Counter-productive way of dealing with inflation?price control

September 25th, 2007

Share |

As we all know, price inflation in China is getting more and more serious as the days go by. In the year to August, the official price inflation rate hit 6.5%. Our long time readers should be clear on why this is happening?see Why is China printing so much money? and Cause of inflation: Shanghai bubble case study. But recently, China is trying something very foolish in an attempt to control price inflation.

Price controls!

As this article, Inflation in China builds up steam says,

THERE is not an economist in China who thinks Premier Wen Jiabao can stop inflation by telling power utilities, petrol stations and even salt vendors to freeze their prices until next year.

How can you possible control price inflation by imposing price controls when you are, at the same time, printing money like there’s no tomorrow? We believe such folly will end up doing more harm than good.

To help you see why, imagine you are making a living by making and selling cakes. As price inflation roars ahead, you find that your input costs (e.g. eggs and flour) rise. Therefore, the only way for you to remain in business is to raise the selling price of your cakes. Now, what happens if the government decreed that you are not allowed to raise the price of your cakes? Initially, you may be able to remain in business by reducing your costs through degrading the quality or size of your cakes. But eventually, if this decree is not revoked, you will go out of business.

Now, extend this scenario to the rest of the economy and what will you get? Widespread layoffs and business failures! This will then result in lower aggregate production, unemployment, lower profits and so on. In the end, the economy will suffer.

In an economy, prices tells us how to allocate limited resources to satisfy unlimited wants. Once you meddle with prices, the economy loses this vital piece of information. For example, if the price of petrol is rising, it tells producers that there’s money to be made by digging out more oil. It also tells consumers they should curtail their demand for oil by being more frugal in their use of petrol. Once you impose price controls on petrol, producers will not produce more and consumers will continue to consume more. What will happen then? Shortages! In this example, thanks to government intervention, the market fails!

It does not take a genius to work out that price controls AND printing money is a great recipe for stuffing up the economy.