The European Union has moved forward with price caps on its purchases of natural gas from Russia. After having said no to the price-cap idea in March, and after disagreements among EU energy ministers as recently as early September, the EU has proposed a price ceiling as part of yet another sanctions package against Russia.
Back in June, the G7 countries—some of the world’s wealthiest industrialized economies—discussed a similar price ceiling on purchases of Russian oil. Now the price-cap idea is getting global traction. The United Nations Conference on Development and Trade, UNCTAD, makes a passionate case for price caps: in their 2022 issue of their Trade and Development Report, they propose enforced price ceilings on more than energy products.
There are extreme situations where price controls are necessary, but as I will explain below, they do not work as general policy measures against inflation. Yet that is precisely how the UNCTAD report pitches its price controls: as an alternative to inflation-busting monetary conservatism. The report even tries to suggest the case that monetary conservatism failed to end stagflation four decades ago.
In reality, monetary conservatism was a key element of the policy package that allowed North American and European governments to break the vicious circle of stagflation. Yet the UNCTAD report eagerly tries to dissuade central banks from continuing their current monetary tightening. Rising interest rates, they claim, “could push the world economy into a deeper recession” followed by “a long stagnation” period.
It would be easy to dismiss the UNCTAD report as a case of bad macroeconomics, but since its recommendations of price controls coincide with similar proposals from the EU, and since UNCTAD’s alternative policies would actually exacerbate inflation, it is essential to examine both their macroeconomic reasoning and their price-cap idea. This article takes on the latter; a follow-up piece will address the former.
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After about a dozen different points about how higher interest rates are harmful to economies—including praising inflation for having made real interest rates negative—the UNCTAD report calls on governments around the world to “avoid an undue reliance on monetary tightening.” Their alternative is a system of controls of product prices and corporate mark-ups on their own products. These measures, which the report calls “paramount” (p. 31), are presented as a serious policy recommendation to governments around the world.
Again, price controls can be necessary under extreme circumstances. But inflation per se is not an extreme circumstance, and the reach of the proposed price controls is so vast, so general in nature, that it defies any confinement to the extreme.
As a general policy measure, price controls would work against inflation if, and only if, their absence was the cause of inflation. Yet inflation is not caused by the mere absence of price controls—hence they are not a solution to the problem.
Ironically, the UNCTAD report essentially admits as much. Its authors do not seem to be aware of this, but when they present their own theory of why we have inflation, they fail to list the “absence of price controls” among the causes. As they see it, we have inflation because:
- There was a pandemic;
- The pandemic shut down a lot of things;
- After the pandemic, a lot of things opened again;
- When a lot of things opened, prices went up.
This is a better attempt at explaining inflation than blaming it on ‘no price controls,’ but it is still an inaccurate explanation. The supply-chain problems in the aftermath of the pandemic are not to blame for our current inflation, simply because the supply-chain problems have no real economic explanation. The productive capital and infrastructure that were operational before the pandemic were still there after the pandemic.
What kept the economy from returning to pre-pandemic operations was primarily work-discouraging government policies. Logic therefore dictates that we solve remaining supply-chain problems by rolling back said policies.
It is also worth noting that we are now almost two years out of the pandemic itself. If the inflation problem had been solely about bottleneck effects in global supply of, e.g., food and minerals, then a private sector unhindered by government would have solved those problems by now.
Again: the world’s productive capacity did not vanish during the brief (and partial) shutdown in 2020.
As if knowing that their supply-chain argument is insufficient, the UNCTAD report also suggests that financial speculation in commodities is a reason for high inflation. Using their own report from 2011 as a reference, the authors of the 2022 report propose that speculators on so-called derivatives markets for commodities contribute to inflation in commodities prices.
Their search for a cause of inflation is in vain. From circa 1985 to 2019, financial speculation in commodities markets exploded all over the world. But for more than three decades, the inflation that the UNCTAD report blames on said speculation was nowhere to be found.
Despite the apparent flaws in their report, UNCTAD insists that generally applied “price and markup controls” are effective policy tools against inflation. To see why they are not, we are going to use some very basic terms and analysis tools from microeconomics. We start with the simple illustration of a market where supply meets demand, a price is established and a quantity of the good or the service is exchanged:
The supply curve slopes upward because the cost of producing more of the product increases with volume. In terms of natural gas, this cost increase originates from the need to drill new wells, in transportation capacity reaching its peak (which includes pipelines), and in hiring more workers.
An increase in production or transportation capacity, e.g., the opening of new wells and new pipelines, shifts the supply curve down and to the right. Every unit, measured in, e.g., cubic feet, is now produced at a lower price than before. Likewise, the loss of production or distribution capacity (someone blows up a pipeline) raises the unit price, i.e., shifts the supply curve up and to the left.
The demand curve slopes downward for equally obvious reasons: we energy consumers have a limited budget, which means that if we are going to buy more energy, we need to see the price fall first. If our income rises, we can buy more of the same product at any given price, hence the demand curve shifts up and to the right; a loss of income has the opposite effect.
We can use this simple model to represent the European market for Russian natural gas. Let us see what happens when the EU introduces a price cap.
There are essentially two types of price caps, the first of which applies to the wholesale market for energy. This market, where power companies buy fuel—in this case, natural gas—to produce electricity, is the one that the EU wants to target with its price cap.
The other type of cap applies to the retail market, or the market where power companies sell to households and businesses. We start with the wholesale cap, then move to the retail market.
One morning, EU Commission President Ursula von der Leyen wakes up with an urge to call Moscow:
Ursula: “Hey, Vlad, how are you?”
Vlad: “Good, thanks. How are you?”
Ursula: “We have new sanctions for you. We are not going to pay you more than P for your natural gas—you don’t mind, do you?”
Vlad: “Let me think about it.”
Figure 1 (above) illustrates Ursula’s idea. The P price is lower than the free-market price, or else there would be no point with the price cap:
When Vlad has thought about it, he calls Ursula back and tells her that he will only be able to deliver QS (Figure 2) amounts of natural gas to the European Union.
Ursula: “But we need more natural gas than that! We need QD! It’s getting cold here.”
Vlad: “It’s pretty cold in Siberia, too.”
Next, Vlad calls Narendra, his buddy the Prime Minister of India:
Vlad: “Hey, Nari, how are you?”
Nari: “Nice and warm here in New Delhi.”
Vlad: “Want to buy some extra natural gas?”
Nari: “Sure, why not?”
As it happens, Vlad’s buddy in Beijing hears about the available gas and promises good money for it. When Ursula calls back again …
Ursula: “Hey, Vlad, we really need all that natural gas I want, at the price I dictated.”
Vlad: “Sorry, but I’ve got so many good offers from others that you’re going to have to pay an even higher price.”
The rise in prices for Russian natural gas for markets other than the European effectively works like a cost increase on gas delivered to Europe. If Russia is going to continue to sell natural gas to Europe, they not only have to pay the cost of producing and transporting the gas, but also compensate for the profit they could have made, had they sold it to India or China instead.
This profit compensation works as a per-unit increase in the price of natural gas. Or, in the technical terms of Figure 3, the supply curve S1:
Europe now ends up with only Q1 amounts of natural gas from Russia, far less than the QS they were offered before the better-paying options opened up, and way below the QD they need.
This is, of course, a theoretical scenario. The actual fallout of the price cap depends in part on the contractual situation between seller and buyer. However, no contract is immune to the forces of the free market.
Hopefully, Ursula wakes up the next morning and changes her mind: no price cap on the wholesale market. But she still wants to do good, and what better way to do that than to introduce a price cap on the retail market?
As it happens, California tried this back in the late ’90s. They combined free-market prices on wholesale energy while putting a cap on how much power companies could charge their customers for electricity. As Charli Coons with the Heritage Foundation explained back in 2001:
Stuck between the rock of the governor’s control on retail rates and the hard canon of supply and demand in the wholesale electricity markets, California’s two largest utilities bore the brunt of the price differential and promptly became insolvent.
To be fair, it is common for utilities, or power companies, to sell electricity at managed prices, such as a fixed rate for a certain period of time. This is helpful, especially for households and small businesses with limited financial margins, but it creates a problem for the power company. The energy they buy on the wholesale market is subject to market prices, which can vary significantly over the course of a year.
Normally, power companies can manage this without any real problems. With the help of statistical models, they can predict price fluctuations in the wholesale market and set less flexible retail prices at a level that expectably balances their cash flow over, e.g., a year.
In Figure 4 below, P1 represents the fixed retail price that allows the power company to balance its expected cash flow. P2, on the other hand, is the result of government intervention:
If the EU enforced a price cap of this type, it would do to the European energy industry what the price cap in California did to their energy industry.
Price caps are recommendable only under extreme circumstances, and not as a general measure to combat inflation. Hopefully, cooler minds will prevail in Brussels, before the EU does even more well-intended harm to the European economy.