Pragmatic Prices

An excerpt from How China Escaped Shock Therapy

The following is an adapted excerpt from How China Escaped Shock Therapy: The Market Reform Debate.

Price setting in the Second World War

European and American traditions of economic theorizing on price control are intimately connected with war. The experience of the First World War had been one of inflation and limited price controls throughout its duration, followed by a sudden liberalization after the war’s end. The transition from war to peace gave rise to a sharp boom bust cycle and eventually led to the Great Depression.

The experience stood as a warning for policymakers during World War II. With the exception of China, all major powers experiencing hyperinflation1 implemented price and wage controls that were far more comprehensive than those of the First World War: “Controls over prices and wages were the rule; freedom from such regulation was the exception.”2 Despite their scale, the policies were not based on elaborate theoretical principles. In fact, some of the most sophisticated 20th century economists—Keynes, Hansen, Galbraith—were unable to reconcile with the realities of the war economy. John Kenneth Galbraith, the most prominent American price-fixer of the Second World War, described inflation control as an evolutionary development “in the sense that the final structure was influenced less by an effort to build to an overall design than by a series of individual decisions.”3

In the following extract, I survey the theory, practice, and outcomes of price setting during the Second World War and its aftermath. In doing so, I argue that the implementation and practice of American price controls was less a result of ideology, economic theory or calculation than pragmatic decision making according to economic needs. In fact, the most beautiful theoretical plans for inflation policies crumbled when confronted with the reality of the war economy. The pragmatism that ultimately served to stabilize prices was made possible through the surrender of theoretical dogmas in the face of emergency.  

Three views on wartime inflation

In 1940, Keynes’s How to Pay for the War set the tone for reflections by professional economists on war finance and economic stabilization. His considerations of the war economy radically departed from the principle of effective demand—the concept for which he is most famous. Keynes had derived the importance of effective demand for the general case of peacetime in his General Theory. But he did not believe that it applied to the special case of war: “[I]n war time, the size of the cake is fixed,” he argued. “If we work harder, we can fight better. But we must not consume more.”4

According to Keynes, the reason for this difference was that, in times of war, all expansion of production is to supply the goods needed for the war: “The war effort is to pay for the war; it cannot also supply increased consumption.” 5 Under conditions of war, Keynes argued, the government had to expand its spending and, before full employment of labor and capacity was reached, demand for consumption goods exceeded their supply. This was the case because “[e]ven if there were no increases in the rates of money-wages, the total of money-earnings [would] be considerably increased.”6 Keynes suggested that people previously unemployed or not in paid employment were drawn into military service or civilian war production and hence received a money wage. The aggregate wage fund increased, but it encountered roughly the same amount of consumption goods that had been available before that increase.

In principle, Keynes indicated three alternatives for solving this problem. A laissez-faire solution, comprehensive price controls and rationing, and his preferred scheme of deferred pay combined with price controls for selected essentials. The first was based on the assumption that peacetime economic policies and taxation were, in essence, fit to serve the war economy and needed only to be complemented with propaganda to encourage voluntary saving. 7 Keynes found it highly unlikely that voluntary savings were sufficient to limit the purchasing power in order to match the constrained consumption supply as well as to provide the necessary finance for the war effort.8 This scheme would imply a repetition of the policy of the First World War, which entailed a “sufficient degree of inflation to raise the yield of taxes and voluntary savings.”9 But this would not actually be a voluntary saving. It would, rather, be “a method of compulsory saving, converting the appropriate part of the earnings of the worker which he does not save voluntarily into the voluntary savings (and taxation) of the entrepreneur.”10

Keynes warned that inflation would be fueled by a price-wage spiral. As the economy approached full employment and the wage fund increased, prices would rise. If workers were compensated for the rising prices, this would put renewed pressure on the price level.11 As a result of accelerating inflation, workers would be left without savings and without increased consumption enjoyments. Capitalists, on the other hand, would profit from the increasing prices and would become creditors to the government. Keynes cautioned that, after the war, the state would be left with very high debt in the hands of a few powerful and rich. The workers would have paid with their labor for the war but been left with nothing.

If Keynes’s first alternative was somewhat laissez-faire, the second alternative was the opposite. It was to “control the cost of living by a combination of rationing and price-fixing.”12 Keynes took an equally critical stance toward this approach. It might be “a valuable adjunct” to his main proposal, but it would be “a dangerous delusion to suppose that equilibrium [could] be reached by these measures alone.”13

In Keynes’s eyes, price controls would not serve to effectively limit the excess purchasing power that resulted from the war-driven expansion of employment. “[I]t would never be practicable to cover every conceivable article by a rationing coupon” and, by the same token, to control all prices. 14 Therefore, Keynes suggested that the purchasing power would be redirected toward those commodities, which remained uncontrolled because they attracted relatively little demand. The consumer would end up receiving what is “least desirable” while an overall excess demand remained and drove up the prices of these uncontrolled commodities.

In sum, for Keynes, comprehensive price controls and rationing were unlikely to be effective in containing the excess purchasing power. If, against his prediction, they were to be effective, the result would be an undesirable allocation of the limited supply of consumption goods.

Instead, Keynes promoted a third alternative: “a scheme of deferred pay” combined with carefully selected price controls to the extent necessary. He argued that the excess purchasing power of the wage earners should be withdrawn during wartime by forced saving with a government-run bank. This way, they would be rewarded after the war by “a share in the claims on the future which would otherwise belong to the entrepreneurs.”15 Keynes thought that inflation would be contained by the resulting temporary reduction in aggregate demand. The same could be achieved by taxation, but in this case, the wage earner would be left without any individual claim on future wealth.

The plan of deferred pay was to be assisted by limited price controls and rationing, which would serve “to divert consumption in as fair a way as possible from an article, the supply of which has to be restricted for special reasons,” such as the interruption of foreign trade. 16 Such a diversion of demand should, according to Keynes, take the form of rationing and price control only “if this article is a necessary, an exceptional rise in the price of which [was] undesirable.” 17 For all other goods, demand should be checked by “the natural method” of a rising price in response to a limited supply.

Keynes’s plan for deferred pay was the most prominent theoretical contribution to the question of war finance, not only in the United Kingdom but also in the United States.18 Even Hayek acknowledged that Keynes had set the standard for thinking about the problem of wartime inflation.19 Another important contribution more tailored to the specific conditions in the United States came from Alvin Hansen, an institutionalist and one of America’s leading teachers of Keynesian thought at Harvard University.20

Hansen departed to some extent from Keynes in his vision of price controls. For him, “until an approach to full employment [was] reached … the main danger of inflation [was] in the development of bottlenecks”21 and, hence, these bottlenecks should be the primary target of anti-inflation policy. Hansen recommended that “the weapon of specific price increases where these may help eliminate bottlenecks” should be used when “provision of adequate plant and equipment capacity and … an adequate supply of skilled mechanics” was readily forthcoming.22 In the event of a lack of such capacity and labor with regard to a specific bottleneck, however, direct price control and rationing could help prevent inflation. Hansen saw the most serious of these bottlenecks in steel. 23 Thus, he differed from Keynes by shifting attention from price controls on necessary consumption goods to those on production goods. While Keynes’s plan relied almost entirely on the relationships between homogeneously perceived aggregates, Hansen considered the great asymmetries in sectorial production capacities and demand pressures. In this view, shortages could exist side by side with oversupply driving inflation up long before full capacity utilization.

Galbraith—then a young economist—made his name by deepening Hansen’s analysis of such heterogeneities. He too emphasized the pressing need to prevent inflation, which had as a result of the First World War been an “almost paranoiac concern in 1940 and 1941.”24 But neither Hansen’s peacetime-inspired notion of bottlenecks nor Keynesian considerations of some aggregate relations would serve to capture the dramatic change in requirements resulting from war and, hence, to understand the problem of war inflation. According to Galbraith, the problem of the war economy was “progressively more difficult” than these two notions suggest, and it entailed nothing less than a reorganization of the resources in the whole economy. Under the circumstances of such restructuring, one would “encounter a steadily increasing number of industries where the supply function [would] be inelastic.” As a result of these rigidities, Galbraith argued, there would be “price advances in the interim” and “[f ]ull employment will have little or no relation to the appearance of inflation.”25

Nevertheless, Galbraith remained optimistic that “[r]easonably full use of resources without serious inflation [could] be achieved.” But, contrary to Keynes, in Galbraith’s view, it was impossible to “rely entirely, or even in major part, upon measures which reduce[d] the general volume of spending in the economy.”26 Such a reduction in aggregate demand had to be combined with direct measures to facilitate the industrial reorganization. This, according to Galbraith, had to include two main tasks: first, it was necessary to develop capacity, skills, and domestic sources of material supply to smooth the expansion of anticipated pressure points; second, “in the areas where resistance develop[ed]… specific price controls or price-fixing” supported by a degree of rationing was needed. Thus, Galbraith believed in a role for Keynes’s investment policies during wartime, while Keynes himself had declared his own theory inapplicable to this special case.

Practical attempts at control

While the arguments of Keynes, Hanse and Galbraith were all convincing on their own terms, they all proved impractical in reality. At the time when Galbraith caught the attention of the economics profession with his bold argument in favor of greater price controls, Leon Henderson was heading the newly created Office of Price Administration (OPA). He was a prominent economist in the Roosevelt administration, and his approach to economic policy “had the characteristic New Deal qualities of public activism, brash experimentalism.”27 Henderson had become involved in attempts at price stabilization when the prices of raw materials and industrial goods shot up after the German invasion in Poland, which he thought would impede the recovery of the American economy still suffering from the Great Depression.28 When the United States entered the Second World War in December of 1941, Henderson immediately pushed for far-ranging controls to stabilize prices during the war effort and to prevent a boom–bust cycle upon its end.29 Conscious of Galbraith’s writing, Henderson decided to offer him what would come to be called “the most powerful civilian post in the management of the wartime economy.” Galbraith was put in command of all prices of the United States.

Thus began “the longest and most comprehensive trial [of price controls] in America’s history.”30 The American price-fixers had to defend their selective price schedules on multiple fronts. They had to debate the high-powered economists with their theoretical considerations, negotiate fiercely with the industry bosses, and fight to be granted the necessary legal power from Congress. Yet, to the surprise of the price-fixers, for those commodities for which they published specific price schedules, the ceiling prices were well observed even before penalties could be imposed.31 By the fall of 1941, their informal controls effectively restrained about 40 percent of wholesale prices.32 But the task of determining commodity-specific prices for all relevant products, while allowing for a degree of flexible price adjustments, proved impossible.

The price-fixers were challenged by the complexity of input-output relations and “began to realize for the first time what an unreasonably large number of products and prices there were in the American economy.”33 Further, they had overlooked the importance of “wage–push inflation.” 34 The OPA, in line with the New Deal legacy, remained committed to the cause of the poor, the workers, and the farmers and initially tried to abstain from wage controls and strict price controls for agricultural goods. A mutually reinforcing upward pressure on wages as employment was expanding and, as a result, also drove up agricultural and industrial prices. This proved to be a great challenge to the effort of price stabilization.35

Despite the OPA’s efforts, consumer prices had risen by 11.9 percent, and wholesale prices by 17.2 percent, from April 1941 to 1942 alone.36 This immediate inflationary pressure was much higher than most economists had expected at the beginning of the war. As a result, the OPA and Galbraith became amenable to the ideas of Bernard Baruch.

Baruch’s voice was very different from that of most of the professional economists. Born in 1870, he had become rich in his early years on Wall Street and had gained influence as a political advisor to President Woodrow Wilson. He became chairman of the War Industries Board during the First World War and, as such, was also a member of the Price-Fixing Committee. Baruch experienced the challenges of controlling inflation firsthand. 37 He lobbied for an overall price freeze in the Second World War. Instead of selective price controls, he believed that all prices should be pegged where they stood. This became known as the Baruch Plan. 38

Henderson, Galbraith, and their team, joined by celebrated economists such as Irving Fisher, had initially lobbied against the Baruch Plan. But about a year into Galbraith’s work at the OPA, they had to admit that their own attempt at scientific price-fixing had failed to prevent the price level from rising rapidly. 39 On April 28, 1942, the General Maximum Price Regulation was imposed under the lead of the OPA. All “prices legally within reach” were set a ceiling that was defined as “the highest charged [price] in March by that seller for the same item” 40, and wages were brought under government control. 41 The new policy was based on given prices observed in the market within a certain time span, rather than trying to determine abstractly what the price for each commodity should be.

The General Maximum Price Regulation was more effective than selective controls, but it failed to stabilize the overall price level sustainably due to a lack of control over wages and agricultural prices. Following Henderson’s initiative, Roosevelt finally received backing from Congress for legislation to freeze farm prices at parity and to stabilize wages in September of 1942.42 This proved unpopular with both workers and farmers and caused severe losses for the Democrats in the congressional elections. As a consequence, Henderson had to resign.

On April 8, 1943, President Roosevelt issued an executive order to force an effective general price freeze. This policy was called “hold the line” and enforced that no “further increases in prices affecting the cost of living or further increases in general wage or salary rates” would be tolerated, “except where clearly necessary to correct substandard living conditions.”43

With the executive backing of the “hold-the-line” order—and thanks to a great popularization effort to make dollar-and-cents price ceilings known to sellers and consumers—the OPA, under Henderson’s successors Prentiss Brown and Chester Bowles, managed to halt inflation. The annual Bureau of Labor Statistics living cost index increased by less than 2 percent annually between spring 1943 and April 1945, or one-sixth the rate of the preceding two years.

The outcome of wartime controls

The benchmark for the OPA’s work was to achieve greater price stability and higher output growth than occurred during the First World War. Year-by-year comparisons of the macroeconomic performance during the Second World War, relative to that of the First World War, were a common tool for evaluation as well as a public demonstration of the effectiveness of price controls.44 At the end of the Second World War, the Harvard economist Seymour Harris delivered a careful empirical analysis of the detailed workings of price controls in the United States; his analysis documents the comparatively superior stabilization record in the Second compared to the First World War. Harris suggests that “the most significant test of the success of any price-control program is its effects on production”45 (see Figure 2.2). As they were slowly put in place in the later years of the war effort, the partial price controls of the First World War did help to some extent to stop inflation from rising further. Nevertheless, the experience of the First World War was one of inflation under lose price controls, while production stagnated; in the Second World War, price controls became strict, price rises were low, while the increase in output was almost beyond imagination.

In contrast with Keynes’s assumption of a fixed “size of the cake” during wartime, the gross national product (GNP) of the United States almost doubled from 1940 to 1944: private capital formation declined but was more than compensated for by a dramatic expansion of government expenditures and a slight increase in consumer expenditures (see Figure 2.3). Instead of crowding out private expenditures, government expansion drastically increased the size of the cake.

The consumption of durable goods such as automobiles and furniture declined, but personal savings rates more than tripled during the Second World War, from the prewar level of about 6 percent of GNP to more than 20 percent in the years 1942–1944.46 Personal savings, which peaked at about USD 30 billion in 1945, were critical to closing the gap between the growth in purchasing power and that in the supply of consumption goods.47 In the context of an increasing supply of consumption goods, effective rationing of scarce goods, and extremely high saving rates, black markets were by far not as pervasive as many had predicted, and quality deterioration was limited to a few products.48 At the same time, corporate profits might not have skyrocketed in the ways some business leaders had hoped, and the profit rate fell during the war. But annual profits after taxes still more than doubled from 1939 to 1943, from USD 4 billion to USD 8.5 billion, as a result of the rapid expansion of GNP.49

In 1952, Galbraith wrote A Theory of Price Control to summarize his reflections on the workings of price controls. He argued:

[T]he strategy of control must involve a two-way move. Along with the controls over the growth of income from the side of taxation and savings there must be direct market controls. On this side the role of price control per se … is strategic. No more than the economist ever supposed will it stop inf lation. But it both establishes the base and gains the time for the measures that do.50

The postwar transition

On August 15th, 1945, Japan announced its surrender; on the 18th, the new President of the United States, Harry S. Truman, issued an executive order “for the orderly Modification of Wartime Controls.”51 It stated the aim to “move as rapidly as possible without endangering the stability of the economy toward the removal of price, wage, production and other controls and toward the restoration of collective bargaining and the free market.”

As part of this order, direct wage controls were removed.52 Truman was aware of the dangers of a hasty price increase as a result of decontrol, but he hoped to be able to relieve the direct controls and “hold the line” through voluntary cooperation with business leaders and trade unions.53 When this failed, he changed course and sought support against a policy of decontrol.

Truman was not alone. In 1946, fifty four economists published a letter in the New York Times urging the extension of the Price Controls Act for another year. Opinion polls showed that the general public also strongly supported the plan of keeping price and wage controls.54 But the eventual bill extending the price control contained so many “crippling amendments” that on June 29, Truman vetoed it, hoping for a bill that would keep price and wage controls in place more effectively. Such a bill never passed. As a result, wartime price controls reached an abrupt end.

The sudden end to almost all price controls did, in fact, cause the inflationary rise in prices as the President, the OPA staff, and the letter by economists had predicted (see Figure 2.1). Some key input commodities, such as steel scrap, copper, tin, and rubber, still had their prices set by the government, and rents, sugar, and rice remained controlled. But, irrespective of this, prices rose rapidly after the failure to renew the Price Control Act.

Michael Kalecki analyzed postwar inflationary tendencies in the United States and other countries on behalf of the United Nations Department of Economic Affairs. He showed that, in particular, the prices of essential raw materials and foodstuff, for which the respective demand by producers and consumers is inelastic, shot up.55 Wage increases did not compensate for the increase in the cost of living, so price decontrols resulted in a decline in real incomes for workers. Real labor incomes had declined 8 percent by the first half of 1947, as compared with the first half of 1946.56 At the same time, profit margins increased, and there was a shift of gross private income from labor to capital. In the course of the war, labor had increased its share. By the first half of 1946, labor still accounted for 61.5 percent, which declined to 58.8 percent by the first half of 1947. Conversely, gross corporate profits rose from 11.6 to 14.0 percent.57 The rapid decrease in workers’ purchasing power, the redistribution of income, and the devaluation of their wartime savings unleashed the greatest wave of labor strikes of the US postwar decades.58 The immediate postwar years saw a short, inflationary boom paired with labor unrest, followed by a sharp downturn. The United States thus experienced the boom–bust cycle Truman had feared.59 Yet, a Great Depression was avoided, possibly thanks to spending for the Korean war.

Pragmatic prices

In “Reflections on the Invisible Hand,” mathematical economist Frank Hahn warned that both those believing in the omnipotent power of the visible and the invisible hand “take it for granted that somewhere there is a theory, that is a body of logically connected propositions based on postulates not wildly at variance with what is the case, which support their policies.” 60 During the Second World War, even the self-declared pioneer of free enterprise, the United States, retreated to a pragmatic approach in its use of the visible hand and controlled, among other things, most prices and wages to finance the war while achieving low inflation. Not only had the ideal of the invisible hand been abandoned, but, more fundamentally, it had been acknowledged that there is no such “theory, that is a body of logically connected propositions” that serves to draw up a comprehensive blueprint for economic policy. Instead, one had to apply “the wishy-wash, step by step, case by case approach,” which Hahn recommended as “the only reasonable one in economic policy.” In our current moment of crisis and instability, we would do well to heed this advice.

  1. Weber, I. M. “The Ordoliberal Roots of Shock Therapy: Germany’s ‘Economic Miracle’ in China’s 1980s Reform Debate.” In: Slobodian, Q. and D. Plehwe (Eds.),Market Prophets from the Margins: Neoliberals East and South (Brooklyn: Zone Books, forthcoming).

  2. Galbraith, J. K. A Theory of Price Control, (Cambridge, MA: Harvard University Press, 1980), 1.

  3. Galbraith, A Theory of Price Control, 45

  4. Keynes, J. M. How to Pay for the War: A Radical Plan for the Chancellor of the Exchequer. (New York: Harcourt, Brace and Company, 1940).

  5. Keynes, How to Pay for the War, 30

  6. Keynes, How to Pay for the War, 8

  7. Keynes, How to Pay for the War, 58

  8. Keynes, How to Pay for the War, 9, 28, 69

  9. Keynes, How to Pay for the War, 58

  10. Keynes, How to Pay for the War, 69

  11. Keynes, How to Pay for the War, 74

  12. Keynes, How to Pay for the War, 51

  13. Keynes, How to Pay for the War, 51

  14. Keynes, How to Pay for the War, 52

  15. Keynes, How to Pay for the War, 74

  16. Keynes, How to Pay for the War, 53

  17. Keynes, How to Pay for the War, 54

  18. Galbraith, A Theory of Price Control, 5-6.

  19. Hayek, F. A. “Review: How to Pay for the War by J. M. Keynes.” The Economic Journal, 1940: 50(198/199), 321–326.

  20. Hansen, A. H. “Defense Financing and Inflation Potentialities.” The Review of Economics and Statistics, 1941: 23(1), 1–7.

  21. Hansen, “Defense Financing,” 6

  22. Hansen, “Defense Financing”

  23. Hansen, “Defense Financing,” 1

  24. Galbraith, J. K. A Life in Our Times. (Boston: Houghton Mifflin Company, 1981), 127

  25. Galbraith, A Life in Our Times, 83

  26. Galbraith, A Life in Our Times, 84

  27. Bartels, A. H. “The Office of Price Administration and the Legacy of the New Deal, 1939–1946.” The Public Historian, 1983: 5(3), 8.

  28. Bartels, “The Office of Price Administration,” 7-8

  29. War Records Section Bureau of the Budget. “The United States at War: Development and Administration of the War Program by the Federal Government.” Washington, DC: United States Government Printing Office, 1946, 239-40.

  30. Rockoff, H. Drastic Measures. A History of Wage and Price Controls in the United States. (Cambridge: Cambridge University Press, 1984), 85.

  31. Galbraith, A Life in Our Times, 136, 164

  32. Bartels, “The Office of Price Administration,” 9

  33. Galbraith, A Life in Our Times, 164

  34. Galbraith, A Life in Our Times, 142

  35. Bartels, “The Office of Price Administration,” 10-12

  36. Rockoff, H. Drastic Measures. A History of Wage and Price Controls in the United States. (Cambridge: Cambridge University Press, 1984), 109.

  37. Baruch, B. The Public Years. (New York: Holt, Rinehart and Winston, 1960).

  38. War Records Section Bureau of the Budget. “The United States at War: Development and Administration of the War Program by the Federal Government.” Washington, DC: United States Government Printing Office, 1946, 237-238.

  39. Galbraith, A Life in Our Times, 164; Rockoff, Drastic Measures, 89, 91; Bartels, “The Office of Price Administration,” 13.

  40. Galbraith, A Life in Our Times, 165

  41. Rockoff, Drastic Measures, 92

  42. Bartels, “The Office of Price Administration,” 15–16

  43. Roosevelt, as cited in Rockoff, Drastic Measures, 85

  44. Mansfield, H. C. Historical Reports on War Administration: A Short History of OPA. (Washington, DC: Office of Temporary Controls and Office of Price Administration, 1947), 82.

  45. Harris, S. E. Price and Related Controls in the United States. (New York: McGraw-Hill Book Company, 1945), 11

  46. Brunet, G. Stimulus on the Home Front: The State-Level Effects of WWII Spending, 2018, 33; Goldsmith, R. W. A Study of Saving in the United States. (Princeton: Princeton University Press, 1955), 62-65.

  47. Goldsmith, A Study of Saving, 63; Mansfield, Historical Reports, 57

  48. Harris, Price and Related Controls, 267; Galbraith, A Life in Our Times, 171; Mansfield Historical Reports, 44-45

  49. Harris, Price and Related Controls, 27

  50. Galbraith, A Theory of Price Control, 258

  51. Truman, H. S. Executive Order 9599. (August 18, 1945). Retrieved April 30, 2017.

  52. Rockoff, Drastic Measures, 99

  53. Truman, H. S. Memoirs of Harry S. Truman. Vol. I: Year of Decisions 1945. (London: Hodder and Stoughton, 1955), 423-424.

  54. Rockoff, Drastic Measures, 101

  55. Kalecki, M. Inflationary and Deflationary Tendencies, 1946–1948. (New York:United Nations Department of Economic Affairs, 1949), 38.

  56. Kalecki, Inflationary and Deflationary Tendencies, 39

  57. Kalecki, Inflationary and Deflationary Tendencies, 40

  58. Hibbs, D. A. “On the Political Economy of Long-Run Trends in Strike Activity,”British Journal of Political Sciences, 1976, 160; Richter, I., and D. Montgomery. Labor’s Struggles, 1945–1950: A Participant’s View. (Cambridge: Cambridge University Press, 1994), 48-50.

  59. Rockoff, Drastic Measures, 109

  60. Hahn, F. “Reflections on the Invisible Hand,” in Fred Hirsch Memorial Lecture. University of Warwick. 


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