13 Cost Inflation


Cost Inflation

Today’s chronic inflation is all the more uncanny because its nature is difficult to assess. It does not fit into any conceptual cliché but is something new in economic history... Only one thing is plain: slowly but inexorably, everything becomes more and more expensive.88

These words from a 1960 book by a German economist epitomize the lack of understanding of the inflation phenomenon that has bedeviled twentieth century economic thought. The whole world is in the grip of something that simply does not fit into any pattern that current economic theory is able to assign to it. Almost everyone regards inflation as an evil, but neither economist, government official, nor layman has a clear idea as to what causes it, or even just what it is. As a result, there is a widespread tendency to use the term “inflationary” in a pejorative rather than a descriptive sense. Those who are opposed to a particular action condemn it as inflationary (that is, it is bad), while those who favor it are equally firm in their insistence that it is not
inflationary (that is, it is good).

There is no indication that the situation is improving, either in understanding or in the results of attempts to deal with the problem. These comments indicate how matters now stand:

From Samuelson and Nordhaus:

There is wide disagreement among economists about the nature of inflation.89 And, indeed, the problem seems to be getting worse over time, as higher and higher unemployment rates are necessary to restrain inflation.90

From Heilbroner and Thurow:

There is no general consensus among economists as to the causes or even the mechanism of inflation comparable to the consensus that exists about many other kinds of problems.91

Inflation has become intertwined with the problem of depression because we do not know how to control an inflationary propensity short of sending the economy into a tailspin.92

The truth is that economist and layman alike have allowed themselves to be confused by an economic complexity that does not actually exist. The question as to whether or not an economic action is inflationary is a plain matter of fact. Inflation, as it has been defined herein, and as everyone knows without the need for any specific definition, is an increase in the general price level; that is, an increase in the ratio of purchasing power expended to goods received. Hence if any action increases the flow of money purchasing power relative to the production of goods, it is inflationary-it raises the market prices level. If it decreases this ratio, it is deflationary-it reduces the market price level. If it has no effect on the ratio, either because it does not alter either component or because it affects both equally, then it is neither inflationary nor deflationary-it has no effect on the market price level. Whether or not the avowed purpose of the action meets with our approval is completely irrelevant.

The whole subject of inflation can be reduced to easily understandable terms by making use of the cooling system analogy. As pointed out in Chapter 8 where this analogy was first introduced, the functional correlation is very close. Indeed, if we make the two small modifications of the usual gasoline engine cooling system that were previously described we will have essentially perfect correspondence between it and the economic system from the standpoint of general operation.

We can get a clear insight into the manner in which economic inflation originates if we simply take a look at what would be required if we deliberately undertook to “inflate” the cooling system. Such an “inflation” is, of course, a decrease in the BTU per gallon of water flow, equivalent to a decrease in the value of money (goods per dollar) in the economic system. One way of accomplishing the result would be to pump water our of the auxiliary tank that we installed, and thereby swell the stream going to the radiator. This is analogous to the money inflation that we examined in Chapter 12. Or alternatively, we could change the setting of the thermostat that governs the relation between the water flow and the amount of heat to be removed. This alternate method of causing inflation in the cooling system is analogous to the economic process that we have defined as cost inflation, which is similarly due to an arbitrary action in resetting the economic “thermostat” that governs the production price-chiefly by the establishment of wage rates and the imposition of business taxes.

Because of the finite size of the auxiliary water tank, withdrawals from the tank can take place only temporarily and in limited amounts. Continued use of this auxiliary system is therefore possible only on a cyclic basis, in which the tank is periodically refilled from the main stream. “Inflation” of the cooling system by this method must therefore be followed by “deflation” in a “cooling cycle” analogous to the business cycle. No such limitation applies to the adjustment of the thermostat. Ultimately the maximum capacity of the pump or the piping would be reached, but until then the “inflation” could continue indefinitely, without any requirement that it must be followed by a “deflation.”

The situation in the economic system is almost identical. For purposes of the discussion of cost inflation in this chapter, the most significant points brought out by the cooling system analogy are (1) that cost inflation and money inflation are two separate and distinct economic phenomena, even though both have the same ultimate result: they raise market prices; (2) cost inflation results from deliberate arbitrary actions, such as wage increases or imposition of business taxes, which raise the price level directly (reset the economic “thermostat”), and (3) there is practically no limit to the extent of the inflation that can take place by this means.

Much of the current confusion with respect to the causes and effects of inflation is due to the lack of proper differentiation between cost inflation and money inflation. The man-in-the-street often associates the word “inflation” with currency inflation, and it calls to mind such events as those which occurred prior to World War II in China and after the war in Germany, where the currency depreciated at an accelerating rate until it was finally worth no more than its value as waste paper. What this amounts to is government bankruptcy, and it comes about in the same way as individual bankruptcy; that is, the government tries to live on credit, and continues spending in excess of its income until finally its credit collapses.

Few governments have the ability and the fortitude to meet crises such as major wars with sound fiscal measures, and under these conditions they nearly always resort to heavy use of credit, with the hope that the situation will not get out of hand. Sometimes, as in the World War II experience in the United States, this hope is justified and the economy pulls through with no more than a severe money inflation; sometimes there are narrow escapes, as in the case of the Civil War greenbacks, which depreciated to approximately 35 cents to the dollar before recovery set in; and sometimes the gamble loses, as in China and Germany.

The economists recognize that our current problem is not currency inflation, but, as a rule, they fail to distinguish clearly between cost inflation and money inflation. In fact, there are even contentions to the effect that it is not possible to distinguish clearly between the two. For example, William G. Bowen, in a book entitled The Wage-Price Issue, tells us that it is impossible to allocate the responsibility for inflation between the “demand induced” and the “cost induced” components, and he concludes that it “is clearly not possible... to supply a clear, unequivocal answer to the question of who or what is the “cause' of upward price adjustments.”93

As a result of the lack of differentiation between these two types of inflation there has been a general tendency on the part of individual economists to concentrate on one of them, often concluding that it is the only source of inflation. Keynesians tend to concentrate on the demand mechanism, in line with Keynes’ strong emphasis on demand. Moulton, on the other hand, insisted that inflation is a cost phenomenon. Relying more on empirical studies than on the theoretical approach favored by the Keynesians, he assembled an impressive mass of data to correlate general price rises with wage increases. But instead of interpreting this as an indication that wage increases are a cause of inflation, an irreproachable conclusion, he interpreted it as an indication that they are the cause of inflation. “Our conclusion,” he says, “is that rising costs constitute the only pressure toward higher prices.”94

Moulton’s principal argument in favor of his conclusion is interesting, as it illustrates just what is wrong with much of the relatively minor effort that the economic profession does make to provide factual support for its conclusions. He points out that, except in a quite insignificant proportion of the total transactions, “the goods are priced before they reach the hands of merchants and dealers,” and that the producers “establish prices which will cover costs and leave a necessary margin for profits.” From this he concludes that there is “no support for the thesis that consumer demand is the propelling force in price advances... Rather the line of motivation runs from the cost side. Rising wages and other costs lead to compensating advances in wholesale prices, which in turn lead to markups through distributive channels to the ultimate retail outlets.”

It is evident that price increases can, and do, take place by means of this mechanism. This is cost inflation, as we have e defined the term. But Moulton has made a mistake (one which is unfortunately all too common in physical science as well as in economics) by stopping as soon as he arrived at an explanation of price increases, and not completing his analysis to determine whether there are other explanations. In this case, the mere fact that business enterprises frequently operate for a time at a net loss is sufficient evidence in itself to show that the producers are not in a position to “establish prices which will cover costs and leave a necessary margin for profits.” Obviously some factor other than production costs is involved in market price changes. Reduced production costs certainly are not responsible for the catastrophic fall of the price level in a depression-one of the characteristic features of depressions is that for many producers the prices drop below the zero profit level.

The facts cited by Moulton with respect to the retail price mechanism must therefore be open to a broader interpretation that that which he has placed upon them, and, indeed, it is not difficult to see where he has gone astray. It is true, as he states, that goods are priced before they reach the retail merchants, and that all the latter do is to add their customary markups, but what he fails to recognize is that these preestablished prices are only tentative. In most of the American retail markets the consumers do not normally have an opportunity to bargain over the prices, but they have the opportunity to accept or reject them. If they will not, or cannot, buy in sufficient quantities at the established prices, the producers must reduce those prices and content themselves with smaller profits. If the acceptance is better than anticipated, they can give consideration to increasing the prices and improving their profit margins. Thus, regardless of the fact that the operation of the pricing mechanism is in the hands of the producers, it is the consumers who have the ultimate control. In essence, the market system is simply a gigantic Dutch auction.

Unless the increase in price is exorbitant, the average consumer does not ordinarily refuse to buy something that he definitely wants, if he has the purchasing power readily available. He may grumble, but he buys just the same. If the total purchasing power remains unchanged, the higher price that has to be paid for this item means that consumers must reduce their purchases of other items. This forces a reduction in the prices of these other items, and initiates a competitive round of repricing that ultimately arrives at a new equilibrium between the prices of different goods, leaving the average price level just where it was to begin with. But if the amount of purchasing power available to the consumers changes in parallel with the price increase, the result is different, as in this case the average price level adjusts itself to the new amount of purchasing power.

This explains the very different effect of the two basic types of inflation on real income. The wage increases and associated items that cause cost inflation give consumers in general the exact amount of additional purchasing power that is necessary in order to meet the inflationary rise that takes place in the market price level; that is, real income is unchanged. No alteration of consumers’ buying habits is therefore necessary, aside from the effects of the transfer of income from certain groups to others because of the selective nature of the wage increases. Money inflation, on the other hand, reduces the real purchasing power of the recipients of earned income-wages, rent, interest, profits, etc.-by the amount of goods diverted to those who get the benefit of the money purchasing power drawn from the reservoirs.

Business as a whole is similarly unaffected by cost inflation, as this adds to the income of the producers in the same measure that it adds to their costs. Money inflation likewise adds to income, but has little effect on costs, hence business enterprises are abnormally prosperous during a boom, but when this situation is reversed in a recession, and income drops without a corresponding reduction in costs, they suffer, sometimes very severely. It should be remembered, in this connection, that only a small percentage of the total income of a business finds it way into the profits of the enterprise under normal conditions, and a relatively small drop in gross receipts without a corresponding reduction in costs is therefore sufficient to wipe out profits altogether. Mitchell poses a question here. “But granted so much,” he says, “why cannot businessmen defend their profit margins against the threatened encroachments of costs by marking up selling prices... Once squarely put, this question is not easy to answer squarely. It sounds well to say that the advance of selling prices cannot be continued indefinitely. But this plausible statement challenges the abrupt question: Why not?”95

Mitchell’s inability to see the answer to this question was another result of the economists’ insistence on viewing the establishment of the general price level as a composite of the market prices of the individual goods, and therefore a matter of supply and demand. This is another of the places where they have arrived at wrong conclusions because they apply supply and demand reasoning to situations in which supply and demand are not relevant. The concepts of supply and demand are not applicable to goods-in-general because in real terms, the only measurement that is meaningful in this connection, the supply of goods-in-general (the goods as goods) is the demand (the goods as purchasing power).

Once wages are set and the most efficient production methods have been put into effect, there is nothing more that the producers can do to influence the general price level, and their own individual prices must be consistent with this general level regardless of the effect on their profits. If the general level of production costs rises because of wage or tax increases, they can raise their prices accordingly, since the additional money purchasing power necessary to sustain the higher prices is automatically available. Price increases of this kind (cost inflation) can be continued indefinitely. But price increases cannot be made in the face of deflationary conditions of the kind to which Mitchell referred. Indeed, price decreases are unavoidable, because the money purchasing power flowing to the goods markets under these conditions is not sufficient to maintain the existing price level. Businessmen cannot do anything about this price situation. They simply have to conform to the requirements of the markets.

Summarizing the foregoing discussion, we may say that cost inflation causes a permanent increase in the price level, but this type of inflation is not damaging to the economy as a whole. Money inflation is damaging, but not permanent; it must inevitably be followed by deflation (although cost inflation proceeding concurrently may prevent an actual fall in the price level). Either type of inflation creates serious inequities between individuals and between economic groups.

Since there is more than one type of inflation, there is also more than one kind of economic stability that can be achieved by eliminating the causes of inflation. Usually the word “stability” is interpreted in terms of business stability; that is, elimination of the cycles of boom and recession. As pointed out in Chapter 11, the answer to this stability problem is to take compensatory action to offset any unbalanced flow into or out of the money reservoirs. Such action will not keep the market prices at any fixed average level, but will keep market prices in balance with production prices, so that the rate of money purchasing power flow will be the same in all parts of the circuit, and there will always be enough money purchasing power entering the markets to buy the full amount of current production at the full production price, including normal profits.

This kind of stability benefits almost every participant in economic activity, at least in the long run, and, as will be brought out later, there are available practical methods of accomplishing the stabilization which are quite unobtrusive, and have no undesirable collateral effects. Furthermore, business stabilization is a prerequisite for development of any practical program for maintaining employment at the optimum level. It does not appear, therefore, that there is any reasonable doubt as to the advisability of putting such a program into effect, and it has been assumed for purposes of the subsequent discussion that the “decision makers”-the general public, in this instance-will accept this kind of stability as a desirable economic objective.

The situation with respect to maintaining a stable market price level is quite different. Heretofore it has been quite generally assumed that economic equilibrium and stability of the price level are one and the same thing, but this analysis shows that stability is attained when market price conforms to whatever price changes occur at the production end of the mechanism, so that market price and production price are always equal. Under conditions such as those which have existed in recent years where the wage cost per unit of production is continually rising-that is, cost inflation is taking place-the market price level will also continue to rise even if the business cycle is eliminated. In other words, stabilization of the money purchasing power flow eliminates money inflation, the kind of inflation originating in the goods markets, but it does not eliminate cost inflation, the kind of inflation originating in the production market. If it is desired to eliminate cost inflation as well as money inflation, and thus establish a stable price level in addition to a balanced flow of money purchasing power, it will be necessary to take some definite and systematic action to prevent wages from rising any faster than general productivity.

Here we arrive at a question of public policy which is outside the field of economic science. Unlike money inflation, which works to the detriment of the majority, in the long run, and has few friends, cost inflation due to wage increases takes from some for the benefit of others, and therefore has powerful support from those who are benefited, particularly labor union members and those who are in a position to keep pace with union wage increases-supervisory employees in the high wage industries, for example. Ironically the “high wage” policy also receives much support from the very individuals who are its chief victims. The unorganized worker generally feels that if the union member receives a pay increase, he will ultimately get one too, not realizing that when and if this increase materializes it will do no more than make up for the price rise due to the previous .union wage increases, and will merely put him back in the same relative position that he occupied to start with, whereas the favored groups have prospered at his expense in the meantime. Similarly, socially conscious groups, such as the school teachers, who, whether or not they are unionized, are inclined to support all efforts that are made to raise the pay of the industrial workers, not realizing that their own “low pay scales” about which they complain so bitterly, are not low by any absolute standard, but are relatively low simply because they have been outdistanced by the inflationary processes which the teachers themselves have assiduously, if unintentionally, promoted.

The explanation for this absurd situation, in which large economic groups are exerting their best efforts, without any conscious altruistic motive, to reduce their own economic well-being by extending special favors to other groups, lies in the general acceptance of the totally fallacious idea that wage increases are secured at the expense of the employers. As pointed out earlier, it is conceded by almost all of those who have made a full-scale study of the matter that the average compensation of the suppliers of capital, in percent return on the investment, is, and of necessity must be, fixed by considerations which operate independently of the price of labor. It therefore follows that, irrespective of what may take place between any individual employer and his employees, the total compensation of the suppliers of capital services depends entirely on the amount of capital employed, and it cannot be altered by wage manipulation. As expressed by J. M. Keynes, “The struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not the average amount per unit of employment which depends... on a different set of forces.”96

Wage increases, then, are not secured at the expense of employers as a whole. If the increases are selective, the benefits to the favored workers are secured at the expense of the workers who do not participate in the increase and the individuals who receive fixed money incomes. If all workers receive comparable increases there is no benefit to any except what can be gained at the expense of the fixed income recipients-bondholders, pensioners, insurance policyholders, and the like. In any event, this gain is relatively small, as the fixed component of the national income is a minor fraction of the total, and the inflationary impact on the recipients of these fixed incomes is being counteracted by an increasing number of devices such as “cost of living” adjustments for pensioners, convertible bonds, inflation clauses in contracts, “indexing” for inflation, etc. As a first approximation, therefore, the existence of incomes that are fixed in monetary terms can be disregarded in a mathematical examination of the relation between wages and prices.

In undertaking such an examination, let us look at the general situation in which the average wage per unit of output is W, the average investment per unit of output is I, and the average cost of the services of capital is x percent of the value of the capital utilized. All production costs can be reduced to labor and the services of capital. and the total production cost (production price) under the circumstances described is therefore W + xI. The investment per unit of output in the short term situation is fixed, and if we denote the ratio of W + xI to W by the symbol a, we can express the production price per unit of output as aW, and the capital cost component as
(a-1)W. Since the normal market price is equal to the production price, the normal market price is also aW.

In discussions of the question as to the effect of higher wages on market prices, the statement is frequently made that even though the wage increase does raise prices, the worker makes a proportional gain at the expense of other elements of production cost, such as taxes and materials, which remain unchanged. But in reality, payments for such items are merely indirect payments for labor and capital services, and since the cost of capital is determined by considerations which are independent of the wage rate, such statements as the foregoing amount to nothing more than assertions that workers who receive wage increases gain at the expense of other workers whose pay is not increased. This is true, of course, but it has no bearing on the question that we are now examining, the question as to the effect of an increase in the average wage rate. It should also be noted that the cost of capital services is fixed in real terms, and changing the money labels by raising wages does not enable making gains at the expense of the suppliers of capital.

Returning now to the mathematical development, if wages are increased from W to mW, this causes the normal market price level, the price of goods-in-general, to increase by a factor which we will call n. Our question, then, is: What is the relation of m, the increase in wages, to n, the increase in prices. In approaching this question, we note first that the investment I is in the form of capital goods, and because of the increase in the price of goods-in-general these capital goods increase in monetary value proportionately, raising the investment to nI. The relation between normal market price and the two components of production price then becomes

mW + (a-1)nW = anW

In the short term, where a is constant, this equation reduces to m = n, which tells us that an increase in wages produces an equivalent increase in prices, and the normal price level at any specific rate of productivity is proportional to the average wage. The level of money wages in the economy as a whole therefore has no effect on real wages, the wage in terms of ability to buy goods.

In spite of the fact that Keynes arrived at the same result from different premises, this finding will be vigorously resisted, both because most people do not want to believe it, and because to the superficial observer (and most of us are superficial observers of the things we have not studied in detail) it seems obvious that the workers who secure a wage increase have made a gain at the expense of the employer. But this is just another outcropping of that notorious logical error so common in the economic field: failure to recognize that what is true of a part is not necessarily true of the whole. A business enterprise does not operate in a closed compartment of its own; it operates as a part of the general economy, and it operates under very rigid rules, one of which is that in order to survive it must compensate the suppliers of capital services in amounts that are commensurate with the value of the services of wealth, as defined earlier.

Income cannot be diverted from suppliers of capital services to workers in any more than a very limited and temporary way without coming in conflict with this rule. The average business enterprise cannot absorb the added cost of a wage increase by taking a smaller profit, even if the company’s executives would prefer to do so. It must compensate for the loss in net revenue in some manner; otherwise the necessary inflow of new capital dries up and the business soon ceases to exist.

When the wage settlement is industry-wide, an immediate price rise is even more certain. A good demonstration of this was provided some years ago when the federal government attempted to prevent a wage increase in the steel industry from being followed by a price increase. The steel industry’s announcement of an immediate increase was furiously assailed by every means, legal and extra-legal, available to the administration, and the industry was forced to withdraw the higher prices. Yet only a few months later, the same administration bowed to the inevitable and meekly acquiesced in an increase dressed up in a slightly different form. The attempt to prevent the increase was not only futile, it was doubly futile, inasmuch as all that would have been accomplished had it been successful would have been to increase the price of something else, rather than the prices of steel and steel products. Some price must rise when money purchasing power is arbitrarily increased.

Even though it is not within the province of economic science to arrive at a decision on a question such as that of whether some control should be exercised over wage rates, it is definitely appropriate for a scientific work to point out the facts upon which such a decision should be based. This is all the more desirable when the facts, such as those that have just been discussed, are so generally unknown or deliberately ignored.

A point that should be taken into consideration in this connection is that some of the economic developments of recent years have resulted in a significant change in the impact of cost inflation. In earlier eras there was a tendency to look upon the effects of such inflation with equanimity, on the assumption that the principal losses were suffered by the recipients of fixed incomes, and these individuals, being members of the wealthier classes, could presumably absorb the losses without too much hardship. The great increase in life insurance in the past few decades, the rapid growth of pension programs, and the widespread sale of government bonds in small denominations have completely changed this picture. Today a large proportion of those who are the principal victims of inflation of any kind are in the middle and lower income brackets. In this connection it should be noted that while the amount of gain to the workers at the expense of the fixed income recipients is quite small in proportion to the extremely large total of wages and earnings on equity capital, this amount is a very important item when applied against the much smaller total of fixed income.

It should also be realized that the improvements in productivity which take place in any particular industry-the automobile industry, for example-are not exclusively due to increased efficiency on the part of the labor and management in this industry. On the contrary, they are primarily, sometimes entirely, attributable to events that have occurred elsewhere: improvements in the tools and equipment that are supplied to this industry by thousands of other producers, more efficient production on the part of other thousands of producers who supply the industry with materials of one kind or another, perhaps discoveries made in our university laboratories, certainly the efforts of the teachers who have educated the individuals that are responsible for the improvements, and so on, almost without end. The annual increase in productivity that we regularly experience is the result of continued interrelated efforts on the part of all segments of the economy.

It is rather generally believed that the process of bargaining between employer and employees in any enterprise or industry is a matter of arranging an equitable division of the products of their joint efforts, and the current system of wage negotiation in the United States is based on this premise. If the employees and stockholders of each enterprise consumed their own products, this belief would have considerable justification, but the participants in the modern business enterprise do not divide their own products. They divide the buying power-that is, the values-of those products, and those values are not inherent in the products. They are mainly created by the community as a whole, not by those who supply the labor and capital in the individual enterprises.

Here is one of the reasons why it was necessary to go into so much detail in discussing the basic elements and concepts of economics in the preceding chapters. The nature of economic value is by no means self-evident. Without taking the time to analyze the subject, one can hardly be expected to realize, for instance, that the value of non-necessities is determined almost entirely by the productive efficiency of those who produce the necessities. Yet it is easy to see that this is true. If Mozart or Schubert were alive today, their compositions would be worth millions instead of the trivial sums that these composers actually received, not because their inherent merit would be any different, or because today’s public has any greater appreciation of musical masterpieces, but simply because the producers of the necessities of life have increased their productivity to such a degree that high values can be placed on non-necessities.

The values of necessities are more directly related to the productive efficiency than those of non-essentials, but this gives no more support to the idea that the workers and their employers are dividing up what they produce, as the relation is inverse; that is, the less efficient a basic industry is, the greater the market value of its product.

Many, perhaps most, readers will take exception to this statement because of the prevailing opinion that the profitability of an industry depends on its productive efficiency. But there are two things wrong with this general opinion: first, it is not true; second, it is not relevant to the point at issue. The profitability of the individual enterprise depends on its relative productivity as compared to that of its competitors, but the general level of profitability in the industry as a whole is dependent on a large number of factors not related to efficiency. And in any event, wages are not paid out of profits; they are paid out of income. The income of an industry for a given volume of production depends on the market price, which in turn is determined by the cost of production. Inefficient production raises the cost, which raises the selling price, which raises the total producer income. The demand for the products of these basic industries is relatively inelastic. Consequently, any increase in costs, such as that due to an increase in the wage rate, can be, and promptly is, matched by a corresponding increase in market price, which brings back to the producer the amount of money that is required in order to pay the higher wage.

What this means is that the wages are not adjusted to the income of the industry, in accordance with the assumption on which the prevailing method of establishing wage rates is based. The income is automatically adjusted to the wage settlements. Thus the participants in a wage negotiation are not arriving at a decision as to how they are going to divide the products of their efforts; they are being permitted to decide how much they are going to draw out of the general production of the community. These comments apply to all agreements between employers and employees on rates of pay, irrespective of the type of work involved or the basis of payment, not merely those arrived at by means of the “bargaining” procedure.

In the light of the foregoing facts, together with the points previously brought out concerning the impact of the inflationary burdens, it seems apparent that the nation should at least begin giving some consideration to methods of controlling wages and salaries, not only to prevent them from rising faster than productivity, and thus inflating the price level, but also to insure that all those who work for a living participate in whatever increases may be appropriate, rather than allowing the benefits of the increased production, toward which all have contributed, to fall mainly into the hands of certain favored groups. Obviously, however, this is a highly controversial subject, and it has therefore seemed advisable to limit our consideration of practical inflation control measures in the later chapters to the elimination of money inflation only, leaving this more sensitive subject of cost inflation for treatment elsewhere. The question of wage and salary controls will, however, receive further attention in connection with other aspects of the economy that are affected by a lack of balance in the wage structure.

Some further consideration of the inflationary aspects of various economic actions will be appropriate at this time in order to round out the theoretical treatment of the subject. Inasmuch as the discussion on Chapter 12 was directed mainly at money inflation, the kind of inflation that is responsible for the business cycle, with its accompaniment of depressions, recessions, and assorted economic ills. we will now be concerned primarily with cost inflation. As pointed out in the preceding chapter, inflation is simply the automatic reaction of the economic mechanism to attempts to get something for nothing. It enforces the conservation law and effectively frustrates all of those attempts. But the conservation law applies only to the situation as a whole. It does not prevent certain individuals from getting something for nothing at the expense of other individuals.

Actions of the kind that cause money inflation are aimed at getting unearned income-pure something for nothing-for their beneficiaries. Actions of the kind that cause cost inflation are mainly aimed at getting more earned income out of nothing; that is, increasing the income of those who participate in the production process without any actual increase in production. Inasmuch as the conservation law requires the books to be balanced from an overall standpoint, those who earn income must pay the bill in either case, but as a whole they also receive the benefit of the actions that cause cost inflation, and these actions therefore accomplish nothing except to favor certain income earners at the expense of others. Money inflation, on the other hand, takes from those who earn income in order to provide unearned income for the beneficiaries of the inflationary measures. Real purchasing power (ability to buy goods) cannot be created out of nothing, in spite of the numerous assertions to the contrary that emanate from front rank economists. It can come only from production. It therefore follows that if any purchasing power is made available to individuals or agencies in any other manner than as payment for participation in the production process, that gratuitous purchasing power must come out of the earnings of those who do participate in production either as suppliers of labor or as suppliers of the services of capital.

The mechanism of the inflation processes can easily be seen by inspection of the economic flow chart. As the chart indicates, the dilution of the money purchasing power stream by money inflation occurs after the act of production, and it therefore creates an unbalance between market price and production price. Because of the unearned money injected into the stream the consumer has to pay a price in the goods market that is higher than the price established at the production end of the mechanism by the payments for labor and the services of capital. The buying power of earned income is therefore reduced. In cost inflation the dilution of the money purchasing power stream occurs before the act of production, and it therefore affects production price and market price equally. In this case then, the average buying power of earned income is not reduced. All that has been accomplished, aside from favoring some individuals at the expense of others, is to change the money labels.

It might be well to mention that the term “earned income,” as used herein, refers to payments for labor or the services of capital utilized in production. This term is frequently restricted to income from labor only, but from a purely economic standpoint, labor and the services of capital are equivalent items, differing only in the time factor. The definition which restricts the adjective “earned” to labor only is based on another of the social distinctions that have made their way into economics, much to its detriment.

The remainder of this chapter will present a brief survey of the principal economic actions that produce cost inflation or deflation. Some of these items have been discussed previously, but we will now want to look at them from a somewhat different angle. Heretofore we have been interested primarily in their effect on the general operation of the economy. Now we will examine them specifically from the standpoint of their effect on the price levels. In beginning this discussion it will be desirable, as a matter of clarifying the general background, to give some consideration to two kinds of economic actions that are not inflationary.

One of these is an increase or decrease in the volume of production. According to Principle IX, the volume of production has no effect on the price level, and hence changes in volume hive no inflationary or deflationary effect. The general impression that we can take care of an excess of money purchasing power by producing more goods is totally wrong. Such additional production adds equally to the purchasing power and to the volume of goods produced, and does not change the ratio between the two.

Price increases, which are popularly viewed as the principal villains on the inflationary stage, likewise have no inflationary effect, and all of the effort that is put forth to block them, whether it be a strident call for “restraint” emanating from the White House, or a boycott of the local supermarket organized by aroused housewives, is completely wasted. As has been emphasized throughout this work, the general market price level is a resultant. It is the quotient that results from dividing the rate of flow of money purchasing power by the rate of production of goods. If the President succeeds in intimidating the steel companies to the point where they roll back the price of steel, or if the housewives succeed in persuading the supermarket to reduce the price of beef, all that is accomplished is to raise the price of something else, because those actions do not change the rates of flow in the two economic streams, and without such a change the general price level must stay just where it is.

The causes of inflation are actions that increase the flow of money purchasing power without a corresponding increase in the volume of goods produced. Price increases are simply the result of such actions. They do not increase the flow of money purchasing power and therefore have no inflationary effect. But wage increases-increased many compensation for the same amount of productive work-do increase the flow of money purchasing power and are therefore inflationary.

Here, again, as in so many other places in the pages of this book, the conclusions of the analysis will be distressing to a great many persons. According to our findings, wage increases, which are very popular, are inflationary, and raise the cost of living for everyone who does not receive the increase in pay, whereas price increases, which are universally detested, have no adverse effect at all, and are merely a means of putting into effect the inflation due to the wage increases and other inflationary actions. Blaming the manufacturers and merchants who raise their prices instead of the individuals who demand and receive more pay is like blaming the tax collector who presents us with a high tax bill instead of the Congress that levied the tax.

In current practice, the negotiation of a new pay scale for any large group is normally accompanied by a rather heated controversy as to whether the proposed changes are or are not inflationary. The truth is that all wage increases are inflationary; that is, they increase the general price level. However, the average productivity per man hour is slowly rising, and this has the opposite effect, reducing the price level. If the average nationwide increase in wages does not exceed the average increase in productivity, these oppositely directed effects on the price level cancel each other, and in this sense it may be said that wage increases thus limited in amount are not inflationary. No one has to pay any higher prices than he did previously. However, if the increase is selective, as it always is under present conditions, it is inflationary from the standpoint of those who do not receive the benefit of the higher wage, as it prevents them from getting any of the additional goods that are being produced.

The foregoing conclusions as to what the effects of price and wage changes theoretically must be are amply confirmed by a host of experiments that demonstrate what these effects actually are. Throughout the world, nations are faced with rising prices because they are trying to maintain a higher standard of living than their production will support. The most common governmental response to public complaints about high prices is to raise wages and forcibly “roll back” the prices of critical items. Of course, these actions are not officially labeled as economic experiments. Nevertheless, they are economic experiments; they are actions taken in the expectation of accomplishing certain specific specific economic results, and since there is no advance assurance that they will succeed, they are experimental. The mere fact that no one actually says, “This is an experiment.” does not alter the situation. The results of these oft-repeated experiments are always the same. “Price controls” do not keep the general price level down, and wage increases cause further inflation. No country ever halts its inflation by these easy and popular measures. The only effective remedy is to bring income and expenditure into balance by increasing production or by some kind of a program that brings expenditures down to the level that the existing production can support.

One of the principal criteria by which scientists judge the validity of the results of an experiment is the “reproducibility” of these results; that is, whether other workers who carry out the same experiment arrive at the same results. It is therefore worth noting that the economists, and the governments that they advise, are not only undertaking a wide variety of economic experiments, in spite of their insistence that meaningful experimentation is impossible in economics, but they are also, in many instances, establishing a remarkable record for reproducibility. The results of the myriad of economic “something for nothing” schemes, including the attempts to combat inflation by wage increases and price controls, are perfectly reproducible; they never work.

Increases in social security payments, unemployment compensation, welfare, etc.-transfer payments, in the language of the economists-also add to the total flow of purchasing power and are inflationary. In this case, however, there is no net inflationary effect if the funds are obtained by taxation or non-inflationary borrowing, inasmuch as these measures reduce the money purchasing power available to consumers, and are deflationary. If the transfer payments are financed by borrowing from the banks or by issuing currency there is no offsetting deflationary effect, and the transactions as a whole are inflationary.

A higher productivity rate, more production per equivalent man hour, is deflationary, inasmuch as it reduces the labor cost per unit of product; that is, it lowers the production price, as that term is used in this work. The distinction between increased volume of production and increased productivity should be recognized. A greater volume achieved by working more hours adds as much to the purchasing power stream as to the goods stream, and it therefore leaves the price level unchanged. An increase in productivity, on the other hand, adds to the volume of goods but not to the purchasing power stream, and thus reduces the price level. Higher productivity, if it can be achieved, will offset some of the cost inflation resulting from wage increases or other causes, while conversely, a decrease in productivity, or a slowing of the normal rate of increase, will aggravate an inflationary situation.

An increase in business taxes adds to production costs in the same manner as an increase in wages, and therefore results in cost inflation. The ultimate incidence of a tax on business is almost identical with that of a sales tax, but since the business tax is concealed in the price of the products, and is not usually recognized as a tax by the consumer who pays it, whereas a sales tax is very much out in the open, the tax-levying authorities prefer to tax business to as great an extent as they consider feasible. A somewhat amusing side effect is that many of those who are strongly opposed to sales taxes because of their “regressive” nature are among the most ardent supporters of taxes on business, which are even more regressive, as they are not subject to any of the exemptions that are usually introduced to soften the impact of sales taxes.

To most people it seems obvious that if taxes are levied on business enterprises they are paid by those businesses. The economist realizes that this superficial view is wrong; that business enterprises, as such, do not and cannot absorb any of the costs that they incur. All such costs must ultimately be borne either by the customers or the stockholders of the enterprise. But the inexact methods of the economic profession have been unable to produce a definitive answer to the question as to which of these two groups actually pays the tax. Samuelson expresses the uncertainty in these words: “Economists are not yet in agreement on final results. Some think the corporate income tax falls mostly on the consumer, some argue that it falls mostly on stockholders or capitalists. Some split the difference between the two. Some toss a coin. And some throw up their hands in despair.”97

The concept of the isolated producer can be of considerable assistance toward getting a clear view of the incidence of the business taxes. As explained in Chapter 11, this hypothetical isolated producer operates in the same manner as the average producer in the individual enterprise system; that is, it must obtain all labor and capital services from private suppliers, it must compensate the suppliers of capital at the current rate of interest, and it must distribute all of its income, actually or constructively, to the suppliers of labor and capital services, so that the result to the productive enterprise itself is zero. It is clear from the points brought out in the preceding pages regarding the operation of this isolated producer that any change in production price must be accompanied by an equivalent change in market price, and that the income from sales of goods must therefore necessarily equal the expenditures for productive services,

Inasmuch as the rate of payment for capital services is fixed, neither wage nor tax increases can be made at the expense of these payments. The full amount of any cost increase must therefore be added to the market price. No “restraint” on the part of the producing organization itself, or forcible action by the government to hold down prices, can alter this situation, because it is the additional payments for wages and taxes that swell the money purchasing power stream, and thereby raise the price level. Unless some offsetting action, such as the imposition of higher consumer taxes, is taken to absorb the additional money purchasing power generated by the tax increase, prices must rise.

As the conditions under which this isolated producer operates are also those that are applicable to the average producer in the American economy, these conclusions also apply to the existing economic situation. Business taxes are paid by the consumers. The question then naturally arises, Why do most economists fail to recognize this fact? Reynolds gives us an explanation that throws some light on the situation. Speaking of what he calls the “traditional view” that these taxes are paid by the stockholders, he says:

The reasoning behind this conclusion is simple; under either monopoly or competition, the intelligent business manager will adjust his production and selling price to make maximum profit. It will not pay him to alter this adjustment, even though the government decides to take away half his profit in taxes.98

It seems almost incredible that such an argument would be raised in all seriousness, inasmuch as it rests on the preposterous assumption that an additional cost imposed on his competitors will not alter the business manager’s estimate of the price that he can charge for his product. Everyone knows that the competitive process is geared to the rate of profit, and the economists, at least, recognize that the average profit must approximate the interest rate, with only limited modifications depending on the current stage of the business cycle, because of the mobility of capital. If average profits fall below this competitive level for any reason, the competitive pressure relaxes. Prices then can be, and of course are, raised to the point where the normal profit rates are restored, a fact of business life that can easily be verified by a look at the record. This means that the entire amount of an addition to the business tax is promptly added to the price paid by the consumer.

Even without the analytical aids developed in this work, such as the concepts of the isolated producer and the conservation of purchasing power, the ultimate incidence of the tax should be clear to anyone who faces the issue squarely. It is hard to avoid the conclusion that those who contend that the tax is paid, in whole or in part, by the owners of the business are being influenced by their emotional reactions: their conviction that the owners-the “capitalists”-ought to be taxed.

The basic reason for this inability to understand the tax situation is a distorted view of the position of the producer-personified in the owner or manager of the producing enterprise-in the operation of the economy. To the economist, the producer is in the driver’s seat. It is he who makes the decisions. It is he who determines what he is going to produce, how much of that product his enterprise will turn out, how many workers he will hire, what he will pay them, and what price he will place on the product. Much of the antagonism which the academic economist displays toward business, particularly toward big business, is due to his distaste for the criterion by which he believes that these business decisions are made: the “profit motive,” as he calls it.

But in the real world very few of the economic “decisions” that the businessman makes are decisions in the sense in which the economist is using the term. The only major economic decision that he actually makes is whether or not to undertake production of a particular kind of goods. This is a genuine decision. Here the producer decides what he is going to do. But once entry into the business arena is accomplished, further decisions of the same kind, except in minor matters, are impossible. The producer can no longer decide what he is going to do; all that is now possible is to figure out, to the best of his ability, what he can do. He cannot decide to produce x units per day of product A. The best that he can do is to conclude that the prospects of selling x units per day justify beginning operation on this basis. If his analysis of the situation was wrong he must adjust his operations accordingly, even if this means closing down entirely. He cannot decide to hire y workers. He must hire the full number that he needs to produce x units of his product, and he must not hire more than he needs. He cannot decide what he is going to pay them. The wage and salary scales are determined either by the pressure of competition, by law, or by labor negotiations. He cannot decide to sell product A at price z; all that he can do is to estimate that he can sell his output at that price. If this estimate is wrong, he must either alter his price or his volume of production, or both.

The truth is that the producer operating under the individual enterprise system is subject to an extremely rigid set of controls, and he has only a very limited range of economic options. He has considerable freedom in technological and organizational matters, and his primary objective is to manipulate these factors in a manner that will put him in the most favorable relative economic position. The explanation of the successful operation of the system lies in this very fact that most economists seem unable to see: the fact that the ordinary producer can improve his own position only by actions that increase productivity and thereby benefit the consumer (on the basis of the values determined by the consumers themselves). He cannot achieve such an improvement by the kind of actions that the economists believe are his main concern: economic actions aimed at getting a bigger slice of the pie. Of course, some producers have the benefit of monopoly positions of one kind or another, but in almost all cases these are either recognized as being in the public interest (patents, etc.), established with the consent and under the control of the consumer (brand name products, etc.), or illegal (in which case it is the fault of the community if they continue to exist). The producer who receives a subsidy likewise occupies a preferential position, but such concessions are within the control of the government, or the public, not the producer.

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