Prices & Wages Do Not Depend on Demand

TWO cherished economic maxims no longer hold true in the U.S. economy of today:

P:Prices do not rise and fall in strict relation to the demand for goods and services.

P:Wages do not drop or climb according to the supply of labor--or the amount of unemployment.

These lessons, brought home by the current recession, were the principal topics of 47 leading economists who were asked by the Joint Economic Committee of Congress to examine the question: can the U.S. achieve maximum (or full) employment as laid down in the Employment Act of 1946 and at the same time achieve stable prices? The economists' answer: No. Said University of Michigan Economist Gardner Ackley: "We cannot aim at absolutely full employment, or even 98% employment, unless we are willing to accept considerable inflation."

Economists have long known that 100% employment is impossible under any circumstances because there is always a certain amount of frictional unemployment caused by transitional or "between-job" idleness. But after World War II they did think that a level of "reasonably full employment" could be achieved along with stable prices, generally agreed that it would average out at 96% employment, or 4% unemployment. If unemployment rose above 4%, they felt that lowered purchasing power would cause prices to fall; if unemployment dropped below 4%, increasing demand would push prices higher. Now they know that this level no longer applies. The level of unemployment is getting progressively higher simply because the mere availability of labor or products has less and less effect.

In 1949 unemployment averaged 5.5% of the labor force, and prices dropped 1.9% on the BLS Consumer Price Index. But in 1954, when unemployment was about as high, prices declined only .5%. In short, prices are growing more and more rigid. Unemployment stands at 7.5% of the labor force, yet prices are still climbing. Last month they hit an alltime record 123.5 on the index, and no real end to the upward spiral is in sight.

Demand no longer sets the price of goods and services because, as Indiana University Economist Robert C. Turner points out, "prices are not related significantly to demand, but to costs. The price setting process has been shifted from the competitive marketplace to the conference table."

In the same way, wages are growing more and more rigid. They are on a ratchet, clicking steadily higher, but locked against any slippage downward. Despite the recession, there are so many escalator clauses, unemployment benefits, and automatic increases that wages this year are still going up (see State of Business). The belief that rising productivity will make up for wage increases, thus holding prices stable, has also proved false--at least in the short run. In 1957 wages jumped 4.5%, yet output per man-hour rose only 1.8%--and prices jumped 3%. The Government, with its farm subsidy and other aid programs to various sectors of the U.S. economy, also keeps an upward pressure on wages and prices regardless of what happens to employment.

The net effect of the changing nature of the economy is that a much larger drop in employment must occur --and remain for longer periods--than anyone before thought necessary to force down prices to any appreciable extent. Johns Hopkins' Joseph Aschheim estimates that unemployment must continue at between 5% and 10% for an extended period to attain price stability, thinks that it is closer to 5% than to 10%. Other economists set unemployment levels at 8% or more before prices will stabilize, or drop.

To keep prices from spiraling too fast, a handful of the economists argued for an agency, such as a permanent Wage and Price Commission, which would gather accurate statistics, compute the effects of wage-price increases, and formulate standards for government policy. Economists such as the University of Chicago's Albert E. Rees would also like to see the Government itself put an end to price-boosting devices, e.g., farm price supports, tariffs and import quotas that shelter inefficient domestic producers. Said he: "If the Government is to condemn private enterprise for using rigid prices, it should itself cease being the greatest single source for price rigidity in the economy."

Whatever the solution, the theories about full employment will have to be changed in the light of today's rigid wages and prices. The U.S. can no longer operate on the premise that maximum employment, i.e., 4% jobless or 2,700,000 workers, is compatible with stable prices. Unless it is willing to accept the idea of close to 5,000,000 unemployed as "reasonably full employment," then it must expect a continuing rise in prices.

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