Why price controls won't help Chinese inflation

Today is a holiday in China, although for the poor kids spending the last of three days taking the dreaded gaokao, China’s college entrance exam, I am sure it feels like anything but a holiday. Of around 18-20 million kids born in the same year, about 10.5 million will be sitting for the exam, and just under 6 million of them will go on to attend 2-year or 4-year college. For the past three years – and for an especially grueling final year, during which time kids spend almost no time at all doing anything besides studying – their whole educational system has prepared them for this three day period.

The three days is almost as tough for the anxious parents waiting outside the schools as it is for the kids inside. An awful lot rides on the results they achieve in the gaokao, not just whether they go to university, but also which university, and China has an extremely hierarchical university system. Two schools, Tsinghua University and Peking University – schools almost impossibly difficult to get into – represent the absolute pinnacle of the educational hierarchy. A second group, including Fudan and Jiaotong in Shanghai, Zhejiang University in Hangzhou, Nanjing University, Nankai University in Tianjin, University of Science and Technology in Hefei, and Renmin (People’s) University in Beijing, represent China’s “Ivy League”. To get into any of these schools marks you for success.

In China just getting into a top school is not the end of the story. The gaokao can even determine what a student’s major will be since, within each university, every school sets its own minimum required score, and students often choose a major by selecting the school or major with the highest minimum score lower than theirs. The pressure on the kids during these three days is intense and far too many of them believe (they have been told this over and over again) that the rest of their lives will depend on how well they will have done in the past three days.

Still, it is officially a holiday, the stock market is closed, and not a whole lot seems to have happened in the financial and monetary front, at least publicly, since the jump in minimum reserve requirement Saturday night. Most of us are waiting for the CPI numbers to come out this week, and I have already been invited Thursday to join a current events television program to discuss the numbers as soon as they come out (although unfortunately I will be traveling that day). To summarize the results for the year:

Two different readers did ask me by email to explain what I meant when I said in yesterday’s blog entry that the government’s forcing down prices of a number of energy and food products was “conceptually the same as increasing the money supply.”

The point I was trying to make is similar to why I believe the fact that most of China’s CPI inflation can be accounted for by food-price increases does not mean that Chinese inflation is a too-little-pork problem. Basically, rising food prices absorb demand. If China had a monetary policy consistent with low inflation, there would not have been a huge increase in net demand, and so the surge in food prices would have absorbed so much demand that there would have been downward pressure on the prices of non-food goods and services. There hasn’t been downward pressure, so I concluded that China’s monetary policy was consistent with a significant increase in demand – i.e. it was inflationary.

The flip side is true about price controls. Normally, rising energy prices should absorb demand for other goods, as households spend more money on energy. If the price of energy is kept artificially low, however, rising energy prices will not absorb as much demand as they should, and so excess demand will simply show up elsewhere, and cause greater inflation there. When the problem is too much money, in other words, price freezes do not reduce inflation – they simply shift it elsewhere (and I am ignoring the many other costs associated with price freezes).

In case my horrible explanation fails to explain, let me put it another way. Let us assume that we are in a non-inflationary environment. If the government were suddenly to announce that they were cutting the money supply in half and also cutting prices of every good and service in half, there would be (ignoring all the other enormous problems caused by this bizarre announcement) no subsequent inflation. Prices would stabilize at the new level.

If, however, the government simply announced that prices for every good and service would be cut in half, and that there would be no change to the money supply, China’s money supply would suddenly become twice as large as the economy needed, and the result would be inflation to the point where prices rose on average by 100% – to re-establish the non-inflationary relationship between the money supply and the size of the economy. This is because after the announcement the very large amount of money relative to goods and services would create excess demand that would drive prices up until supply and demand were once again in balance.

Pushing prices down without changing the amount of money in the system, then, causes subsequent inflation in the same way that increasing the money supply without simultaneously raising prices would. If the government holds down artificially the prices of certain goods, this has the same impact. It reduces the amount households would have to pay for those goods, thus releasing their excess demand for other goods and services. Total inflation is the same, but it is redistributed (very inefficiently, by the way).