Economic Environment - Dealing with Price Spirals

When he took office in 1985, Peruvian President Alan Garcia ordered controls on the price of rice, sugar and other goods to try to keep those staples within reach of the poor. But when shortages continued and a black market arose, five years later, his presidency was dissolved in a spiral of hyperinflation.

Peru is not alone in facing spiralling prices. From Argentina and Venezuela to Russia, China and Thailand, governments are meeting the challenge of rising food prices by imposing price controls – fixing prices below market level – hoping to ease the burden on their populations and avoid social unrest. But history shows that such measures do not reverse price trends – they can end up having the opposite effect.

The current round of rising food prices began since 2001, and last year, the situation collided with sharply higher oil prices, forcing many governments to look for quick fixes. The quickest, easiest and most popular are price controls.

In China, where inflation is at an 11-year high, authorities introduced controls on a range of goods from instant noodles to milk, calling it a temporary intervention to battle “unreasonable price hikes”. It was the first time in over a decade that Beijing waded into the food market.
In Thailand, the government is taking similar steps on instant noodles and cooking oil, and in Russia, authorities are trying to cap prices of bread, eggs and milk. In Mexico, the government is trying to control the price of tortillas after protests there, and Venezuela is capping prices on staples including milk and sugar. So far, the World Bank has found 21 countries exercising controls on strategic staples.

Economists warn that price controls and other interventions can lead to market distortions because they have the effect of discouraging domestic production, processing and trade, and ultimately reducing supply. By dampening the underlying causes of inflation, price controls prevent market solutions, these experts say. Already, some countries are finding this to be true.
Argentina, which imposed an export tax on grains, in addition to controls on domestic food prices, has been shaken by nationwide protests by farmers. Meanwhile, Malaysia is reviewing controls on 21 food items, including milk, salt, wheat flour and rice, because they have led to severe shortages and smuggling.

According to experts, controls are only likely to work where staple foods are a small share of total household spending, or when controls are implemented for a very short time, such as in Morocco over the Ramadan period. If price controls are kept too long, odds increase for a precipitous and destabilizing jump in prices.

In poor countries, where food makes up a large share of what people buy, a general increase in food prices has a bigger impact. While price controls may be seen as a tempting quick fix, there is little proof that they have worked to dampen inflation.

"The historical experience is that price control rarely works for very long," said David Orden, a senior research fellow at the International Food Policy Research Institute.

"For developing countries relying on food imports, it becomes very expensive to the government." Countries with limited fiscal resources resort to printing money, which in turn creates inflation.

In 1971, US President Nixon imposed a 90-day freeze on wages and prices to tame inflation. The 90-day freeze turned into nearly 1,000 days and when the wage and price controls were mostly dismantled by April 1974, US inflation had exceeded 10%. "Governments need to take focused action, with direct subsidies for the poor rather than the whole country," said World Bank economist Don Mitchell. Mitchell argues that food assistance for poor people (so transferring income) will work more efficiently and sustainably than more general steps at the national level.

"In general we don't like price controls," IMF chief economist Simon Johnson said. The key to dealing with higher prices is to tackle the problem with targeted income transfers programs, steering away from country-wide subsidies or unpredictable trade policies.

Re-elected 20 years after his first term in office, Peru's Garcia has drawn on past experience and rejected price controls. He is focusing this time on tighter monetary policy to control inflation. "Prices of basic products are rising – gas, oil, corn, chicken and bread," Garcia told a local radio station. "This is what the people feel, and I understand that, but there is no miracle I can perform to force the world to lower prices."

Adapted from an article
by Lesley Wroughton, REUTERS Reprinted by the Standard, April, 2008