands of
prices and then enforcing compliance, a task that had been considered by most
economists to be impossible, turn out to be less difficult than expected? Second,
why didn’t the suspension of the price mechanism cause chaos, as had so often
been predicted?
3.1. How was it Possible
According to Galbraith, economists were not wrong in thinking that price controls
would be (almost) impossible in a purely competitive market. Their mistake was
inbelievingthatthepre-wareconomywasstillacompetitiveone,andthat prevail-
ing prices were mostly determined by free-market forces. Economists did not
realize how American capitalism had changed, how widespread imperfectly com-
petitive markets had become, and how relatively easy it would be to control prices
in such markets:
concentration in American industry had gone far beyond the current estimate or
appreciation of the textbooks. Oligopoly ... was no longer the exception ... it
Figure 1. Price and production during both wars for the first 52 months of the conflict.
582 S. Laguerodie & F. Vergara

was the rule. Where a few large firms dominated an industry, as they did steel,
aluminum, oil, chemicals, pharmaceuticals and many others, prices were
already controlled ... these markets lend themselves to price regulation to a
far greater extent than had previously been supposed. (Galbraith, 1952,
pp. 10–11, emphasis added)
The belief that many prices were already fixed, long before the war began,
was not new. Most classical economists admitted this fact, but believed that
such prices should be considered as exceptions to the rule. Institutionalists went
even further; they considered these administered prices (as Gardiner Means bap-
tized them) as part and parcel of their model from the very beginning (Goode,
1994, pp. 173–184).
Administered prices were not new to Galbraith. In 1938, when searching
for the causes of the persistence of the Great Depression, he strongly suspected
the culprit to be rigidity in the price of commodities like automobiles, steel, and
cigarettes, which (unlike agricultural prices) refused to fall in face of reduced
demand. It was clearly not the forces of supply and demand that were keeping
these prices up, but some kind of market power possessed by producers (or, as
he then calls it, ‘jurisdiction over price’). He noted that: ‘the sort of producer
jurisdiction over price which is to be found in the automobile industry ...
holds over the great range of American industry’ (Dennison & Galbraith,
1938, p. 24).
Widespread price rigidity, which he (at the time) believed to be a curse that
largely explained why the economy was experiencing great difficulty coming out
of the Depression, was now seen as a blessing that would help win the war. The
same economic forces and institutional arrangements that kept prices from
falling during the Great Depression, could now be harnessed to stop them from
rising during the war. As Galbraith (1952, p. 17) summarizes: ‘I am tempted
to frame a theorem that is all too evident in this discussion: it is relatively easy
to fix prices that are already fixed’ (emphasis added).
Galbraith tells us, in his memoirs, how shocked most economists had been
when Bernard Baruch proposed a suspension of the mechanism of freely
moving market prices. They had not noticed that the free-market price mechanism
had already been suspended to a significant extent before the war. It had been sus-
pended, not by any sudden government decree, but by the gradual extension of
market power. George Adams (1942, p. 138) already saw that:
the area in which prices are administered, rather than formed competitively in a
free market, has been growing ... To move from a world in which many prices
are fixed by private industry to a world in which many prices are fixed by
Government ... is not so drastic a change as some critics of governmental
price control have assumed.
It is easier to understand why comprehensive price controls are possible if we
distinguishthethreeprincipalproblemsthatsuchcontrolsaresupposedtoencoun-
ter. The first is that of determining at what level (or inside what interval) we desire
to keep different prices. As already noted, it was believed that this was an imposs-
ible task for government to perform in a modern economy. How could a govern-
ment agency decide what the right price is for millions of commodities, produced
The Theory of Price Controls 583

under millions of different conditions, and in as many different localities? And as
we saw above, if a government agency tried to find the best price ‘commodity by
commodity’ the task is endless. But, if it imposes the prices practiced during the
month before, a complete set of prices already exists, and is ready to be used over-
night, as a satisfactory starting point.
A second problem is that of the ‘rationing mechanism’ by which the
allocation of commodities to different buyers will be performed. Since a govern-
ment-imposed price will be lower than the market price, demand at that price will
be greater than supply and not everyone will get all he wants. Those who are
excluded will be tempted to secretly offer the producer more than the legal
price, and a black market will develop, unless someone has the power to decide
who will be deprived of the commodity and who will get to buy it. Since there
are so many producers, buyers and commodities, it is impossible for a government
agency to make these decisions (for the same reason that it was impossible for it to
decide prices one by one).
In a purely competitive market (with a large number of producers and
buyers), sellers do not know who their buyers are; so, even if they wanted to
decide which buyers should be rationed and which should be served, they
would have no way of doing so. In an imperfectly competitive market, it is other-
wise. When there is imperfect competition, the government does not have to make
these decisions – the sellers can make them. The seller knows his buyers so, if
there is need for rationing, the seller is in a position to perform it:
when the number of buyers is relatively small, or the number of sellers relatively
small, or both ... It is possible for sellers to allocate scarce supplies to specific
customers ... it is possible, and even rather easy, for sellers to give large, habit-
ual, or otherwise favored buyers, preference rights to what is available and this is
a very natural pattern of behavior ... in the ideal case there is no supply left to
enter a free (or black) market. (Galbraith, 1952, p. 11)
The government then doesn’t have to create, ex nihilo, a bureaucratic appar-
atustoperformtherationingfunctionsincesuchanapparatusalreadyexists.Itjust
has to control and monitor it to make sure that this rationing function is performed
in conformity with the war effort.
The third problem concerns the surveillance mechanism needed to police the
system (i.e., to report eventual violators). In a competitive market, where there are
many sellers and buyers, there are innumerable potential offenders to watch over.
Each violation of the law will be small and very few people will be informed of it.
Those who are informed (the violating seller and the violating buyer) have an
interest in keeping it secret, so it will be relatively difficult and very costly to
detect.
In a monopolistic market with big corporations, illegal actions are more
important and known to a greater number of employees. Buyers who have been
penalized (i.e., excluded) will be bigger and have an interest in, and the means
to, investigate and disclose illegal actions: ‘in the competitive market there is
little hope that the buyer will police the price regulation imposed on the sellers;
in the imperfect market, the market of administered prices, there is considerable
chance that he will’ (Galbraith, 1952, p. 15).
584 S. Laguerodie & F. Vergara

3.2. Why Price Controls did not Produce Havoc
The dominant opinion among economists, as Galbraith tells us, was that
free-market prices are indispensable and should be disturbed as little as possible:
Freely moving prices, as the first textbook lessons tell, are the rationing and
allocating machinery of the economy. They keep demand for goods equal to
what is available, they guide resources from less to more important uses.
Obviously if prices are fixed they can no longer perform these functions ...
At a minimum, the effect must be some malfunctioning of the economy; at a
maximum, it might be chaos. (Galbraith, 1952, pp. 2–3)
Why didn’t this happen? Several explanations have been given.
For many economists price controls had direct, negative effects on
production because they distorted market signals and produced inefficiency in
allocation. But their indirect, non-economic effects (through their impact on
morale and patriotism, for example) were positive. Price controls helped convince
people that their forced savings would not be eroded by inflation, that profiteering
was being contained, that the burden of war was being more or less fairly shared.
Had excess demand been withdrawn from the market by taxes, or had inflation
eroded real wages and savings, or had wartime profits skyrocketed, it is not
certain that unions would have respected no-strike agreements or people would
have worked longer hours without complaining.
This is the way Keynes, who often writes of the waste and inefficiency he
observed during the war, saw the problem; but Keynes believed that the indirect
positive effects largely outweighed the direct negative ones. Economic historian
Hugh Rockoff, in his 1984 book on the history of wage and price controls in
the United States, expresses a view similar to Keynes (Rockoff, 1984, p. 139).
However, 11 years later he seems to have changed his opinion. His later view is
that the direct negative effects outweighed the indirect benefits. ‘All in all, price
controls made a limited and probably negative contribution to the speed and
maximum degree of the mobilization’ (Rockoff, 1995, p. 12, emphasis added).
Other authors also believe that the negative economic effects were relatively
small. Scitovsky et al. (1951, pp. 122–123) suggest that the optimal prices that a
competitive market is supposed to generate (those prices that should not be dis-
torted), do not change very rapidly. So, if they are frozen for a short period of
one or two years, the harm done (by directing resources to sub-optimal uses) is
probably small.
Others argued that the initial prices were probably not optimal to begin with.
This opinion is expressed by Scitovsky et al. (1951, Appendix II), which speaks of
the theory of efficient allocation through free-market prices as a ‘belief’ belonging
to the past: ‘That all this is accomplished by the pricing system in the market
economy was believed to be proved by the theory of perfect competition.
Today, perfect competition is looked upon merely as a model of economic perfec-
tion of which our economy falls short’ (Scitovsky et al., 1951, p. 259, emphasis
added). If the initial prices then were not optimal, there is no a priori reason for
believing that government intervention distorts them; it could even make them
‘better.’ This was Galbraith’s line of reasoning.
The Theory of Price Controls 585

One of the main forces behind the free market argument is that if the
government-imposed price is lower than the market price, less will be supplied
by the producer. But this assumes that we are in a situation of pure competition
and decreasing returns. With monopolistic competition and increasing returns,
there is no presumption that if government lowers prices, less production will
be forthcoming. As Pigou (1941, pp. 128–129) noted:
authoritative limitation of the price that may be charged for a thing produced
under competitive conditions is likely to check the output of that thing. With
a thing produced by a monopolist ... price limitation, by preventing him from
seeking his gain by high prices, may force him to seek it through large sales,
and so may actually stimulate production.
Likewise for Galbraith (1952, pp. 22–23):
many, if not most, of the economists actively associated with price control .. .
consciously or implicitly assumed that where large increases in production
would be required, it would be at increasing cost ... In retrospect ... the
number of manufacturing industries expanded at increasing cost was extremely
small ...most industrial expansion during the war was at constant or decreasing
cost.
4. Price Controls in Time of Peace
Keynes argued in the 1930s that recessions could be mitigated, and a higher level
of employment maintained, by modulating government spending. Government
programs during the war tended to confirm this theory by wiping out unemploy-
ment; but they also caused inflationary tensions that had to be neutralized lest
they hinder the war effort.
Inspiredbythisresult,theEmploymentActof 1946 imposed upon the federal
governmentoftheUSthelegalobligationtopromote‘maximum employment’.
2
It
was widely believed, at first, that standard monetary and fiscal policy could
achieve this goal without unleashing the inflationary tensions seen during the
war, since the required stimulus would not have to be so massive. If demand
could be increased without pushing it above what the existing capacity and
labor force could cope with, high employment could be obtained without trigger-
ing inflation. This was a popular view in the years immediately following the
Second World War. As Kalecki (1943, p. 323) put it: ‘if Government intervention
aims at achieving full employment but stops short of increasing effective demand
over the full employment mark, there is no need to be afraid of inflation’. And as
David Colander (1984, p. 33) points out: ‘The lesson most economists learned
from World War II was that Keynesian aggregate demand policy worked. The
fact that the expansion of aggregate demand had been accompanied by major
controls over wages and price ... was lost on the majority of the profession’.
2
The exact wording was ‘to promote maximum employment, production, and purchasing
power’.
586 S. Laguerodie & F. Vergara

4.1. The Problem of ‘Premature’ Inflation
As often happens in economics, things do not turn out as expected. In the years
followingtheSecond World War,asort of prematureinflation(asMilton Friedman
called it) appeared, an inflation that tended to spring up long before full employ-
mentwasin sight. At first,economistsblamedthe specific circumstancessurround-
ing each new bout of inflation. The price increases in 1946 were explained by the
liberationofpent-up demand duringthewar.The second surge,in1950,was attrib-
uted to the increase in spending related to the Korean War. When prices surged
again in 1956, although the economy was in ordinary circumstances (the Korean
War had been over for three years and public spending had been falling for four
consecutive years), many economists suspected that there was a deeper underlying
cause at work.
Paul Samuelson (1960), who was hoping for an unemployment rate of 3.5%
to begin with (and for it to go below 3% once the right policies were in place)
put it this way: ‘instead of setting in only after you have reached overfull
employment ... inflation may be a problem that plagues us even when we
haven’t arrived at a satisfactory level of employment’. Similarly, Robert Solow
(1966, p. 42) identified a key policy difficulty. ‘It is a fact ... wages and prices
begin to rise too rapidly for comfort while there is still quite a bit of unemployed
labor and idle productive capacity and no important bottlenecks. This tendency
creates a dilemma for public policy’ (emphasis added).
No one disputed the fact that restrictive fiscal and monetary policies could
check inflation. But the pain was much greater than was expected. It seemed
that an unemployment rate of 6%, 8%, or even 10% (unacceptable in the
postwar years) was required. Some other way of containing inflation would
have to be found, or it would mean the end of full-employment policy. In his
January 1961 report to President-elect Kennedy on the state of the American
economy, Samuelson (1961, p. 28) characterized the situation as follows: ‘Econ-
omists are not yet agreed how serious this new malady of inflation really is. Many
feel that new institutional programs, other than conventional fiscal and monetary
policies, must be devised to meet this new challenge’ (emphasis added).
What could these new institutional programs look like? Should some form of
price controls be part of the solution? Should controls be extensive or limited?
Should they be permanent or transitory? Should they be compulsory or voluntary?
4.2. Market-power or Excessive Money-supply?
Different explanations of this unexpected inflation were given and different
policies were proposed for ending it.
While recognizing the role played by specific factors such as pent-up
demand, bottlenecks, and military expenditure, Galbraith believed that there
was a deeper underlying cause that explained this premature inflation. He
pointed to the power that large corporations (and important trade unions) have
to increase prices (and wages) even in the face of falling demand (and employ-
ment), a power that the rest of the economy lacked. If anti-inflation policy was
to be effective, this market-power would have to be controlled.
The Theory of Price Controls 587

Friedman also believed in an underlying cause of inflation, and he also saw it
as stemming from an abuse of power, but he pointed to political power as the
culprit. According to Friedman, the deep underlying cause of inflation is always
excessive growth of the money-supply: ‘inflation is always and everywhere a
monetary phenomenon ... I know of no exception to this generalization’. Since
the money supply is controlled by government, inflation is the government’s
fault: ‘In modern times, the government has direct responsibility for the creation
and destruction of money. Since inflation results from unduly rapid monetary
expansion, the government is responsible for any inflation that occurs ... the
only effective way to stop inflation is to restrain the rate of growth of the quantity
of money’ (Friedman, 1966, pp. 18–25).
Friedman conceded that a corporation with market power could use it to raise
its prices above the normal market level, but he didn’t think this process could be
repeated again and again. Market power might explain why some prices were
higher than they should be, but not that they were rising: ‘Insofar as market
power has anything to do with possible inflation, what is important is not the
level of market power, but whether market power is growing or not ... the degree
of monopoly has not been increasing, this monopoly power will not and cannot
be a source of pressure for inflation’ (Friedman, 1966, p. 57, emphasis added).
Moreover, Friedman thought that the market power explanation had cata-
strophic political effects. It blamed ‘the rapacious businessman and power-hungry
labor leader rather than point to the government printing press as the culprit’
(Friedman, 1966, p.24).Thepolicyofwageandpricecontrolsthatfollowsnaturally
from the market-power explanation will not be effective: ‘it does not eliminate
inflationary pressure. It simply shifts the pressure elsewhere and suppresses some
of its manifestations ... suppressed inflation is far more harmful, both to efficiency
andfreedom,thanopeninflation...itencouragesdelayin takingeffectivemeasures
tosteminflation,distortsproductionanddistribution,and encouragesrestrictionson
personal freedom’ (Friedman, 1966, p. 18–24).
4.3. The Medical Analogy
According to Galbraith, monetarists saw inflation in the US as an infectious
disease that had entered the healthy body of the market economy. It could be
purged only by taking an appropriately bitter medicine. In an article for the
New York Review of Books, he had called this ‘the peristalsis theory’ (Galbraith,
1982, p. 34). Inflation had crept in because of the erroneous policies of using
public spending to push unemployment below its natural rate, and letting the
money supply grow too fast. Inflation then became anchored in expectations
because these erroneous policies had been followed for too long. If restrictive
policies were imposed for a while, they would be painful but the infection
would be defeated, and health would come back.
Galbraith disagreed completely with this analysis. For him, this new form of
inflation was more like a chronic condition due to age. The root cause cannot be
eliminated, but the unwanted effects (rising prices) can be contained. American
capitalism had changed; it passed from a situation in which competitive
markets prevailed to one where imperfect competition prevailed. Here was the
588 S. Laguerodie & F. Vergara

cause of inflation, and not the easy-money policies castigated by Friedman. Since
the cause of inflation is not excessive money supply growth, the remedy cannot be
restrictive monetary policy: ‘In the industrial countries we can no longer control
inflation by the designs – notably the monetary policy – that were appropriate to
the classical market economy. Professor Friedman is not wrong; but he is right
only for the last century’ (Galbraith, 1983, p. 39).
4.4. The Ineffectiveness of Restrictive Fiscal and Monetary Policies
In an early paper, ‘Market Structure and Stabilization Policy,’ Galbraith (1957)
gave both moral and economic arguments against the restrictive fiscal and
monetary policies proposed by Friedman. There is, first of all, the painfulness
and injustice of the policy because, if it works, it works by affecting the
weakest and most vulnerable. But the main economic objection is that it will
not really work.
The higher interest rates and lower global demand that are a direct conse-
quence of these policies have opposite effects on the two different sectors of the
economy. The smaller and weaker companies of the competitive sector reduce
their prices when they are faced with lower demand, and they scale down their
investment projects in face of higher borrowing costs. But the big companies of
the monopolistic sector can maintain their prices in face of reduced demand, and
they can continue their investment projects since they are less dependent on
bank credit or are given preferential treatment by the banks: ‘while inflation con-
tinues in the corporate half of the economy, there can be falling farm prices and a
painful recession in the competitive sectors ... The practical conclusion is that
inflation cannot now be arrested by fiscal and monetary policy alone unless
there is willingness to accept a very large amount of unemployment’ (Galbraith,
1977, pp. 195–196) .
By making the small companies of the competitive sector reduce their prices,
restrictive policies can influence inflation but, by pushing more of them out of
business, they increase the respective weight of the monopolistic sector, which
was the cause of inflation in the first place. So restrictive fiscal and monetary
policies camouflage inflation more than they cure it, and they end up making
the situation worse for the next surge in prices.
Some form of ‘price controls’ seems necessary, and the permanent control of
prices set by the monopolistic sector appears to be the natural solution. As Dunn &
Pressman (2005, p. 185) explain: ‘Galbraith accepted neither the monetarist sol-
ution to the problem of inflation nor the fiscal solution of Keynes, arguing that
both fail to assimilate the consequences of institutional change in the industrial
structure into the conduct of macroeconomic policy’.
5. The Return of Free Market Ideas
Thepoliticalsituationisverydifferentnowfromthatwhichprevailed atthe end of
the Second World War, and the US did not implement the policies that Galbraith
proposed. Not everyone thought that the new goal America had set itself (maxi-
mize employment) had the same priority as the previous one – winning the
The Theory of Price Controls 589

war. Even among those economists giving full employment high priority, many
believed that there were other, less controversial ways of attaining this goal
(reduction of the minimum wage, supply-side policies, deregulation of
markets). The orthodox ways of reducing inflation, which had been discarded
during the war (raising interest rates, reducing public expenditure, opening
markets to cheaper foreign goods) did not seem so out of line any more. The
success of wartime price controls had been forgotten, and they were again
largely believed to be impossible or harmful for the economy.
Differences of opinion did not only fall along party lines. Here is how
William Barber (1975, p. 150) describes the situation among economists
surrounding Kennedy in the 1960s:
a sharp division emerged over whether a government position on wage-price
policy was needed at all ... among those who accepted the need for an official
position on wages and prices, the ranks divided on the form it should take.
Should intervention be directed primarily toward wages ... or should even
handed treatment of both labor and management be adopted? Should the objec-
tive of policy be comprehensive coverage or should government involvement be
reserved for selected sectors? Was it realistic to expect that without direct con-
trols, potentially inflationary behavior could be policed?
Solow (1966) largely agreed with the market-power explanation of prema-
ture inflation. But he was skeptical about compulsory controls and was only
willing to accept voluntary guidelines for wages and prices of the monopolistic
sector. Samuelson (1975) was hesitant: ‘When I hear my good friend of long
standing, Ken Galbraith, speak about the merits of permanent price-wage con-
trols ... applied mainly to a few hundred large corporations and the few dozen
unions they bargain with ... I cannot help but wonder’. Four years later, in an
article for the Encyclopedia Britannica, he was still hesitating: ‘controls work
rather effectively in the very short run, for three or six or nine months. But
increasingly they become ineffective, inefficient, and inequitable’ (Samuelson,
1979, p. 63).
The return of inflation after the war, and the question of what to do about it,
set the stage for a long battle that eventually turned out to be a fight about the path
that American capitalism would follow. Would it continue in the direction opened
up in the 1930s by the New Deal and experiment in original forms of enlightened
government intervention to solve economic and social problems? Would the US
embark on a road more like that of the Scandinavian countries, or would it be
tempted by a more free-market ideal of society?
Many indecisive skirmishes were fought. Kennedy and Johnson (and later,
Jimmy Carter) had recourse to voluntary wage-price guideposts (Sheahan,
1967). In 1971, Richard Nixon surprised everyone by imposing a 90 day
wage-price freeze (Weber, 1973) followed by several stages of selective con-
trols. The consensus around the neoclassical synthesis began to disintegrate,
and most strands of macroeconomic thought converged against all forms of
government intervention, while monetarism made a remarkable, though short-
lived, comeback.
590 S. Laguerodie & F. Vergara

6. Concluding Remarks
After the inauguration of Jimmy Carter in January 1977, the Fed began steadily
increasing the Federal Funds Rate. It reached 15% in 1980 and remained at
these high rates during Ronald Reagan’s first two years in office. The US
economy experienced two consecutive recessions and stagnated for four years
(from 1978:4 to 1982:4); unemployment reached 10.8% before a recovery
started. The US and the Western World entered a period of about 25 years of
low inflation which may be ending now.
Economists are divided on why inflation declined after 1985, and especially
when it declined after 1992. Some believe that Paul Volker’s shock monetary
therapy purged inflation from the system, and that central bank credibility has
somehow kept it from coming back. Others believe that the growth of competition
from European and Japanese companies, and then the influx of low-priced Asian
commodities, neutralized the market power of big American corporations and
trade unions that Galbraith blamed for inflation. Whatever the respective merits
of these rival explanations, interest in them seems to be receding today as inflation
has reappeared. And with the re-emergence of inflation comes the question of
price controls.
Byrecallingsomeofthediscussionsconcerning price controls that took place
during the Second World War, and with the full employment policy after the War,
wehopeto have giventhereader some backgroundtobetterunderstand thiscurrent
debate. The same rival camps seem to be forming. On one side are those who see
the worrisome price movements as precious information being signaled to us by
the admirable forces of supply and demand, signals that should not be distorted.
Others suspect, as Galbraith always did, not only that the forces of supply and
demand sometimes produce destructive price movements but also that the price
movements we are experiencing probably have a wider diversity of other causes
than just supply and demand. Among the many suggested culprits in generating
our current rising prices are market power, speculation, fear, and rumors. These
were the causes that Galbraith recognized as stemming from the nature of
mature capitalist economies. Likewise, Galbraith thought that neither the direction
nor the degree in which prices move should be considered as sacred.
Each one of us can decide for himself whether the discussions to which
Galbraith contributed, and his attitude towards dominant economic theory, are
of value only for the historian or if they should be taken seriously by policy
makers today.
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