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Raising Prices to Curb Inflation

The deputy chairman of the Planning Commission made an extraordinary statement the other day, namely that the oil-price increase, which everybody opposes for adding to inflation, was really an anti-inflationary measure; it would reduce inflation.  The deputy chairman’s is an exalted position; and the current incumbent is an economist of repute.  There is a danger therefore, especially given our feudal ethos where a proposition is taken to be true if propounded by an exalted person, that the economics taught to our students will soon come to incorporate the rule that if inflation is to be curbed then prices must be raised.  Such an eventuality must be prevented, for the deputy chairman’s argument, as reported in the press, can be faulted with regard to its coherence, consistency, and appositeness.

It states that the rise in petro-product prices would “suck liquidity” from the economy which would help to reduce inflation.  But since the sellers of petro-products are not “outside” the economy, a rise in their prices only means that more money is transferred from the buyers to sellers than would have happened otherwise; it does not mean money getting “sucked out of the economy”.  Even if we assume, momentarily for argument’s sake, that the economy excludes the sellers of petro-products, if they spend the money they have supposedly sucked out, then it again goes back into the economy.  So the argument is really about spending, not about money getting “sucked out”.

What a rectified version of it would state is that if the extra “money” that comes into the hands of these sellers of petro-products does not get spent, then the real expenditure of the sellers would have remained unchanged while that of the buyers would have shrunk (since they would have reduced spending elsewhere to buy petro-products at higher prices), resulting in an overall lowering of expenditure; if inflation was caused by excess demand in the economy then this lowering of expenditure helps to eliminate it.  (And if inflation was not caused by excess demand, then in a modern capitalist economy where the supply of money and its substitutes adjust to the demand for them, no amount of “sucking out of money” as such would curb it anyway.)

A moment’s reflection however would show that any increase in prices, ie, inflation itself, if caused by excess demand, does what is being attributed to the petro-price hike.  If it is caused by excess demand, it also eliminates excess demand.  It does so by shifting purchasing power from some, whose loss of purchasing power reduces their demand, to others whose gain in purchasing power does not increase their demand.  The former must be persons, whose incomes do not rise with prices; the latter must be those whose expenditures do not rise with incomes even as their incomes rise with prices.  In short, inflation squeezes the working people whose incomes are not price-indexed, and benefits the profit earners, whose incomes rise with prices.

It follows that such inflation is self-limiting, as long as some people have fixed money incomes, and the beneficiaries of inflation have lower propensities to spend out of extra income than the losers.  If for instance the level of money wages is kept constant, then any excess-demand inflation will automatically come to an end (provided the propensity to spend out of profits is less than out of wages, which is likely).  All talk of “sucking out liquidity” is irrelevant: to say that the petro-product price hike would bring inflation to an end is no different from saying that inflation would bring itself to an end.

The point of inflation-control however is not to bring inflation to an end in this way, but in some other way where the working people with money incomes not indexed to prices (which includes the overwhelming bulk of the Indian population) are not made to suffer.  The idea in short is for the government to intervene deliberately to reduce the demand of some other, better-off, groups in the economy, so that excess demand is resolved not through an inflationary squeeze on the poor, but precisely by warding off such an inflationary squeeze, ie, by ensuring that prices do not rise relative to the money incomes of the working people.  The petro-product price hike in the case of excess-demand inflation therefore would not amount to controlling inflation; it would constitute inflation.  It would be doing precisely what inflation does, and precisely what any government worth its salt should be avoiding.

The question arises: can excess-demand inflation be warded off by reducing some other element of demand?  And here we come to the inconsistency of the argument.  An obvious way of reducing the demand of some other, more affluent, group, so that excess demand in the economy does not have to be resolved through inflation, ie through squeezing the living conditions of the working people, is by direct taxation.  And nobody can claim that there exists no scope for raising direct tax revenue: on the contrary the government has been lowering direct tax revenue through such massive concessions to the corporate sector that even their partial reversal will do away with the need for raising petro-product prices.  In fact even now such partial reversal can finance a roll-back in these prices.

Even if we accept, for a moment for argument’s sake, the deputy chairman’s proposition that “sucking out of liquidity” from the economy helps combat inflation, it can occur as much through direct taxation as through a petro-product price-hike.  The proceeds of such taxation will accrue to the government whose expenditure however need not increase, in which case “liquidity has been sucked out of the economy” and a blow has been struck against inflation.  In other words, the petro-product price-hike is not the only way for dealing with inflation; there are other ways as well, even going by the logic of the deputy chairman.  The real issue is which way an excess-demand inflation should be controlled: by letting it run its own course and squeezing the working people in the process (or imitating through administered price-hikes what would spontaneously occur anyway), or by restricting it through larger direct taxation and squeezing the demand of the more affluent sections of the population.

Finally, we come to the inappositeness of the argument.  The current inflation in India is by no means a domestic excess-demand inflation.  No significant supply constraints underlie it, not even in the case of foodgrains, where substantial stocks still exist with the government, and where there is much talk of a good harvest, from which further stocks can be garnered.  Inflation at present is a world-wide phenomenon, caused by a combination of oil price increase, and substantial diversion of foodgrains for energy production in response to it, which, superimposed on a long-term decline in world per capita foodgrain output, has caused acute food shortage and rise in food prices.  The third world is a special victim of it.  Controlling inflation in the Indian economy requires not a curbing of aggregate domestic demand, but an insulation from world food price trends, domestic supply management of foodgrains, and a curb on the supply price of food by keeping energy costs low, which entails not passing on the increase in world oil prices.

So far we have discussed the deputy chairman’s argument.  A similar defence of the petro-product price hike has been mounted by other government spokesmen, but using a different argument: if the petro-product price-hike had not occurred then the government’s fiscal deficit would have increased for covering the “losses” of the oil companies.  And since fiscal deficits accentuate inflation and curbing such deficits is a means of reducing inflation, the petro-product price hike which is meant to do precisely this is ipso facto anti-inflationary.

In fact the oil companies are not making any “losses”, contrary to the impression usually conveyed; but let us ignore that for the moment.  What is relevant is that the prices of all petro-products, net of local input and labour costs, consist of three components: the price of the imported crude, the profits of oil companies, and the taxes of the government levied at various stages.  And if the profits of the oil companies and the government’s tax revenue are not to shrink, then any rise in the international price of crude must be “passed on” in the form of higher petro-product prices to the domestic buyers.

Here again we have the implicit assumption that there are only two ways of financing government expenditure: commodity taxation and borrowing (fiscal deficit).  If as the import price of crude goes up, the petro-product prices are not raised, but the profits of the oil companies are protected by a lowering of commodity taxation in this sector, which is made up by direct taxation elsewhere, then there need be no increase in the fiscal deficit.

Interestingly, the deputy chairman’s argument goes against the fiscal deficit argument.  The presumption underlying his argument for raising petro-product prices is that the oil companies, when they get extra profits, do not raise their expenditures.  If this is correct, then the presumption that a fiscal deficit adds to aggregate demand need not hold.  If the government did not raise petro-product prices, but simply handed over resources to the oil companies in the form of claims upon itself, then the fiscal deficit would increase no doubt, but would not add to aggregate demand immediately.  Expenditure out of such claims could even be calibrated in a manner that made the increase in demand (when such expenditure did occur) manageable.  We have had Compulsory Deposit Schemes (out of DA payments) in the past; and there is no reason why oil companies cannot be asked to show the restraint that government employees have done earlier, in which case the claim that petro-product prices must be raised to prevent increasing the fiscal deficit becomes even more untenable.

Indeed this particular argument for raising petro-product prices, namely that in its absence the fiscal deficit would rise and worsen inflation, reminds one of that famous Japanese film where a father kills his children because he is afraid that they would be killed in a nuclear holocaust.


Prabhat Patnaik is a Marxist economist in India.  This article was first published in People’s Democracy on 17 July 2011; it is reproduced here for non-profit educational purposes.


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