You can't defeat inflation by banning price rises

PUBLISHED : Monday, 09 May, 2011, 12:00am
UPDATED : Monday, 09 May, 2011, 12:00am


China's powerful National Development and Reform Commission has slapped consumer goods company Unilever with a hefty fine for warning its customers that it may have to raise prices.

You can follow the NDRC's thinking here. Premier Wen Jiabao has told Chinese officials that their No 1 policy objective this year is to put a lid on inflation. And when you are fighting inflation, dampening people's expectations of future price rises is half the battle.

If people think prices are going to go up, they will bring forward their planned purchases, buying sooner rather than later. The extra buying adds to demand, which amplifies the upward pressure on prices. If not checked, inflation expectations become a self-fulfilling prophecy.

It's a lesson Chinese officials have learned from bitter history. In 1988, expectations of future price rises prompted people to embark on a buying binge that stripped shop shelves of many essentials and pushed inflation to double-digit rates. The result was a swelling tide of popular discontent that led eventually to the Tiananmen Square demonstrations the following year and their suppression.

It's a pattern the current generation of mainland leaders are resolved not to copy. In their efforts to quash people's expectations of higher prices, officials from Wen downwards have repeatedly declared their determination to do everything necessary to defeat inflation. That includes ordering companies - including multi-nationals like Unilever - not to raise prices, and slapping them down vigorously when they warn customers that they may have no choice in the matter.

Unfortunately for Wen and the rest of his crowd, there is a problem here. Telling companies not to raise prices doesn't work. You can no more defeat inflation by prohibiting price rises than you can cut waiting times by banning queues.

Mainland officials should know this by now. Over the years they have tried to control the prices of a whole range of goods, and their efforts have always backfired.

Consider coal. For years Beijing had strict controls on the price of coal to supply cheap energy to the country's factories. The idea was to give Chinese products a competitive advantage in global markets, powering rapid economic growth.

But by holding down the price of coal, Beijing cut into the profitability of China's mines, reducing incentives to invest in the mining industry.

While manufacturing industries developed by leaps and bounds, China's coal sector remained in the dark ages.

The results were persistent energy shortages and the country's appalling safety record, with fatality rates 50 times as high as in South African coal mines.

The lesson is clear: you can't fight inflation with price controls. If you set prices artificially low, you merely encourage black-market trading and hoarding. Either that or you push suppliers out of the market because they can no longer make a decent profit.

Either way, prices continue to rise - although the increases may not show up in official figures - or you end up with shortages in supply. Inflation continues unabated and consumer expectations of future price rises are undented.

If you really want to get a grip on inflation, either you must increase supply - not advisable in China where investment is already running out of control - or you must rein in demand by discouraging people going out and spending.

That wouldn't be too difficult. The obvious way to discourage spending in China would be to raise the interest rate on bank deposits to well above the rate of inflation, which would provide people with an incentive to save their money rather than to spend it.

Of course the trouble here is that Beijing wants to boost consumer spending as a proportion of economic activity, not discourage it.

And there's the rub: Beijing's main economic objectives - to control inflation and to boost consumer spending - are fundamentally contradictory. The government can do one, or the other, but not both.

Slapping Unilever with a 2 million yuan fine won't change that.