Why price controls are the best response to soaring gas prices

Inflation in the United States and the United Kingdom has reached its highest rate in decades, matching the rise in prices in much of the developed world over the past year. Surprising increases in specific goods and services, such as gas in the UK, have previously been attributed to aftershocks from the first year of Covid as economies reopened. But with inflation remaining stubbornly high, claims that rising prices are just a transitory problem are clearly false. Instead, we are entering the early years of a new world of high inflation and limited supply that conventional economics and economic policy will struggle to manage.

Two conventional explanations can be ruled out. Money supply growth has been explosive over the past decade as major central banks have turned to quantitative easing (QE) to support their economies after the financial crisis. QE involves the central bank issuing huge new amounts of electronic money, which it then uses to buy assets – usually government bonds. The Bank of England has now issued £895bn of new money via QE since 2009.

Crude economic theory suggests that issuing money like this should lead to disastrous inflation, as more money in circulation drives out the same supply of goods and services, driving up prices. But although some specific asset prices, such as US stocks, have risen, prices in general over the past decade have at various times risen sharply, remained fairly flat, or even fallen. There is no obvious and stable relationship between inflation and money supply growth.

The belief that inflation is due to rising wages is also not empirically supported. The theory here claims that rising prices will cause workers to demand wage increases, raising costs for suppliers and thus forcing them to raise prices even higher in the dreaded “wage-price spiral.” But it is obvious that price inflation today has little or nothing to do with rising wages. Prices rose in many different sectors of the economy last year, but in the United States and the United Kingdom there was no clear relationship between price increases and wage increases in a given sector. In the United States, certain sectors of the economy, such as motor vehicle manufacturing, have seen strong increases in consumer prices, but very little change in wages. Others, like nursing, have even seen their wages rise and prices fall.

Instead, the inflation we see today emerges as a result of ecological degradation. Almost every week brings news of new environmental calamities, from bushfires to record high temperatures. These have a direct impact on supply, from coffee (hit by exceptional droughts in Brazil) to semiconductor chips (hit by droughts in Taiwan and wildfires in Texas). Insurer SwissRe has estimated the global cost of extreme weather over the past year at $250 billion, a 24% increase from 2020, itself well above the ten-year average cost. Our environmental prediction models indicate that these ecological shocks will only worsen over time.

Usually, we think that one-off supply shocks have only a limited impact on broad inflation. If there is a shortage of a good or service it may be a temporary annoyance, but it is usually possible to buy something different and invest in increasing the supply of the affected product over time. time. The supply shock hits the market, pushing prices up, then gradually fades, leaving little impact on inflation.

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There are a few commodities that are so ubiquitous that rising prices could induce more general inflation. Oil is the most obvious example, changes in its price having an impact on the whole economy and thus rapidly changing the rate of inflation. In general, however, no good or service is so important that it dominates everything. But if these supply shocks continue to occur in different markets – whether due to floods, fires or epidemics – the cumulative impact will be to drive prices up and then keep them there. .

Our current set of inflation-fighting policy tools will become increasingly redundant. The classic monetary policy response is to raise interest rates to make borrowing more expensive and thus reduce demand. It is, at best, unnecessary. As Bank of England Governor Andrew Bailey has pointed out, “monetary policy will not increase the supply of semiconductor chips, it will not increase the amount of wind…and it will not nor will it produce truck drivers”. Rising interest rates will make investment more expensive, reducing the likely future supply of goods and services: if we invest less today, we can generally expect less output in the future.

Worse still, raising the interest rate in erroneous response to complex environmental shocks and shortages only reinforces the impact of these shocks on demand without necessarily altering their effects on prices. As the demand for goods and services declines, employers’ demand for labor may also decline. “Stagflation” – rising unemployment as well as rising inflation – would be the result. Monetary policy should, on the contrary, adapt to shocks by keeping interest rates low and credit readily available.

But conventional fiscal policy won’t work either. Reducing government spending in the face of repeated supply shocks will be similar to raising interest rates: compressing employment without doing much for prices. US Treasury Secretary Janet Yellen’s push to promote the “modern supply-side economy” – directing investment into shortage industries, such as energy and semiconductors – makes much more sense. But its impact will only be felt in the future.

The ideal policy in response to repeated environmental shocks is one that conventional economics has tended to scoff at, but which is emerging as common sense: price controls. A recent paper in Econometrica shows that a market with price controls may provide a more efficient way to allocate goods and services when inequality is high than a free market alongside government transfers. Indeed, at high levels of inequality, taxing the very rich is easier said than done. The authors demonstrate that in these circumstances, fixing or regulating the price may be a preferable solution.

Price caps in UK domestic gas markets correspond to this situation, and the authors themselves note that rent caps and minimum wages can work in a similar way. All three regulate the price of a specific good or service under conditions of high inequality, effecting redistribution through the regulated price to low-income consumers, and thus achieving a more efficient allocation of resources than a pure price mechanism. This is not an argument for general price controls, but regulating certain goods or services in response to specific shocks may make sense. The Treasury would consider a mechanism for the gas market that would work in this direction.

We live in highly unequal economies battered by environmental calamities. If the goal is to provide security against such shocks, and to do so fairly for all, specific and targeted controls are the right approach.

[See also: Why inflation could break Britain]

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James V. Hayes