Commodity prices - what happens when governments do Jesus cosplay?
You don’t need to search hard these days to find incoherence in government policy. In his first year in office, US President Joe Biden has stamped a boot on the domestic oil industry (the Keystone XL pipeline ban and elsewhere) while simultaneously begging OPEC and others to pump more oil to keep prices down.
In little England, fish and chips have got just that bit more expensive with the British government imposing a 35% tariff on imports of Russian white fish. Quite how this defeats the Russian bear is not clear, but it certainly makes Friday night’s tea a little dearer. At the same time, the government has delayed a ban on 2-for-1 offers on unhealthy food (part of the war on obesity) to help families struggling with the cost of living. Joined-up thinking 101.
For the first time in forty years, politicians in the West are facing the problem of proper inflation. Not the 2% penny-ante stuff that central banks target, but the real thing. Non-monetary inflation from supply shocks (war, pandemic lockdowns, de-globalisation, and the energy transition) as well as monetary inflation from the monstrous government deficit spending of 2020-1 which was monetised by the central banks.
Something must be done. While not limited to the pandemic, government in the developed world has long been enticed by a period of falling inflation and low interest rates, in part abetted by central bank policy, to think not only that they should intervene but also they can do so without consequence since the financing cost for government spending is so low. This is the basic argument underpinning modern monetary theory (MMT). Spend until you get inflation, then raise taxes or tighten monetary policy to curb demand - that’s the plan, at least on paper.
The issue is that the inflationary problems have to a large extent been caused by government action, not just in the last few years but prior to the Covid-19 pandemic. War is a choice, de-globalisation is a choice, the lockdowns were a tough choice but a choice nonetheless and so on. Even Trump’s 2018 tax cuts, creating a Federal government deficit of 5% when unemployment was at historic lows and with US GDP growing at a 3% annualised clip, were a choice. The term in medicine that describes this is iatrogenic illness, one actually caused by the doctor (the ancient Greek for doctor is ὁ ἰατρός). We now want the same folk to sort the problem they caused.
Inflation isn’t just a number, it’s also a mindset. Monetary inflation implies a decline in the spending power of money. Non-monetary inflation comes from supply shocks for the most part. We have both, but people notice it in terms of the price they pay for stuff. The graph below shows US Henry Hub natural gas prices surging. The US has $7 gas (petrol to non-Americans) and an emerging diesel shortage which will further inflate food prices due to higher transport costs. Europe, the UK and Japan all face similar if not more serious challenges.
Developed world governments in which the ‘something must be done’ mentality has become almost institutionally ingrained have started reacting in the usual way - subsidies. Scottish Enlightenment philosopher David Hume was sceptical of miracles, saying he’d never seen one or met anyone who had (he didn’t spend much time in the Vatican), and he would likely be sceptical of governments borrowing and printing money to bring down the price of commodities which are both in short supply and also whose price is already on the rise due to the debasement of money from all that Covid-related deficit spending. You can print money but you can’t print commodities. That’s why you should leave the loaves and fishes stuff to Jesus.
In economic terms, subsidies maintain demand in an economy when normally higher prices reduce demand. This perpetuates and heightens inflation rather than reducing it, a process abetted if the currency falls in value (in the international markets) if the government finances the subsidies through deficit spending. In this situation, higher prices aren’t the cure for higher prices, and given the ongoing hostility towards the oil and gas sector, it seems unlikely that higher prices will spur further investment and production in the energy sector which is the usual means by which commodity supply comes back into balance with demand. Energy prices and supply issues remain the key concern.
Price caps simply do not work. The story from Germany on residential rent caps is instructive. Landlords, unable to make a profit because the rents they can charge are capped, historically under-invested in both the upkeep of existing properties (which made tenants’ lives rubbish) as well as in new housing stock, causing a shortage. The lesson is clear - meddling in supply and demand factors to effect a particular outcome usually has bad consequences.
The other knee-jerk reaction from governments tends to be the windfall tax. US Senator Elizabeth Warren has been particularly vociferous about oil company profits in recent months (she was notably silent on their losses when oil was negative $40 per barrel in April 2020…), but it’s not just in America where the super-tax drum beat is sounding in the deep.
In the UK, it is power generators as well as oil companies which seem to be heading towards the imposition of a windfall tax, whatever the ideological opposition that seems to be coming from No. 10 Downing Street.
A £10b figure is mentioned in a front-page article in the Financial Times (‘Big power generators in Sunak’s sights for widened windfall tax', 24/05/2022, FT Link). What the casual FT reader (can there be such a thing?) might miss is the corresponding article tucked away on page 10 where the CEO of Harbour Energy discusses the wider consequences of windfall taxes (‘Harbour boss sounds alarm over windfall tax threats’, 24/05/2022, FT Link). CEO Linda Cook is quoted as saying:
“A higher tax burden will make it more challenging for new oil and gas projects to meet investment hurdle rates, meaning fewer projects will be sanctioned. This is at a time when industry is being encouraged to increase domestic UK oil and gas production and support an orderly energy transition.”
Once again, headline-grabbing statements on the green transition and ending the reliance on Russian energy imports bely a totally incoherent approach to medium- and long-term energy policy which will mean, in the short-term at least, higher energy prices for consumers, which in turn means higher inflation, which means more intervention. This is one of the routes you get to stagflation. A cursory glance at the British governments’ record of industrial intervention in the 1970s (google British Leyland to start with) will tell you how successful this heavy-handed approach is likely to be.
Is it possible to get out of this cycle? Central banks will have a very tough time hiking rates enough to destroy demand without risking either the job market, the bond and credit markets, or both. It is questionable whether interest-rate policy (a demand-side tool) is in fact the right one for what is partially a supply-side problem. Aside from that, it seems unlikely that governments will want to stop meddling any time soon. Only a currency crisis or a revolt in the bond market would stop that.
The thing to watch for now is the de-anchoring of inflation expectations, something which often accompanies a wage-price spiral as workers demand to be paid more to offset the cost of inflation while perpetuating that inflation by their own wage demands. This is the point at which inflation becomes a thing - something which gets its own personality and which seems to have its own anima (as it did in Weimar Germany or in 1970s America). It then tends to last until it has burnt itself out, regardless of what we try to do about it.