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The Cure for lnflation
277
higher than usual unemployment. That is the basis in experience
for our judgment that there is no way to avoid side effects of a
cure for inflation.
However, it is possible to mitigate those side effects, to make
them milder.
The most important device for mitigating the side effects is to
slow inflation gradually but steadily by a policy announced in
advance and adhered to so it becomes credible.
The reason for gradualness and advance announcement is to
give people time to readjust their arrangements
and to induce
them to do so. Many people have entered into long-term con-
tracts—for employment, to lend or borrow money, to engage in
production or construction—on the basis of anticipations about
the likely rate of inflation. These long-term contracts make it
difficult to reduce inflation rapidly and mean that trying to do so
will impose heavy costs on many people. Given time, these con-
tracts will be completed or renewed or renegotiated, and can then
be adjusted to the new situation.
One other device has proved effective in mitigating the ad-
verse side effects of curing inflation—including an automatic ad-
justment for inflation in longer-term contracts, what are known
as escalator clauses. The most common example is the cost-of-
living adjustment clause that is included in many wage contracts.
Such a contract specifies that the hourly wage shall increase by,
say, 2 percent plus the rate of inflation or plus a fraction of the
rate of inflation. In that way, if inflation is low, the wage increase
in dollars is low; if inflation is high, the wage increase in dollars
is high; but in either case the wage has the same purchasing
power.
Another example is for contracts for the rental of property.
Instead of being stated as a fixed number of dollars, the rental
contract may specify that the rent shall be adjusted from year to
year by the rate of inflation. Rental contracts for retail stores often
specify the rent as a percentage of the gross receipts of the store.
Such contracts have no explicit escalator clause but implicitly they
do, since the store's receipts will tend to rise with inflation.
Still another example is for a loan. A loan is typically for
a
fixed dollar sum for a fixed period at a fixed annual rate of in-
terest, say, $1,000 for one year at 10 percent. An alternative is

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to specify the rate of interest not at 10 percent but, say, 2 percent
plus the rate of inflation, so that if inflation turns out to be 5 per-
cent, the interest rate will be 7 percent; if inflation turns out to
be 10 percent, the interest rate will be 12 percent. An alternative
that is roughly equivalent is to specify the amount to be repaid
not as a fixed number of dollars but as a number of dollars ad-
justed for inflation. In our simple example the borrower would
owe $1,000 increased by the rate of inflation plus interest at 2
percent. If inflation turned out to be 5 percent, he would owe
$1,050; if 10 percent, $1,100; in both cases plus interest at 2
percent.
Except for wage contracts, escalator clauses have not been com-
mon in the United States. However, they are spreading, especially
in the form of variable interest mortgages. And they have been
common in just about all countries that have experienced both
high and variable rates of inflation over any extensive period.
Such escalator clauses reduce the time delay between slowing
down monetary growth and the subsequent adjustment of wages
and prices. In that way they shorten the transition period and
reduce the interim side effects. However, useful though they are,
escalator clauses are far from a panacea. It is impossible to esca
-
late
all
contracts (consider, for example, paper money), and
costly to escalate many. A major advantage of using money is
precisely the ability to carry on transactions cheaply and efficiently,
and universal escalator clauses reduce this advantage. Far better
to have no inflation and no escalator clauses. That is why we
advocate resort to escalator clauses in the private economy only
as a device for easing the side effects of curing inflation, not as
a permanent measure.
Escalator clauses are highly desirable as a permanent measure
in the federal government sector. Social Security and other re-
tirement benefits, salaries of federal employees, including the
salaries of members of Congress, and many other items of govern-
ment spending are now automatically adjusted for inflation. How-
ever, there are two glaring and inexcusable gaps: income taxes
and government borrowing. Adjusting the personal and corporate
tax structure for inflation—so that a 10 percent price rise would
raise taxes in dollars by 10 percent, not, as it does now, by some-
thing over 15 percent on the average—would eliminate the im-

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The Cure for Inflation
279
position of higher taxes without their having been voted. It would
end this taxation without representation. By so doing, it would
also reduce the incentive for the government to inflate, since the
revenue from inflation would be reduced.
The case for inflation-proofing government borrowing is equally
strong. The U.S. government has itself produced the inflation that
has made the purchase of long-term government bonds such a
poor investment in recent years. Fairness and honesty toward
citizens on the part of their government require introducing es-
calator clauses into long-term government borrowing.
Price and wage controls are sometimes proposed as a cure for
inflation. Recently, as it has become clear that controls are not
a cure, they have been urged as a device for mitigating the side
effects of a cure. It is claimed that they will serve this function
by persuading the public that the government is serious in attack-
ing inflation. That, in turn, is expected to lower the anticipations
of future inflation that are built into the terms of long-term
contracts.
Price and wage controls are counterproductive for this purpose.
They distort the price structure, which reduces the efficiency with
which the system works. The resulting lower output adds to the
adverse side effects of a cure for inflation rather than reducing
them. Price and wage controls waste labor, both because of the
distortions in the price structure and because of the immense
amount of labor that goes into constructing, enforcing, and evad-
ing the price and wage controls. These effects are the same whether
controls are compulsory or are labeled "voluntary."
In practice, price and wage controls have almost always been
used as a substitute for monetary and fiscal restraint, rather than
as a complement to them. This experience has led participants in
the market to regard the imposition of price and wage controls as
a signal that inflation is heading up, not down. It has therefore
led them to raise their inflation expectations rather than to
lower them.
Price and wage controls often seem effective for a brief period
after they are imposed. Quoted prices, the prices that enter into
index numbers, are kept down because there are indirect ways of
raising prices and wages—lowering the quality of items produced,
eliminating services, promoting workers, and so on. But then, as

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the easy ways of avoiding the controls are exhausted, distortions
accumulate, the pressures suppressed by the controls reach the
boiling point, the adverse effects get worse and worse, and the
whole program breaks down. The end result is more inflation, not
less. In light of the experience of forty centuries, only the short
ti me perspective of politicians and voters can explain the repeated
resort to price and wage controls."
A CASE STUDY
Japan's recent experience provides an almost textbook illustration
of how to cure inflation. As Figure 6 shows, the quantity of money
in Japan began growing at higher and higher rates in 1971, and
by mid-1973, it was growing more than 25 percent a year."
Inflation did not respond until about two years later, in early
1973. The subsequent dramatic rise in inflation produced a funda-