A gas price cap reduces inflation, right? Wrong!

Consequences of artificially reduced energy prices / #27

Today we do some serious economics. Because the topic is serious. It's about the two most significant economic issues these days: energy prices (mainly gas) and (as a result) high inflation.

Politicians in many countries (including Germany) are attempting to lower gas prices for consumers. The intention is to alleviate financial hardship and curb inflation.

At least the latter will not happen with this measure. Although the gas price cap will reduce the consumer gas price, it will not curb inflation. Sounds counterintuitive, but that's how it is.

Here is why.

The idea of the gas price cap is to lower the price for consumers. What the price cap can't do is reduce the price of the gas itself. The resource is bought on the world markets; if you don't pay the world market price, you simply won't get any gas.

Simple insight number one: The gas price cap does not reduce actual gas prices. Instead, the state takes over parts of the gas price, so consumers and companies have to pay less (see chart above).

This leads us to an essential question in this context: How is inflation actually measured? In most cases, consumer prices are used to construct an inflation index. In other words, the prices are taken from what customers pay at checkout. Statistical authorities (in Germany, it is the Federal Statistical Office) put together a fictitious basket of goods and services and compare the costs of this basket over time. If the overall price of the shopping basket rises, this is called inflation; if the price falls, this is called deflation.

The point here is that final consumer prices are not the only prices that arise in an economy. There are, for example, prices for real estate, financial investments and (already mentioned) producer prices. 

So, inflation indices can be applied to many different markets. The one for consumer prices is the most common because these prices affect everyone's life and also because the vital producer prices are generally reflected in the consumer prices. Unless the state implements a price cap. Then inflation does exist, but it is less noticeable.

One could argue that it is OK if we do not notice inflation. But that's wrong. Inflation is just the indicator of a problem – namely, high prices in certain markets.

As a consequence, with unseen inflation, purchasing power decreases anyway because we, as a society, have to spend larger parts of our wealth on gas; it is just noticed less because the state bears these additional costs (which we then have to pay later in the form of higher taxes).

But it's not only that we lose purchasing power (which is another definition of inflation); such price caps themselves drive inflation. 

Why this is the case becomes clear when we remember what inflation is at its core: it reflects the development of prices over time in markets.

And those market prices in turn reflect shortages. If prices rise, there can essentially be two reasons: demand has increased, or supply has fallen. Conversely, if you want to (as a politician) lower prices (which means fighting inflation), you have two levers: You can help expand supply or support demand to fall.

While the gas price cap does not affect supply (the producer price remains untouched), the cap prevents demand falling as much as it would if consumers and companies had to pay the (higher) producer price.

In economic terms: the gas price cap gives the wrong price signal. With two negative consequences. Firstly, less gas will be substituted by other energy sources. Secondly, less energy will be saved. 

But why, as claimed above, does a gas price cap heat up inflation?

Since the demand for gas is slowed down less, the price at the producer level will be higher than without the gas price cap. So the actual inflation increases due to the state intervention.

But inflation is fueled for a second reason. 

The gas price cap is financed with additional government debt. These debts will have to be repaid. For this, taxes will have to rise. Higher taxes mean higher prices. The gas price cap thus increases inflation in the future. As a rule, expectations about future prices already flow into pricing today. So, today's borrowing by the state tends to increase today's inflation.

Conclusion: The gas price cap can alleviate financial hardship (especially if it helps those who are hit particularly hard by high gas prices), but it does not fight inflation. On the contrary. To curb inflation, the gas supply must be increased and/or demand reduced. Since the first is hardly possible in the short run, we must reduce gas demand. Only that helps in the short term against high energy prices and thus against inflation. 

Onwards, 
Johannes Eber

PS, did I promise too much? A really heavy economics topic, right? ;-)