One of the key reasons why it is important to keep inflation in check is that it inevitably leads to price controls–a cure that is often worse than the disease. Venezuela is only the latest in a long line of countries that have tried and failed to cure inflation with such methods.
Perhaps the earliest case in which a government tried to use price controls to prevent inflation occurred in late imperial Rome. By the end of the third century it had clearly reached a crisis. The state could no longer obtain sufficient resources because heavy impositions had destroyed the economic base of taxation. The historian Lactantius, who lived from 240 to 320, tells us that the problem was a bloated welfare state:
“The number of [welfare] recipients began to exceed the number of contributors [taxpayers] by so much that, with farmers’ resources exhausted by the enormous size of the requisitions, fields became deserted and cultivated land was turned into forest.”
Rome was forced to rely ever more heavily on debasement of the currency to raise revenue. By the reign of Emperor Claudius II Gothicus, who served from 268 to 270, the silver content of the principal coin, the denarius, was down to just 0.02%. As a consequence, prices skyrocketed. According to research by economist Pródromos-Ioánnis Prodromidis, a measure of Egyptian wheat that sold for 19 drachmas (a Greek coin used in Egypt, which was a province of Rome) in the middle of the third century had risen to 982 drachmas by the end of it, suggesting an average annual inflation rate of almost 9%.
At this point, the very survival of the state was at stake. Emperor Diocletian, who served from 284 to 305, attempted to stop the inflation with a far-reaching system of price controls. They were justified by Diocletian’s belief that the inflation was due mainly to speculation and hoarding, rather than debasement of the currency.
In 301 Diocletian issued an extensive edict fixing the prices for just about all goods and services, including 900 commodities, 130 different grades of labor and a number of freight rates. The most complete version of the edict that we have takes up 100 pages in Tenney Frank’s Economic Survey of Ancient Rome. The death penalty applied to violations of the edict. Nevertheless, they failed in their purpose. As Lactantius tells us, “much blood was then shed over small and cheap items.” Soon there was nothing for sale and the inflation got worse. Finally, after “many had met their deaths, sheer necessity led to repeal of the law.”
The historical experience with price controls down to the present day confirms their futility and often counterproductive nature; the U.S. experience is no exception. According to a history of wage and price controls by the Congressional Budget Office, they have never worked more than temporarily. In part that is because they have seldom been accompanied by tighter monetary and fiscal policies, which would get at the root causes of inflation. Rather price controls have served as a substitute for more effective anti-inflation policies. Consequently the underlying inflationary forces continued to build, and prices tended to explode once controls were lifted. Indeed, fear of such a price explosion has encouraged politicians to keep controls in place long past the point where they have started to break down, thus compounding their deleterious effect on the economy as resources are mis-allocated due to incorrect price signals.
The CBO explains that price controls always break down after a short time because there are too many prices that, by their nature, cannot be controlled for any length of time. The prices of farm commodities will vary with the weather; those for energy and raw materials will necessarily move with international prices. We can’t control the prices foreigners charge for things we import and it would be stupid for us to give foreigners a gift by artificially holding down the prices of things we export. This inevitably requires adjustments in prices for manufactured goods as the cost of inputs rise.
Nevertheless, politicians have tried to control commodity prices even if it was ultimately futile. Long after the price controls imposed by Richard Nixon were largely scrapped, those on oil and natural gas were maintained. An increasingly complicated and convoluted system evolved to prevent Americans from paying the world price for energy that was at the root of many of our energy problems during the Carter administration. Not surprisingly, they vanished once Ronald Reagan finally decontrolled all energy prices, one of his first acts as president in January 1981.
Interestingly, even to this day vestiges of both the World War II and Nixon era price controls are still in effect in New York City in the form of rent controls. Although politicians know perfectly well what a mess they are and the awful effects they have had on the housing stock, they have always feared that elimination of controls would cause rents to jump as decades of pent-up price increases suddenly take effect. The political power of those benefiting from the controls ensures that no elected official will ever change this 70-year-old system except at the edges.
Even temporary controls can have negative long-term consequences. For example, in 1962 John F. Kennedy “jawboned” the steel industry into reducing its prices even as its labor costs were rising sharply. At that time steel was a much more central commodity in the U.S. than it is today and there was concern that a rise in its price would ripple throughout the economy, setting off a wage-price spiral. Although he lacked the legal authority to force steel companies to comply, Kennedy was successful in getting them to roll back price increases. However, subsequent analysis shows that steel companies also cut back their investments in new technology and modernization of their plant and equipment because of the diminished profits resulting from the jawboning. The upshot was to give foreign steel suppliers in places like Japan an opening and began the long decline of the U.S. steel industry.
For these reasons, even liberal economists like John Maynard Keynes have opposed wage and price controls. As he wrote in The Economic Consequences of the Peace, “The preservation of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself … the seeds of final economic decay, and soon dries up the sources of ultimate supply.”
Even during World War II Keynes opposed price controls, believing that a freely fluctuating price system is critical to the operation of a capitalist system. He favored using forced saving to soak up excess purchasing power and keep prices in check. In effect, a sort of tax would be imposed on everyone, but the money would go into a private account and earn interest. The money could not immediately be spent, but after the war these accounts would be gradually unblocked, thus helping to boost the economy as war spending fell. Even F.A. Hayek, Keynes’ greatest intellectual opponent, thought the plan was brilliant. But the British government imposed controls anyway.
Today Venezuela is suffering an inflation crisis and once again controls are being invoked. Prices rose by more than 25% in both 2008 and 2009 and are expected to rise by 40% to 50% this year. Despite this fact, Venezuela maintained a fixed exchange rate, thus causing a sharp divergence in prices between domestic goods, which have become increasingly expensive, and imports, which have stayed cheap because of the fixed exchange rate.
The official exchange rate between the bolivar, the Venezuelan currency, and the dollar was fixed at 2.15 to one since March 2005 despite the massive inflation. The black market rate rose to 6.4 per dollar.
On Jan. 8 the Venezuelan government abruptly raised the official exchange rate to 2.6 per dollar for the import of essential items such as food and medicine and 4.3 on non-essential items such as airline tickets. At the same time, the black market rate was formalized and will now be managed by the central bank.
Since imported goods will now be significantly more expensive, Venezuelans flocked to the stores to buy as much of everything as they could before prices rise. Retailers, however, were prohibited from raising prices on the grounds that the goods they still have for sale were imported before the devaluation. The government threatened to shut businesses attempting to raise them.
The precipitating cause of the devaluation and price controls is upcoming congressional elections in November. As the International Monetary Fund has documented, this is often the reason why politicians impose controls, as Nixon did in 1971 in order to help him win re-election in 1972. (He also devalued the currency, as Venezuela has done, in order to give a short-term boost to exports.) Venezuelan President Hugo Chávez now has more latitude to buy re-election for his party by increasing government spending and financing it through the central bank.
The chickens will eventually come home to roost, and the Venezuelan economy will probably crash next year. But as long as it doesn’t happen until after the election the price controls will have served their purpose.
Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Action and Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy. His most recent book is The New American Economy: The Failure of Reaganomics and a New Way Forward. He writes a weekly column for Forbes.
Read more Forbes opinions here.