Inflation: Why didn’t we think of it before?

The United Kingdom government will cap energy prices paid by households, which have risen after supply cuts from Russia. Apparently, a goal, if not The The aim (since households would otherwise have simply been subsidized to cushion the shock), is to reduce the rate of inflation (see “UK Government to Cap Household Energy Prices for Two Years,” The Wall Street JournalSeptember 8, 2022):

The move aims to prevent inflation from rising even faster in a country that is already the highest among Western nations at 10.1%.

If inflation can be reduced by capping the prices of some goods, capping all prices will eliminate inflation. Why didn’t we think of it before?

The drawback is that tapping into a (relative) price – for example, the price of natural gas – will do nothing to reduce it. Inflation, which is an increase in all prices Regardless of price movements relative to each other. Perhaps the confusion comes from the fact that measures of inflation (the consumer price index or other similar indicators) must, of course, rely on observations of real prices, which include both inflation and relative price changes. A price change equals its change relative to other prices and inflation, which, to repeat, general The price level (see my post “Inflation Basics”).

Another way to clear the confusion is as follows. Suppose there was no inflation. The Russian government cutting off 40% of gas supplies to Europe would result in roughly the same increase in gas prices as we are seeing now. This increase will be compensated by an equivalent decrease in other prices because people will have to buy less other goods and services so that their consumption of gas or gas-derived products is not too high. (Technically, this approach is informed by the monetarist theory of inflation and the general-equilibrium theory in which changes in relative prices result from a move along the production possibilities frontier.)

My argument is only that the price cap will not only hide inflation, which is quite obvious. This is because price caps interfere with relative price changes, which are essential for transmitting price signals about relative scarcity in the economy and, thus, essential for economic efficiency. A price cap (say, gas) whose increase would signal increased scarcity of the corresponding commodity would have two effects: it would change the statistical estimate of inflation, but without changing underlying inflation at all; And This will mess with gas prices relative to other commodities. Gas shortages will not decrease, as shortages or government subsidies to producers will show. But the cap would obscure the precise signal of the new scarcity, encouraging more consumption and less production without subsidies—that is, it would prevent an efficient adaptation to the new situation.

This is why “we”, i.e. Western governments and most economists, do not usually think of reducing inflation through price fixing, let alone some price constraints. Ignoring it will have dire political and economic consequences. (Incidentally, some governors, such as President Richard Nixon in the early 1970s, considered controlling inflation through economy-wide price controls and failed: see Hugh Rockoff, Austerity: A History of Wage and Price Control in the United States [Cambridge University Press, 1984].)

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