Thursday, September 20, 2007

Controlling China's Inflation

China's inflation rate has increasing, and recently hit 6.5%- the highest level in 10 years. The mainland Government has responded to inflation in the past by gradually increasing interest rates in small increments, with limited success. But now it's bringing out the big guns. From today's South China Morning Post....

"Beijing has issued price-control measures for consumer products, which include a freeze on prices.... the government would not change any of the prices of products and services it controlled for the rest of the year. The government administers a vast array of prices, including those for land, transport, utilities and fuel."

It then goes on, more ominously, to reccommend....

".... price-monitoring systems for food, electricity and medicine, and an emergency response system to address any big price fluctuations..... [L]ocal governments should increase minimum wages as soon as possible to make up for inflation."

Let's boil down the problem of increasing inflation to its elementary economic components. Ultimately, any increase in prices is due to a mis-match between supply and demand. At existing prices, demand exceeds supply across a wide range of goods and services, so producers respond by raising their prices, to maximise their profits. But price increases will likely lead to demands for higher wages, as workers seek to maintain their real wages, which firms will in turn pass on to consumers via higher prices, causing a wage-price spiral.

The government's solution to this problem is to try to limit this process by preventing price rises across the range of goods and services whose prices they control. By definition, they may be able to control these prices, but this is a small front in the overall battle against inflation. And ultimately price controls are futile in this battle.

Price controls are nothing new, but they have never been very successful. Even the United States had price controls over the 1971-1973 period, and while the inflation rate fell from 6% to 3-4% over during the freeze, it shot up to 11% in 1974 when the price controls were removed. That's because the fundamental source of inflation had not been addressed.

So that's one black mark against price controls: they fail to work, except in the short run. But there's another more fundamental reasons to dislike price controls. They cause the price system to break down.

When we as consumers decide what we'd like to consume, the price provides an important input into our decision making process. We tend to skimp on high priced goods, but consume relatively more of low priced goods. Because the prices reflect the resource costs of providing the goods, this is efficient. Our consumption decisions reflect the fundamental cost of providing goods and services, reducing resource wastage in the economy.

Now the Government decides to delink the price from the cost of provision across a range of goods and services. Rational consumers will respond by consuming more of these relatively cheap goods and services. The government will need to respond to this increase in demand by stepping up supply- even though it may be making a loss on each unit of output that it is now providing. Thus valuable resources will need to be diverted from some alternative use to increasing the supply of the price controlled goods.

The alternative is that the goverment fails to increase the supply of price-controlled goods, and instead allows demand to outstrip supply. The end result of this would be shortages, and the likely establishment of black markets where the goods are sold at their true economic value, away from government control.

So if price controls are futile, what can the Government do to try to lower the inflation rate in Mainland China? Ultimately they need to lower the demand for goods in the economy. That requires that the economy cool off, and the break-neck rate of economic growth slow.

The appropriate channels for achieving the required economic slowdown are what we would label a "contractionary monetary policy"- for example, raising interest rates abruptly, by more than the increase in inflation, to ensure that real interest rates rise. Or allowing the currency to appreciate more quickly, so that foreign demand for domestic goods slows, and and domestic demand for foreign goods (which are now cheaper) increases. These steps would deal with the fundamental imblance in the Mainland economy, and ensure that demand moves back into line with supply.

The alternative- a partial price freeze- is like a partial stop bank in the path of a swollen river. Yes it might keep the water out for a while, but ultimately it just won't work.

For my earlier take on price level targeting in China, see here.

See also this column by Thomas Palley in the Guardian.

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