Inflation: Why Didn’t We Think of That Before?

The government of the United Kingdom will cap energy prices paid by households, which have jumped following the reduction of supplies from Russia. Apparently, one goal, if not the goal (since households could have been simply subsidized to dampen the shock), is to reduce the rate of inflation (see “U.K. Government to Cap Household Energy Prices for Two Years,” Wall Street Journal, September 8, 2022):

The move is aimed at preventing inflation from rising even faster in a country that already has the highest rate among Western nations at 10.1%.

If inflation can be reduced by price caps on a few goods, capping all prices would eliminate inflation. Why didn’t we think of that before?

The error is that tapping one (relative) price—for example, the price of natural gas—will do nothing to reduce inflation, which is an increase in all prices irrespective of the movement of prices relative to each other. Perhaps the confusion comes from the fact that the measure of inflation (the Consumer Price Index or other similar indexes) must, of necessity, rely on the observation of actual prices, which incorporate both inflation and changes in relative prices. A change in a price is equal to its change relative to other prices plus inflation, the latter being, to repeat, a change in the general price level (see my post “The Elementary Basics of Inflation”).

Another way to clear the confusion is the following. Suppose there were no inflation. The elimination by the Russian government of 40% of the gas supply in Europe would result in roughly the same increase in gas prices as we now see. The current rate of inflation, about 10%, is tiny compared by the recent increase in the European gas price of as much as 1000%. Without a cap, the jump in the price of gas would be compensated by a reduction of other prices as people would want to buy fewer other goods and services in order not to reduce too much their consumption of gas or gas-produced goods. (Technically, this approach is informed by the monetarist theory of inflation and by general-equilibrium theories where changes in relative prices come from a move along the production possibility frontier.)

My argument is not only that price caps will merely hide inflation, which is pretty obvious. It is that price caps interfere with the change in relative prices, which is essential to the transmission of price signals regarding relative scarcities in the economy and, thus, essential to economic efficiency. Capping a price (say, gas) whose increase would have signaled an increased scarcity of the related good will have two efects: it will modify the statistical estimate of inflation, but without changing the underlying inflation at all; and it will mess with the price of gas relative to other goods.  Gas will remain no less scarce, as shortages or the need of government subsidies to producers will show. But the cap will blur the correct signaling of the new scarcity, encouraging more consumption and, without subsidies, less production of the scarcer good—that is, it will prevent an efficient adaptation to the new situation.

This is why “we,” meaning Western governments and most economists, do not generally think about reducing inflation by capping prices, let alone by capping only a few prices. Ignoring this will have dire economic and political consequences. (Incidentally, a few rulers, like president Richard Nixon in the early 1970s, did think of controlling inflation with economy-wide price controls, and failed: see Hugh Rockoff, Drastic Measures: A History of Wage and Price Controls in the United States [Cambridge University Press, 1984], even if this author does not agree with all my argument.)