America is suffering from the fastest rise in consumer prices in nearly four decades. For months, inflation has been outpacing workers’ nominal wage gains, thereby depressing living standards, sowing financial anxiety, and raising the poll numbers of America’s increasingly anti-democratic opposition party.
It is possible that prices will stabilize in the new year. Global supply chains are slowly recovering from the wounds of the COVID recession. And domestic demand is already poised to decline, as the American Recovery Plan’s stimulative measures fade away. But the Omicron variant is once again throwing the stability of supply chains into doubt. And U.S. households still have exceptionally high stockpiles of savings that could sustain high levels of consumer demand well into 2022. At present, market indicators suggest that next year will witness significant rent hikes. And many food producers have already announced impending price increases; snack-industry titan Mondelez — maker of Oreos, Ritz, and Chips Ahoy — has put a 6 to 7 percent increase in prices on its list of New Year’s resolutions.
Policymakers should be doing more to mitigate inflation and the deprivations it imposes. But their tools for doing so are limited.
In the United States, adjusting benchmark interest rates is the primary mechanism of price management. When inflation runs unacceptably high, the Federal Reserve raises rates, thereby increasing the cost of credit throughout the economy. This serves to temper demand, at least in theory: As borrowing costs go up, consumers become less inclined to take out loans for the purchase of homes, cars, or other goods, while firms pull back on capital investment.
Yet this instrument is imprecise, and it is of limited efficacy when deployed in moderation. Marginal increases in interest rates are unlikely to significantly reduce demand. Large increases, meanwhile, come with nasty side effects. In the early 1980s, Federal Reserve chair Paul Volcker succeeded in breaking the back of inflation by raising prime interest rates to more than 20 percent. But the “Volcker Shock” came at the cost of two recessions, the second lasting 16 months. To make goods and services more affordable in the aggregate, the government effectively rendered them less affordable for the most economically disempowered (put 25 million Americans out of work, and consumer demand will fall). Meanwhile, massively increasing the cost of credit had other, less-anticipated — and longer-lasting — consequences for the American economy. The stratospheric interest rates on U.S. assets attracted an unprecedented influx of foreign capital into the American economy, vastly expanding the nation’s financial sector. At the same time, the dollar’s resurgent strength rendered U.S. exports less affordable for overseas consumers — and thus less competitive in foreign markets — thereby devastating American manufacturing. The top-heavy postindustrial economy that has defined the past four decades of American life is, to no small extent, an unintended consequence of “responsible” anti-inflation policy.
And it is hardly the only one. The costs of managing inflation through interest-rate hikes are larger in the U.S. than in other nations because of the dollar’s role as the world’s reserve currency. Many developing countries finance investment through dollar-denominated loans. These same countries often rely on U.S. consumers to provide a market for their exports. Thus, when America drastically raises interest rates, the consequences for such countries are dire: Demand for their exports drops, while the costs of servicing their dollar-denominated debts soars. For this reason, Volcker’s anti-inflation policy ended up triggering a cascade of debt crises throughout Latin America in the early 1980s.
For now, the Fed is not contemplating rate hikes remotely comparable to Volcker’s; the negative side effects of the central bank’s impending hikes are unlikely to be severe. But they won’t be negligible, either. In recent years, mere indications of impending monetary tightening in the U.S. have caused foreign capital to flee emerging markets for safer American assets. Given the fragile economic condition of many developing nations, which have had less room to stimulate their economies and less access to vaccines than advanced nations, even small rate hikes could have serious consequences for the world’s most vulnerable workers.
Meanwhile, in the peculiar context of the 2022 economy, raising interest rates also threatens to exacerbate existing supply problems. Increasing construction firms’ borrowing costs will not help ease America’s housing shortage, nor will higher interest rates help auto companies rapidly expand the production of personal vehicles.
All of which is to say: The government’s broadly accepted, normal tools for managing inflation aren’t so great.
This is indispensable context for any debate over broadly dismissed unorthodox tools for managing inflation such as price controls.
On Wednesday, The Guardian published a case for using price controls to manage contemporary inflation, written by University of Massachusetts, Amherst, economist Isabella Weber. The piece was promptly pilloried on social media. To many lay observers and policy wonks alike, Weber’s endorsement of price controls was tantamount to a declaration of economic illiteracy. After all, rising prices typically reflect genuine scarcity; when demand for a good outpaces production, the price system effectively rations supply by ability (and/or willingness) to pay. In that context, dictating lower prices by government order only masks the problem. And it does so at the cost of making the problem worse. For all the adverse implications of rising prices, they at least make the disparity between demand and supply visible to producers and provide them with an incentive to close the gap. By contrast, if the government dictates a price ceiling on a scarce good, it reduces the incentive of private firms to expand production.
In invoking these points, Weber’s critics highlighted genuine hazards of price controls, particularly ones that lack precision or complementary supply-enhancing policies. Yet, as already observed, our existing approach to managing inflation has plenty of hazards of its own. The widespread tendency to dismiss price controls of any kind as economically illiterate, while defending interest-rate hikes as economically wise, reflects custom more than reason.
To be fair to Weber’s critics, her case for price controls is fatally undermined by its brevity and dearth of detail. The economist does not acknowledge the potential pitfalls of price controls or anticipate skeptics’ arguments. More critically, she never specifies precisely which prices the government should set.
Weber builds her argument around the precedent of American price controls during World War II. She notes that many of America’s most distinguished economists argued for the maintenance of controls during the transition to a postwar economy. Summarizing their case, she writes, “As long as bottlenecks made it impossible for supply to meet demand, price controls for important goods should be continued to prevent prices from shooting up.” She then suggests that a similar principle be applied to the current transition to a post-pandemic economy.
But her summary of the mainstream argument for price controls after World War II is woefully incomplete. In the letter she cites, Paul Samuelson, Irving Fisher, and other mid-century economic luminaries argued for the maintenance of price controls combined with wage suppression and fiscal austerity to reduce demand, along with various production controls — including export bans — to ensure the supply of basic goods.
This is a major omission. Inflation rooted in supply-chain bottlenecks can’t be resolved through price controls alone. Doing that really would just mask the problem and discourage private investors from resolving it. To be effective in managing genuine scarcity, price controls must be paired with rationing and/or supply-side policies. As noted above, market prices are a means of rationing scarce goods by ability to pay. If you eliminate that mechanism of allocation, you need to replace it with a more rational or progressive one. In the (hopefully fanciful) context of a water shortage, we probably would not want to allocate access to H2O by consumer purchasing power. But merely capping the price at which water could be sold would not ensure an equitable distribution of a vital resource so much as an arbitrary one. Instead, we would want to develop an alternative means of allocation that ensured universal access to a basic volume of water. And we would also want to figure out how to ensure a more abundant and stable water supply going forward.
Similar principles apply to the less-hypothetical scenario of an American housing shortage. Thanks to restrictive land-use regulations and underinvestment in social housing, demand for residences in the U.S. far outstrips their supply. This is a large part of why rental rates in America are high and rising. And there’s a strong case that price controls have a role to play in mitigating the adverse effects of housing inflation.
As the Roosevelt Institute’s J.W. Mason has observed, several recent studies indicate that rent control is more effective at preserving affordability and neighborhood stability — and less detrimental to housing supply — than conventional economic wisdom holds. In the textbook story, rent control is a self-defeating, economically illiterate policy. Forbidding rent increases on select properties may help the lucky few who directly benefit, but it does so at everyone else’s expense: By slashing expected returns on new rental construction, such policies ultimately reduce the supply of housing units and thus increase rents for non-incumbent tenants.
But this doesn’t seem to actually be the case. In New Jersey, Massachusetts, and California, the adoption of rent-control measures has successfully constrained rent increases for long-term tenants, thereby honoring the legitimate interest of such tenants in housing stability, while having no significant impact on new housing construction. Which makes sense. In most U.S. cities with extensive rent-control provisions, the constraint on new building is not excessively low rental prices but excessively restrictive zoning regulations.
So rent control is an example of a potentially worthwhile price control, which could address one important source of contemporary inflation. But rent control, in and of itself, will not solve the problem of housing scarcity. A comprehensive anti-housing inflation policy would combine rent control with public investment in affordable housing and land-use reform that facilitates private investment in new market-rate units.
Although Weber neglects to identify specific targets for price controls, she seems to suggest that the government should concentrate on areas where rising prices reflect monopolistic market power rather than scarcity per se. One salient example would be the prescription-drug market.
The marginal cost of producing most pharmaceuticals is very low. What keeps prescription drugs expensive are the patent monopolies that the state awards to pharmaceutical companies, which ensure that firms have an incentive to develop new drugs. But America’s patent laws are exceptionally generous to its drug companies, which enjoy extraordinarily high profit margins (and invest extraordinarily large sums into mere marketing). There’s good reason to think that dictating lower drug prices by, for example, allowing Medicare to set the rates paid by its beneficiaries would transfer income from Big Pharma to ordinary consumers without significantly deterring innovation. And this is especially true if the government supplements drug-price controls with policies aimed at incentivizing new drug development, such as direct public funding for pharmaceutical research.
These are just two examples of areas where price controls can help mitigate inflation. One could make a strong case for more stringent controls throughout the American health-care system. And price controls are themselves just one of many unorthodox approaches to inflation management. Reducing the monopoly power of price-gouging firms, channeling credit to sectors where demand outstrips supply, forcing (or strongly encouraging) workers to save a fraction of their paychecks, and direct public investment in expanded production are others.
All of these measures have the potential for negative side effects and unintended consequences. But the same can be said of raising interest rates. If policymakers reflexively presume the wisdom of conventional tools, and dismiss the potential of unorthodox ones, we will all pay the price.