Forget price controls, Mr Wen. They won't help fight inflation

PUBLISHED : Thursday, 18 November, 2010, 12:00am
UPDATED : Thursday, 18 November, 2010, 12:00am

Wen Jiabao is worried about mounting inflation, and he thinks he's got a solution to the problem. His government is threatening to prohibit price rises for a range of key goods and services, probably including staple foods, household utilities and public transport fares.

What a simple solution. It makes you wonder why we don't all do the same. If we don't like something, we should just ban it.

Don't like waiting? Ban queues.

Don't like getting out of bed? Ban mornings.

Don't like inflation? Ban price rises.

By now you will have spotted the flaw in Wen's plan. Just as you can't cut waiting times simply by banning queues, so you can't prevent inflation just by slapping on price controls. At best you will simply shift the problem somewhere else.

To see why price controls don't work, consider China's coal mining sector. For years Beijing operated strict controls on the price of coal. The idea was simple enough: by keeping the price of coal low Beijing would supply cheap energy to the country's manufacturers, giving Chinese products a competitive advantage in global markets and helping to power rapid economic growth.

The trouble was that by artificially holding down the price of coal, Beijing cut into the profitability of China's mines, which reduced incentives to invest in the mining industry.

While China's manufacturing industries developed by leaps and bounds, much of its coal sector remained in the dark ages. The results were the energy shortages and disruptions which have plagued the Chinese economy over recent years and the country's appalling mine safety record. Between 2000 and 2006, one Chinese miner was killed for every 250,000 tonnes of coal produced. In South Africa the fatality rate was one death for every 12.5 million tonnes.

Clearly, price controls can carry a morbidly heavy cost. Undeterred, Beijing is now proposing a fresh set of restrictions.

With the official consumer price inflation rate now at 4.4 per cent thanks to food price inflation hitting double digits (please see the first chart below), the government is likely to slap controls on a range of basic foods. On past form, the authorities will require wholesalers of foods like rice, noodles, cooking oils and sugar to apply for official permission to raise their prices. They could extend the ban to vegetables, eggs, chicken and pork, although with those markets much more fragmented, enforcement would be tricky.

To understand why the controls would fail, imagine that you are a farmer. You naturally want to sell your produce at the best market price that you can get. If the government dictates that you can only sell at a lower price, you are likely to do one of several things. First, you could sell on the black market for considerably more than the official price. Second, you could hoard your produce until the price controls are relaxed. Or third, you could decide that farming is an unrewarding business, and chuck it in for a job in the city, where you know incomes have gone up by 20 per cent or more this year.

Now consider the consequences in each case. In the first, black market prices for food shoot up and inflation continues unabated, although it may not show up in the official figures.

And in the second and third cases you get supply disruptions, either because of hoarding or because farmers are quitting the business. Either way the results are shortages, long queues for staple foods and possible outbreaks of unrest.

In short, you can't fight inflation with price controls. Rising prices are caused by the underlying dynamics of supply and demand, and you can't get around those by fixing prices and hope to get away with it. Either the price rises will continue, or you will get supply shortages.

If the Chinese authorities doubt that, they only need look back at their own recent experience. Spooked by rising inflation in January 2008, Beijing slapped price controls on a range of foodstuffs. Prices carried on rising, however, shooting up by 17 per cent over the next two months.

Eventually, that bout of inflation was brought to an end by a combination of easing supply constraints in the food market - notably as the epidemic of blue-ear disease in pigs abated - aggressive interest rate increases, and the bursting of the international commodity price bubble as the financial crisis deepened.

This time around it is hard to blame food inflation on supply factors. Prices in China are rising because of what Societe Generale strategist Dylan Grice termed 'the greatest credit inflation in financial history' - the 10 trillion yuan explosion in bank lending last year which in turn propelled a 30 per cent expansion in China's money supply (see the second chart below).

When your money supply expands that much faster than your economy, the natural result tends to be runaway inflation, whether you impose price controls or not.



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