Ep53 “The Truth About Inflation and Price Caps: Learn From Argentina” with Veronica Rappoport

Price Caps and Inflation

• The concept of price caps as a means to control inflation is not new, but it has been met with skepticism by some experts, including Jules van Binsbergen and Jonathan, who believe that it is not an effective solution based on theory and empirical evidence (41s).
• The proposal to impose price caps to control inflation is not a new idea, and if one applies the scientific method to this question, it becomes clear that this approach has not worked in the past (1m8s).
• Inflation is a complex issue, and simply capping prices does not address the underlying causes of inflation, which can lead to unintended consequences (1m49s).

Understanding Inflation

• There are two types of inflation, and in normal times, many developed economies target an inflation rate of around 2% per year, which means that prices increase by 2% annually (2m36s).
• The target inflation rate of 2% is considered a good number because deflation, or a decrease in prices, is often seen as worse than inflation, and targeting 0% inflation may not be desirable (3m26s).
• A stable 2% inflation rate, such as the one experienced in the US between 1985 and 2020, is generally not a cause for concern, and most people do not seem to mind it (3m49s).

Hyperinflation and Government Spending

• The discussion will also touch on the example of Argentina, which experienced hyperinflation, to illustrate why price caps are not an effective solution to control inflation (2m26s).
• In developed economies, inflation does not seem to have a significant distortionary effect, and everything functions normally, but this is not the case for developing economies experiencing hyperinflation, where people are tempted to turn to price caps (4m12s).
• Hyperinflation is often caused by governments financing their expenditures by inflating the currency, essentially by printing money, which is equivalent to taxing the population (5m27s).
• Government expenditure must come from human beings, either through current taxpayers via taxes, future taxpayers via government borrowing, or by printing money, which is a way of taxing the population through inflation (5m22s).
• The idea that printing money can finance all deficits without problems ignores the fact that real resources available for government programs are limited, and these resources must come from somewhere, ultimately from taxpayers (5m57s).
• There is no free lunch, and financing government expenditure by printing money and putting price caps is impossible, as something has to give, either in the form of shortages or a black market (6m33s).

Consequences of Price Caps

• Price caps can lead to two outcomes: either they are enforced, resulting in shortages, or they are not enforced, resulting in a black market where prices are determined anyway (6m47s).
• An example of the failure of price caps is the story of Michael Sandel, who described how, after Hurricane Katrina hit New Orleans, the government tried to fix the shortage of drinkable water by putting a price cap on it, but this led to the water being bought up by a small number of people and sold on the black market for a high price (7m5s).
• Increasing the supply of goods can help reduce the impact of inflation, as seen in the United States during the recent inflationary episode when supply chain disruptions were resolved, which helped bring inflation back down (8m24s).

Argentina's Inflationary History

• Argentina has suffered from high inflation over the longest period of time, making it a relevant case study for understanding inflation (8m37s).
• Veronica Rappoport, a professor at the London School of Economics and former Deputy Governor at the Central Bank of Argentina, attributes Argentina's inflation issues to a structural fiscal problem, with the country running a primary deficit almost every year from 1970 to 2020 (9m24s).
• This structural fiscal problem led to a loss of market confidence, causing the government to rely on the Central Bank to sustain the fiscal deficit by printing money, which ultimately resulted in inflation (9m54s).

Lessons for the US

• The US can learn from Argentina's experience, particularly the importance of not relying on theories that are too extreme and being aware of the potential consequences of running a primary deficit (10m32s).
• While the US has a larger economy that can absorb more debt, no country can permanently run a primary deficit without stimulating inflation if investors do not want to fund the deficit and the government has no alternative but to sell debt to the central bank (11m27s).
• Veronica Rappoport emphasizes that even the US cannot permanently run a primary deficit without consequences, and that eventually, investors may not want to fund the deficit, leading to inflation (11m39s).
• Countries have two options to manage debt: running a primary surplus to repay debt or using inflation to repay debt, as countries rarely pay off debt and instead allow it to grow or become unsustainable, which can deter investors from holding it (12m2s).
• In the case of Argentina, the debt is perceived as unsustainable due to its short-term and unstable nature, as well as the country's history of not paying back debt when investors withdraw (12m30s).
• Unlike the US, Argentina's debt is not perceived as sustainable, and the country's history of not paying back debt when investors run away contributes to this perception (12m41s).

Manipulating Inflation Statistics

• In Argentina, there is a discrepancy between different measures of inflation, including real-time measures and official statistics, which led to efforts to improve inflation measurement (13m3s).
• One naive approach to dealing with inflation in Argentina was manipulating statistics, where the government intervened in the statistics department and fabricated numbers for the inflation rate (13m40s).
• The government's intention behind manipulating inflation numbers was to convince people that their experiences with inflation were not real, anchor expectations, and reduce government debt payments indexed to the price index (13m53s).
• However, this approach backfired, as people in Argentina became skilled at computing their own inflation rates and measuring inflation expectations, often surpassing the knowledge of the statistics department (14m26s).

Price Controls and Their Effects

• Another approach used in Argentina was implementing price controls, targeting goods with high weight in the price index, but this had varying consequences, including shortages and detrimental effects (14m54s).
• Price controls can have different effects, ranging from short-term effects to no effect or even detrimental effects, such as shortages, and Argentina's experience with price controls was not as severe as Venezuela's (15m16s).
• In Argentina, price controls resulted in monitored prices and agreements between the government and large food companies, but this did not lead to severe shortages like in Venezuela (16m1s).
• Implementing price ceilings on basic product lines can initially increase sales, but prices often jump after the ceiling is removed, having little effect on inflation (16m22s).
• Transitory subsidies to reduce price increases can be difficult to remove and may lead to significant distortions, such as those experienced in Argentina with utility prices (17m11s).
• The removal of subsidies to control inflation can be complicated, as it may lead to short-term inflation, making it challenging for central banks to communicate their actions and maintain credibility (18m7s).

Political Challenges and Short-Term Solutions

• Price controls have a poor historical track record, yet politicians often resort to them during inflationary periods, possibly due to the painful alternative of cutting fiscal positions or the temptation to tell "fairy tales" to voters (19m0s).
• Price controls often include fiscal subsidies, which can be difficult to remove, as seen in European countries' responses to the Russian invasion of Ukraine, where energy price subsidies were implemented (19m40s).
• It may be more effective to help people with cash rather than subsidies, as removing subsidies can be challenging, especially with populist governments and election cycles (19m59s).
• Reducing or removing subsidies can lead to deficits, and governments may need to make difficult decisions, such as reducing investments in utilities or energy (20m22s).
• Implementing price caps may seem like a solution to keep prices down, but it can lead to long-term distortions in prices, high government expenditure on subsidies, or underinvestment in essential sectors like energy and renewables (20m33s).
• Politicians often face difficulties in making decisions that may have negative short-term consequences, even if they are beneficial in the long run, due to their limited decision horizon (21m10s).
• A politician's horizon and decision-making process differ from a larger economic long-term plan, making it challenging to implement policies that balance short-term and long-term goals (21m42s).
• When designing transitory policies, it is essential to include a clear exit strategy to avoid unintended consequences (22m1s).

Argentina's Current Economic Situation

• Argentina's new president has created a stir globally, and despite initial pessimism, he has managed to reduce the fiscal deficit and lower inflation rates, although the country still faces challenges like a 3.5% drop in GDP (22m12s).
• The president's efforts to combat inflation have been successful, with inflation rates decreasing from a peak, but still remaining high at 3% per month (22m54s).
• The economic situation in Argentina has been tough, but people are willing to give the president a chance to implement reforms and eventually overcome inflation (23m37s).
• A joke told by President Macri at Stanford illustrates the risks of government over-intervention in the economy, using the analogy of a government building multiple bridges, eventually leading to the creation of a Department of Water to make rivers (23m43s).
• Argentina's economy is far from a free market, with many distortions that are being addressed with additional distortions, making it difficult to implement a solution (24m33s).
• The country's economic situation is a result of too many government programs and distortions, which could be improved by removing some of these distortions and making adjustments (25m5s).

All Else Equal Podcast

• Veronica Rappoport is being interviewed on the "All Else Equal" podcast, discussing topics such as inflation and price caps, and sharing her expertise (25m16s).
• The podcast is a joint production of the LA Institute at the University of Pennsylvania and The Graduate School of Business at Stanford University, and is produced by University FM (25m49s).
• Listeners are encouraged to leave a review on Apple Podcasts and subscribe to the show to catch future episodes (25m28s).
• More information and episodes of the podcast can be found on the "All Else Equal" podcast website or by following the show on LinkedIn (25m42s).