Economics / History

Aggregate Demand Dominance: the Unknown History of Price Controls

In a previous posting, I again postulated that World War I, World War II and Korea triggered powerful inflationary forces during their respective decades.  I even have a model to demonstrate:

One important caveat: LRAS does not appear.  Aggregate supply rising almost vertically is short-run capacity constraints.  This means the key points are whittled down to just one:

  • The aggregate supply curve illustrates the quantity of goods and services firms sell at any price level.

As the price level takes on an element of preeminence in this model, the most important controlling factor becomes aggregate demand, as a change in AD immediately effects a rise in both real output and the price level. 

Again, this software will not display anything I produce that isn’t text-based.  Thus, I borrowed the above image from here.  I will further describe how to modify the graph to produce a model for an accurate total war scenario:

  1. Potential output (Y*) should in fact lie to the right of the short-run aggregate supply curve—as SRAS turns vertical, real output comes infinitely close to Y*.  For simplicity’s sake, Y*’s value is Y=100.
  2. As the combatant nation mobilizes, a vertical line materializes at a value of Y=110.  This line is labeled WAD, for war-related aggregate demand.  WAD falling outside the confines of SRAS is an acknowledgement that in a total war situation demand for military procurement can easily outstrip the current capacity limitations of a combatant nation’s economy.
  3. Military needs increase, shifting WAD to the right. 
  4. The price level increases as real output is driven toward Y*, sending the signal to expand SRAS.  As potential output moves toward Y=110, military needs shift WAD even further to the right. 
  5. The rate of inflation rises rapidly past the point where the combatant nation’s central bank would need to tighten the money supply in accordance with standard doctrine.  If the central bank doesn’t act, WAD will remain unaffected (continuing to shift right periodically as military needs continue to escalate).  
  6. If the central bank decides to act, it will fail miserably.  For monetary policy to contain rising inflation real output must drop—an economic contraction which cannot be tolerated in an environment of escalating WAD needs.  If the central bankers cannot be convinced of this, military leaders will pressure the combatant nation’s political leadership to stop the contraction.
  7. WAD shifts eventually require domestic aggregate demand (AD) to deform.  The slope of the AD shifts counter-clockwise so that AD and WAD intersect.
  8. The tangent of the aggregate demand curve, being deformed from the effect of WAD, exacerbates the inflation problem.  With AD becoming increasingly price elastic, AD shifts (primarily from an increase in the population) result in larger increases in the price level than increases in real output.
  9. Military needs do not abate.  AD further deforms.  SRAS responds, but inflation has become such a serious problem, the combatant nation’s military demands legislative intervention.

I believe this is an accurate representation of virtually any nation ramping up to wage total war.  What occurs next depends on the reaction of the political system.  For example–the U.S. during World War I at first appears to have simply accepted starkly higher inflation:

Historical Data Chart

Considering there were 1910s attempts to impose a price controls by the U.S. government, perhaps controls simply failed.  My model has an explanation for this:

  1. Policy makers, schooled on the almighty “price stability” mantra from neoclassical economics, create agencies and administrations to force prices to go no higher.  For the sake of example, the ceiling is set at P=20.67 (if the number doesn’t ring a bell, see this).
  2. Military needs require a massive outward shift for SRAS to meet expenditure demands after the commencement of offensive combat operations (yes, inflation will rise from mobilization alone).  Without a rise in price level (i.e.: inflation) SRAS does not expand due to the lack of price signal.  The military responds by demanding expansion regardless of price level and pushes WAD to a value more than double the combatant nation’s prewar economic output.  Price controls fail. 

But this isn’t the only possible result.  In succeeding wars Congress and the Executive Branch appeared to have hit a home run when they created the Office of Price Administration (OPA):

Historical Data Chart

…and the Economic Stabilization Agency (ESA):

Historical Data Chart

Using my borrowed model…

…I’ll explain why price controls are effective policy during wartime (and only wartime):

  • Eventually policy makers realize meeting military production goals require agencies and administrations to force the expansion of SRAS independent of price signals, especially since WAD has reached a point well in excess of Y=200.  Such organizations are created to cajole or force industries to expand.

For price controls to succeed, the economy of a combatant nation must transition to a command economy.  During the Second World War, this was accomplished with the War Production Board (WPB).  During Korea, the Office of Defense Mobilization (ODM) and its primary subsidiary the Defense Production Administration (DPA) took over the reins.  Wait, then why were OPA and ESA even needed?

  1. WAD expands more rapidly than AD, resulting in further AD-slope contortions.  AD outward shifts are immediately inflationary, interfering with the work of supply-controlling agencies.
  2. Supply-control agencies ask price-controllers to minimize price increases to permit more resources to be directed towards increased real output.  A price level target (P=35 in the case of World War II and Korea) is set.
  3. The price ceiling is immediately tested, as WAD-distorted AD shifts remain inflationary. 
  4. Price control agencies turn to rationing to free up resources for supply control.
  5. Patriotism is tied in with the rationing, permitting price control agencies to continuously press down price increases until the conclusion of the war.

The last part is key.  Price controls quickly turn squirrely when no longer accompanied with a wartime command economy.  Using the example of the World War II and Korea-era U.S., OPA and ESA essentially squeezed domestic aggregate demand to permit the allocation of maximum resources to WPB and DPA.  Fat lot of good that does after the U.S. begins to demobilize.  WPB and DPA didn’t have defense production quotas at the end of 1945 or 1953 (production was shutting down en masse).  In fact, WPB and DPA were both dissolved themselves as the demobilization proceeded. 

The consequences of rapid demobilization in the 1940s were felt immediately as the Greatest Generation began spawning the Baby Boomers:

Historical Data Chart

Huge population-based aggregate demand shifts in 1946 unleashed a storm of inflation from the war-distorted slope of the AD curve.  The OPA (it wasn’t disbanded until 1947) was totally powerless to stop the rise.  So, to solve a problem caused by wartime deformation of domestic aggregate demand, newly-appointed Federal Reserve Chairman Thomas McCabe engineered a recession, forcing millions from work:

Historical Data Chart

Five years later, William McChesney Martin Jr. “prevented” an outbreak of inflation that had hounded his two predecessors…

Historical Data Chart

 …by simply stomping on the economy before demobilization-related inflation could arise:

Historical Data Chart

  …and throwing millions more out of work because, as Martin described on 19 October 1955, the Fed “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”  Far more curious was the statement that followed the Martin quotation from Timothy Taylor, the author of the blog I linked to above:

Monetary policy in the 1950s got a lot less attention than it does today: indeed, there was a significant group of economists who believed that it was completely ineffectual. The old story told by Herb Stein in his 1969 book, The Fiscal Revolution in America, was that President John F. Kennedy used to remember what Martin did by “the fact that William McChesney Martin was head of the Federal Reserve, and that “Martin” started with an “M”, as did “monetary,” so he knew that monetary policy was what the Federal Reserve did.

JFK didn’t understand what the Federal Reserve was for?  To think, I was certain my opinion of the warmongering 35th president couldn’t sink any lower…  

For the record, William McChesney Martin Jr. served as Federal Reserve Chairman for just shy of 19 years—1951 to 1970.  I have heard and read the punch bowl metaphor in recent years referred to as if it were timeless folk wisdom rather than a “famous” utterance of the longest serving (yet largely forgotten) Federal Reserve Chairman in history.  Alan Greenspan did not edge out Martin as the longest-serving Chairman in his 1987 to 2006 tenure, but did Clinton have trouble recognizing what Greenspan and the Federal Reserve was responsible for?

I seriously doubt that.  Then again, why would economists in the 1950s question the effectiveness of monetary policy?  Was it because Milton Friedman had yet to leave his mark?  (Some mark.)  Or could it be that postwar economists were still grappling with the economic realities of the World Wars?

Finally, one can make an even more unorthodox—which is not to say incorrect—argument for rejecting the conventional wisdom. One can simply argue that outside a more or less competitive equilibrium framework, the use of prices as weights in an aggregation of physical quantities loses its essential theoretical justification. All presumption that price equals marginal cost vanishes, and therefore no meaningful estimate of real national product is possible.22

In fact, price was “never a factor” in the allocation of resources for war purposes. The authorities did not permit “the price-cost relationship . . . to determine either the level of output or the distribution of the final product to individual uses.”23 Clearly, all presumption of equalities between prevailing prices, consumers’ marginal rates of substitution, and producers’ marginal rates of technical substitution vanished. Absent those equalities, at least as approximations, national income accounting loses its moorings; it necessarily becomes more or less arbitrary.

Sounds like WAD took over to me.  If fact, contemporary economists were grappling with the fact that plotting wartime aggregate demand with domestic aggregate demand is almost impossible:

Some economists appreciated the perils at the time. Noting that the government had displaced the price system, Wesley Mitchell observed that comparisons of the war and prewar economies, even comparisons between successive years, had become “highly dubious.” Index number problems lurked around every corner. Much output during the war, especially the weapons, consisted of goods that did not exist before the war. Even for physically comparable goods, price structures and output mixes changed radically. Production of many important consumer goods was outlawed. Surrounding everything were the “obvious uncertainties concerning [price] quotations in a land of price controls and evasions.”24 Kuznets declared that the “bases of valuation for the war and nonwar sectors of the economy are inherently noncomparable . . . . It is impossible to construct directly a price index of war products that would span both prewar and war years.” Kuznets’s own efforts to overcome these problems never escaped from arbitrariness, as he himself admitted.25

I wonder if these perils could have been rectified had the concept of WAD been introduced in the 1940s (who am I kidding; I haven’t introduced WAD in the 2010s given the fact no one reads this blog).  But at least in the postwar pre-1970s-stagflation era economists tried to grapple with the fact that monetary policy during wartime becomes just another tool of the price- and supply-control agencies.

A question hangs unanswered: what provided the price stability during William McChesney Martin’s tenure that is so lacking today if it wasn’t monetary policy?  Lovers of shiny precious metals tend to scream “The Gold Standard!” to such a question.  Oddly enough, to a certain degree I find myself in agreement with wannabe nineteenth century gold prospectors, but not for goldbug reasons.  Rather, the gold standard and the silver standard that preceded it functioned akin to a centuries-long bout of price controls.


5 thoughts on “Aggregate Demand Dominance: the Unknown History of Price Controls

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  4. Pingback: Aggregate Demand Dominance: Price Controls’ Nemesis—Oil Embargoes and the Onset of Stagflation | In The Corner, Mumbling and Drooling

  5. Pingback: Aggregate Demand Dominance: The Arc Lights and the Ides of March | In The Corner, Mumbling and Drooling

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