Controlling Inflation in the Past

The use of prices and

incomes policy
1
On a number of occasions since the Second World War, governments have attempted to
control prices, wages and maybe other incomes, directly. The aim of these prices and incomes
policies was to reduce inflation: to get price and wage increases below what they would
otherwise have been.
Prices and incomes policies have taken a number of different forms. There are three main
areas in which they differed:

Scope
The policy was sometimes comprehensive: designed to control all prices and all incomes
(wages, salaries, dividends, rent etc). Alternatively it could be a partial policy: a wages policy,
or a prices policy, or a policy to control certain wages (e.g. public-sector workers, or basic
wages, rather than total pay), or certain prices (e.g. nationalised industry prices).

Degree of compulsion
The policy could be:
voluntary without agreement: here the government relied on exhortation, asking
workers and unions for wage restraint and/or firms for price restraint.
voluntary with agreement: this is where the government secured an agreement with
unions (probably through the Trades Union Congress) and/or firms (probably through
the Confederation of British Industry). The TUC and/or CBI would seek to ensure that
their members stuck to the agreement. In return the government might agree to cut
taxes or increase expenditure on various items such as health, education or child
benefit.
semi-voluntary: this is where the government sought an agreement with unions and/or
firms, but reserved the right to use various sanctions if the agreement was broken.
Sanctions could include raising taxes or not granting government contracts to firms
which broke the agreement.
statutory: this is where policy was backed by law. Unions or firms breaking the policy
would be in breach of the law, and could suffer fines, sequestration (confiscation) of
assets, or even imprisonment.

The limits allowed

The policy might take the form of a complete freeze on wages and/or prices, with or without
certain limited exceptions. Alternatively, there might be a ceiling to increases in wages, prices,
profits, etc. These might be expressed in percentages (there was a 10 per cent limit to wage
increases in 1977/78), or absolute terms (there was a 6 per week limit for everyone in
1975/76), or a combination of the two (e.g. a 1 plus 4% limit imposed in April 1973).
Alternatively there might be some norm, e.g. 10 per cent, which people might typically expect
to receive, but some people who are judged as special cases might be allowed more.
Most of these varieties were tried in Britain at one time or another during the 1960s and
1970s. Specific prices and incomes policies differed markedly one from another. As a result it
is difficult to judge whether prices and incomes policies in general were effective. Some types
might have been; other types might not. Some types might have been better for one set of
economic circumstances; other types might have been better for other sets of circumstances.

Problems of prices and incomes policy: harmful side-effects

Even if a prices and incomes policy is successful in controlling prices and incomes, there may
be undesirable side effects.
In a market economy, factors of production are encouraged to move to more efficient uses
by the incentives of the price mechanism. The movement of factors of production is likely to
be reduced if a prices and incomes policy prevents relative wages, profits, rents, etc. from
changing according to demand and supply.
The freezing or controlling of wage differentials discourages the movement of labour.
Growth industries and more efficient firms cannot attract labour by offering higher wages.
Contracting industries and less efficient firms may feel obliged to pay the wage norm, and may
therefore be forced to reduce their labour force. Frictional unemployment may increase if
workers find they have to spend longer trying to find better paid jobs. Thus the Phillips curve
may shift outward to the right.
If profits are frozen or controlled, new firms will be discouraged from moving into growth
industries and from seeking more efficient methods of production. The incentive to invest may
be reduced. Alternatively, if prices rather than profits are frozen or controlled, firms would
have the incentive to lower costs, but they may do this by a reduction in quality, or research
and development, or employment. Price control may lead to shortages and black markets.
If rents are frozen or controlled, this may reduce the supply of rented accommodation.
Thus a prices and incomes policy may reduce growth, reduce efficiency and increase
unemployment. If aggregate supply is thereby reduced, the resulting excess of demand over
supply in the economy (ceteris paribus) will increase demand-pull pressures.
These side-effects can be somewhat reduced if wage increases are allowed for increased
productivity. Such increases provide an incentive for increased efficiency. In many cases,
however, productivity is very difficult to measure, especially for white collar or public sector
workers. Other workers, unable to increase productivity by the very nature of their jobs, may
feel that productivity deals are unfair.
Some groups of workers will feel they warrant increases larger than the norm. Others will
feel it to be unfair if they are paid less than similar workers elsewhere.
Thus if productivity and fairness are to be taken into account, the policy must be flexible.
The more the authorities have to look at individual cases, however, the more expensive the
policy becomes to administer.
Question
Assume you are either (a) an ambulance driver, (b) a teacher or (c) a doctor. Make out a
case why you should be paid more than the norm allowed by a current prices and incomes
policy.

Problems of prices and incomes policy: difficulties in controlling prices

and incomes
Prices and incomes policy may fail to control inflation for several reasons:

Evasion
Some workers and firms may be able to get round government controls.
If basic wage rates are controlled wage drift may occur. This is where total pay increases
more than basic rates. This could be due to promotion, job-changing, job reclassification, more
bonuses, more overtime (without necessarily any increase in output), more perks etc. This
problem is particularly serious for the government if firms are very willing to grant such wage

increases and thereby to assist workers in evading the policy.

This problem could be reduced if the government controlled the total amount of wages
that firms pay out. If, however, the government wished to allow productivity deals, there
would be the problem of checking whether there was a genuine increase in productivity.
Question
Make a list of jobs where it would be very hard for the government to enforce wage control.

Firms could get round price controls by redefining their product, so that it becomes a new
product and thus has a new price. Sunshine washing powder could have extra added
brightness and become New Sunshine. Firms may be able to reduce quality, contents, size
etc. If firms are allowed to pass increases in costs on to the consumer in higher prices, they
could exaggerate cost increases in order to obtain larger price increases.

Problems of enforcement
If enough powerful groups resist the policy, the government may not have sufficient power to
enforce it. If the government resorts to legal sanctions this could create a confrontation from
which the government may feel forced to back down.

Excess demand may increase

If a prices and incomes policy is initially successful in reducing inflation, the government may
feel less constrained to control aggregate demand. The government may even be obliged to
expand aggregate demand (e.g. by increasing social services or by cutting taxes) in order to
gain unions acceptance of pay restraint. Increased demand will increase expenditure on
imports. If the exchange rate is flexible it will tend to depreciate thus driving up the price of
imports.
Increased demand would encourage firms and unions to evade the policy. Firms, facing
increased orders, will be keen to maintain good industrial relations and high productivity. They
may thus be willing to collude with unions to find ways to pay more than is currently allowed
by the policy.

The ending of the policy

Governments which resorted to prices and incomes policy tended (initially) to see it as a
temporary measure, since distortions to the price mechanism, evasion and resistance to the
policy are likely to grow with time. When the controls are removed, however, there is likely to
be a wage/price explosion as people try to make up for what they feel they have lost while the
policy was in operation. If people expect such an explosion, the expected rate of inflation ( P e
) will rise, thus further fuelling inflation.
Question
How may a government attempt to keep the expected rate of inflation down as an incomes
policy is drawing to an end?

Prices and incomes policy in the UK

There were three periods when governments made a significant attempt to impose prices and
incomes policy :

Period 1: 1964-70 (Labour government under Wilson)

Period 2: 1972-74 (Conservative government under Heath)
Period 3: 1975-79 (Labour government under Wilson and Callaghan)
Each period can be divided into a number of phases, or stages. Policies differed from stage
to stage, both in their scope, in the degree of compulsion employed and in the limits or norms
allowed.

Early attempts
There had been some minor attempts at controlling incomes before 1964.
From 1948 to 1950 the Labour government, with the support of the TUC, pursued a
voluntary incomes policy with a zero norm. This had some initial success, but agreement broke
down when inflation began to rise as a result of the 1949 devaluation of the pound, and rising
international commodity prices caused largely by the Korean War.
In 1961 the Conservative government introduced a pay freeze in the public sector. This was
followed by a voluntary policy across the economy with a norm (or guiding light as it was
called) of 2%. A National Incomes Commission was established in 1962 to advise on particular
pay disputes or agreements referred to it by the government.

Period 1: 196470
Initially the labour government favoured a voluntary prices and incomes policy and persuaded
unions and employers to accept wage and price restraint, with a 33% wage norm. The
National Board for Prices and Incomes (NBPI) was set up in 1965 and replaced the National
Incomes Commission, but initially had a very similar function.
By 1966, with rising inflation and a balance of payments crisis, the government felt that this
voluntary policy was inadequate. It imposed a six month freeze on wages, prices and dividends.
The Prices and Incomes Board was given statutory powers to oversee the policy.
Over the next three years the policy was gradually relaxed in a series of stages. More and
more exceptional cases were allowed with many workers getting substantial increases. By the
time Labour lost the election in June 1970, the policy had virtually collapsed.
The period illustrates the difficulties of continuing with a tough policy for more than a few
months. Increasingly resistance to the policy grows as people feel they have been unfairly
treated. If, in order to deal with this problem, the government allows exceptional cases,
everyone will feel they ought to be treated as an exceptional case.
The government in the later stages of the policy placed great emphasis on productivity as the
main reason for granting exemptions above the norm. As a result there was a great temptation
for unions to negotiate phoney productivity deals.

Period 2: 19724
The Conservative government when elected in June 1970 was opposed to prices and incomes
policy. It was felt to be damaging to the working of the market economy, and ineffective as a
remedy for inflation. The government thus abolished the Prices and Incomes Board, and initially
relied on relatively tight fiscal policy to contain inflation.
But continuing high inflation and growing unemployment led to a U-turn in 1972. Aggregate
demand was expanded massively in order to increase growth and reduce unemployment, and a
prices and incomes policy was introduced in order to restrain inflation.
There were three stages in the policy. The first stage was a five month statutory freeze on
prices and incomes. The second and third stages were also compulsory and two bodies were set
up to enforce the details of the policy. A Price Commission was responsible for administering a
Price Code. All large firms needed the permission of the Price Commission before they could

raise prices. Similarly a Pay Board was responsible for administering the wages policy and
ensuring its observance.
Initially the policy seemed to be moderately successful. Inflation was relatively stable at
around 9% for most of 1973.
There were, however, serious problems with the policy:

Many workers were unwilling to accept the policy. The miners strike in the Winter of
1973/74 was a direct challenge to the government. The shortage of fuel led to electricity cuts
and the introduction of a three day working week. The government called a general election
asking for public endorsement of its policies. It was defeated, and as a result the policy
collapsed.
Inflationary pressures were increasing. The government was pursuing a highly expansionary
monetary and fiscal policy in a dash for growth. In these circumstances, a prices and
incomes policy could do little more than temporarily suppress inflation. In addition, world
commodity prices, and in particular oil prices, were rising rapidly in 1973 and 1974. When
the policy ended in February 1974 there was therefore a wage and price explosion.
Thresholds aggravated the problem. A threshold clause in Stage 3 allowed all workers a
40p per week rise for each 1% that price rises exceeded 7% above their October 1973 level.
This was therefore a form of indexation: wages would automatically rise with inflation. The
government had hoped that incomes policy would keep inflation below 7 per cent, and that
unions would not seek excessive wage increases with this threshold safety net.
As it turned out, price rises soon exceeded the 7% mark. The incoming Labour
government felt obliged to keep this part of the policy in force for the full twelve months
originally envisaged. It thus found threshold payments rising month by month, right up to the
end of the period. These automatic wage rises then fuelled further price rises.

Question
Under what circumstances will indexation a) help to reduce inflation b) make inflation worse?

Period 3: 1975-79
The Labour government was committed to free collective bargaining. It thus abolished the Pay
Board. The Price Commission was retained, however, but the Price Code was relaxed somewhat
in December 1974 in the light of falling company profits.
Worried about rising wage inflation, the government relied on a voluntary Social Contract
with the TUC. In return for unions ensuring that wage rises did not exceed the rate of inflation,
the government agreed to introduce various social policies approved of by the unions.
This policy was not enforced, and by early 1975 wage inflation was approaching 30 per
cent! The crisis forced the government to introduce a full prices and incomes policy in August
1975. The Price Commission continued to control prices and a semi-voluntary incomes policy
was adopted. The policy was known as Social Contract Mark II. This prices and incomes
policy had four phases, with each phase intended to last a year.
As with the previous Conservative governments policy, this policy seemed initially
successful. Inflation fell from 24 per cent in 1975 to 16 per cent in 1976, despite slightly
expansionary fiscal and monetary policies. (Although this could equally have been due to the
effects of the huge expansion in aggregate demand from 19724 having finished working
through into prices.)
Given the crisis of 1975, the policy was initially acceptable to the unions. By phase 3,
however, agreement with the unions had broken down. Despite the work of the Price
Commission, prices were rising faster than wages, and unions were not prepared to accept

further restraint. The government had to resort to putting pressure on firms to stick to the
wages policy: the public sector would cease to do business with firms that paid wage increases
above the norm. Not surprisingly, firms too were reluctant to accept this policy, and
increasingly sought ways to evade price restraint, in order to protect profits. Nevertheless,
inflation was still falling, reaching a low of 8 per cent in 1978.
By phase 4 the policy was in ruins. Many unions sought and obtained wage increases
substantially above the 5 per cent norm, in what became known as the Winter of discontent.
The government lost the general election of May 1979, and the incoming Conservative
government abandoned prices and incomes policy.
Such policies have not been used since. The Thatcher government saw them as at best
useless, and at worst positively harmful, preventing markets from functioning so well.
Today, with inflation at around 2 per cent, and with a high degree of confidence that the
Bank of England will be able to maintain it at this level though its control of interest rates, the
thought of ever returning to prices and incomes policy would seem bizarre.
Question
In 1989 and 1990, with inflation rising and pay settlements on average several percentage
points above the mid-1980s, the Conservative government warned of the inflationary
consequences of excessive wage demands. It tried to keep pay increases down in the
public sector and faced industrial action from the rail unions, from ambulance staff and
from other public sector workers. What does this tell us about the governments
perceptions of the causes of inflation?