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Fight Inflation With Price Subsidies

Persistent inflation is crushing American families. Combating the problem with subsides is the best way to lower prices and improve the economy.

 

The cost of living just keeps going up.


As previously covered, the high inflation that began in the second half of 2021 has continued to spike the price of essentially everything. The most recent CPI report confirmed annual inflation remained over 8%—an improvement from earlier in the year, but still significant. The energy sector has led inflation this year, with gasoline, electricity, and utility gas seeing dramatic increases. Energy products were responsible for almost half of overall inflation from earlier this year. Food products, shelter, and vehicles have also continued to rise sharply, and core inflation is becoming entrenched. Americans increasingly need to cut back spending and sacrifice more luxuries and even necessities—especially since some of the biggest price hikes are in the most essential goods. This situation is untenable.


The causes of this inflationary period are mostly the same, with one new addition. Supply chains are still disrupted, and it appears that earlier forecasts that they would balance out in 2022 were too optimistic. Since global supply chains are so complex, it's hard to give an exact reason why they are taking so long to return to normal. The international scope of supply lines makes them prone to disruption if any one region experiences problems—the worldwide effects of China’s coronavirus shutdown earlier this year displayed this issue. In recent decades, companies have also developed “just-in time” supply chains, where they keep very little inventory on hand, so any delays from suppliers result in big problems for production. When everyone experiences this disruption, the issues grow exponentially because everyone has to restock at the same time. Any volatility in supply chains reverberates for a while because all the steps in the chain have to reorganize production every time there is a change. Low inventories lead to more production orders, which then turns into an oversupply of products when inventories fill up. Overstocked inventories force companies to liquidate and stop purchases, which hurts the revenues of production companies, which further disorganizes the supply chain. And if any company in the supply chain doesn’t estimate supply and demand correctly, their failure will then hold up production farther down the chain. Overall, our economy is built on fragile systems that did not handle a global catastrophe well.


Corporate profiteering is still raising prices. Markups, the increase of selling price over production cost, reached an all-time high in the period April through June 2022 (the most recent period where data is available). This means companies are raising prices far beyond what they need to cover expenses and creating the biggest profit margins on record. Focusing on energy, OPEC, a global oil cartel of oil-exporting countries, ended its 2-year agreement to suppress oil production in April. This global accord, brokered by the Trump administration, was a deal to cut worldwide crude production by around 10%—to end the price war between Russia and Saudi Arabia and counter plummeting oil prices in early 2020. Even with the deal expired, the worldwide oil cartel is still slow-walking increases to production because high prices are good for business.


The one new addition is the war in Ukraine. In response to the invasion, countries around the world placed sanctions on Russia. These sanctions inhibited Russian exports, especially oil and gas. Some countries, like the US, banned the import of Russian oil entirely. Since Russia supplies 13.1% of all the oil in the world, these global sanctions have created a significant shortage. Because energy is the predominant reason why inflation continues to be so high, it is safe to say that this war-imposed shortage is causing a great deal of inflation. Fighting has also made it more difficult for Ukrainians to export commodities like grain, which is raising global food prices.


Inflation has already done tremendous damage to people's finances, and every month it continues makes it more entrenched and harder to dissipate, since firms build continual price hikes into their business plans: making inflation a self-fulfilling prophecy. The time is now to fight inflation with stronger measures.


Congress recently tried its hand at fixing the problem with the Inflation Reduction Act. While the bill is anti-inflationary, its effects are very moderate and long-term in nature—not very applicable to the acute problems right now. So far, the main government entity combating inflation is the Federal Reserve. Their two main policies are rate hikes and quantitative tightening. The Fed can raise interest rates across the economy by selling short-term bonds, which means banks and investment firms pay cash to the Fed for these bonds. By draining cash from the financial sector, the Fed reduces the supply of funds that financial firms can loan out. A lower supply of loanable funds means a higher price for the funds—in other words, higher interest rates (prices) for loans. In the overall economy, higher rates mean companies borrow less to expand their businesses and consumers take on less debt to buy things like cars and houses. When you add this all together, higher rates lead to less demand for goods and services, less demand leads to less bidding up of prices, and less bidding leads to lower inflation. Quantitative tightening is a similar policy. It is the reverse of quantitative easing, in which the Fed buys longer-term securities than it normally does, adding cash to the financial sector and encouraging more lending and spending. Tightening is the selling of these long-term securities, which again takes cash out of the financial system. Since earlier this year, the Fed has been pursuing both of these policies, and its short-term interest rate hikes are getting more aggressive over time.


Certainly, the Fed needs to raise interest rates. Holding interest rates low is untenable for a high-inflation environment, and rate hikes will bring some relief. Unfortunately, the tools that the Fed has available are simply not sufficient to deal with these economic circumstances. The Federal Reserve's policies mainly affect demand—the decisions of consumers and businesses to spend money. However, much of our current problems come from the supply side, not the demand side of the economy. Supply chain management will not magically resolve itself if people stop spending. Certainly less demand will alleviate certain shortages, but this creates gluts further up the supply chain as intermediaries get stuck with goods they cannot sell anymore. This creates more headaches for organizing supply lines and disrupts existing relationships between businesses as they scramble to find new partners, which breaks supply chains further. In the past few months, we have seen this supply glut play out in some manufactured goods markets. The results have been more disruption and little change in price. Lowering demand also fails to fully correct for problems of market manipulation and price gouging. While firms that sell luxuries or non-essential items will lose some leverage as the buyers dry up, monopolists in essential industries like food or energy will maintain their edge since no one can afford to not purchase from them. Raising rates will definitely help, but it will not be a silver bullet. The oil and gas shortage brought on by the war in Ukraine is an especially persistent supply-side issue. This is not a traditional form of inflation. It was not caused by a general bidding up of prices by buyers; it was caused by a sudden drop in supply by sellers when sanctions and fighting began. Irrespective of how much gasoline a consumer buys, there will still be this shortage.


While any of the above problems are manageable individually, the main point is that they add up to a choke of supply, not an overheating of demand. Consequently, the Fed’s plan to use its demand-crushing policies is misdirected and far too destructive. To bring down supply-side inflation of this magnitude through rate hikes would require a massive decrease in demand—massive enough to cause a severe recession. The impact on unemployment and wages would be disastrous. This isn't hypothetical either. The last time the Federal Reserve tried to solve a situation like ours was in the late 1970s and early 1980s. After a decade of stagflation—a period of low or negative economic growth and high inflation—the central bank’s last resort was to completely crash demand in the economy to lower prices. Inflation was defeated, but the pay and standard of living for millions of people fell or stagnated for decades afterwards. The reason is simple. Lowering demand in the economy lowers prices by decreasing the purchases of goods and services. Strictly, this decrease is an economic downturn. It makes sense in a demand-side inflationary environment because demand is already too high and can be brought down without crushing the economy. In a supply-side inflationary environment however, the economy is already struggling and purchases are already limited by people's inability to pay for high prices. Lowering demand from this point creates a significant downturn, and that was what happened in the ‘70s and ‘80s.


While a similar recession today would likely be milder, it will still be immensely harmful to already-struggling families. Unfortunately, we have created an economic management system that functions almost exclusively through these demand-side interventions. The Federal Reserve can only work through sorts of policies, which is why Congress and President Biden must step in with a new, supply-side solution: price subsidies.


In this plan, Congress would authorize the executive branch to subsidize certain energy commodities, such as gasoline, diesel, or utility gas. The White House would then negotiate with suppliers for a lower price, and the reduction would be covered by the subsidies. An unsubsidized price control, such as simply capping the retail price of gasoline, would encourage firms to sell less gas because they cannot cover the costs of purchasing wholesale gasoline or the intermediate products that eventually become gas. Subsidizing the price reduction means firms won't lose revenue and reduce their supply. The subsidies could be funded by increasing income taxes on wealthy households—essentially, the reverse of Trump’s tax cuts for the rich.


The benefits would be immediately apparent. As soon as the subsidies took effect, gas prices and utility bills would decrease. People's everyday lives would instantly become cheaper. Since energy is an input in all businesses, lower energy prices would reverberate across the economy and lower costs everywhere. The cost of living would steadily decrease. These highly-visible improvements would improve consumer sentiment, which in turn would improve business sentiment and encourage firms to maintain or expand their businesses. Fighting inflation through the supply-side would lower prices while expanding the economy—not destroying it. Additionally, higher taxes on rich households would curb their consumer spending. This is a demand-reducing policy in a much more targeted and fair way—the costs would be borne by the wealthy instead of the working class. Congress could even raise the taxes on wealthy households beyond what is needed to cover the cost of subsidies, which would reduce the federal deficit and income inequality. These outcomes would also alleviate inflationary pressures.


There is historical precedent for this policy. In the 1960s, when inflation started to tick upward, both the Kennedy and Johnson administrations engaged in loosely organized price control negotiations. Through tacit agreements with large corporations and labor unions, the presidents enforced limits to price increases by firms and wage demands from workers. Nixon, for a few years, continued a variation of these agreements. When the price controls were in place, inflation was constrained to a more manageable level, and it was only after the policies were abandoned that the extreme inflation of the 1970s took over. This history shows us that price subsidies are a viable option. With actual monetary compensation for firms, they can be even more effective than the handshake agreements of the ‘60s. Since the causes of the current inflation are much more temporary than in the ‘60s and ‘70s, price subsidies are more likely to help us through the crisis while supply chains sort themselves out and the economy stabilizes.


While price subsidies are a superior policy to rate hikes, there are some limitations. Firstly, a lower price for a good means more people will want to buy it. If prices were subsidized too low or too quickly, there might be shortages of the subsidized items. The scenes of the ‘70s where cars would line up endlessly for a small quantity of gas could repeat. To combat this, the subsidies need to be phased in gradually and stay within a certain range of the market price. Some degree of shortage is almost inevitable, but at the end of the day people will save money under this plan, if not time. People are already reducing their consumption, but under the free-market solution they lose on both quantity and price. Under subsidies they only lose on quantity. Secondly, distorting prices has harmful long-term effects. Prices are an essential signal in a market economy for consumers and businesses. For buyers, it allows them to weigh how much they want a certain product vs. what it costs society to produce that item, creating an efficient use of economic resources. Conversely, prices are a signal to businesses as to what is in demand and what they should invest in producing; higher prices also create the incentive for production because they mean higher revenue. Over the long-term, subsidized prices spur underinvestment in affected industries, because there is less revenue and incentive to fund capital expenditures. These subsidies need to be temporary and limited to the current problem, so Congress should have them automatically expire after a set period, such as six months or a year. Given the general inaction of Congress, creating a situation where they have to proactively vote to reauthorize it means it probably won't happen, so we will guarantee the subsidies are temporary.


Like any economic policy, price subsidies would come with potential side effects, but strong action is necessary to combat the very real problems in the cost of living right now. This supply-side policy is much more suited to our situation than traditional Fed actions, and it will cause much less harm to the average American. We are living in unprecedented times, and we need unprecedented actions to match. Price subsidies are the best path forward.


Kevin Sciackitano is a fourth-year Economics major in the College of Arts and Sciences. They are the Editor-In-Chief for the American Agora.


Image courtesy Walmart, Creative Commons.