In a world of overlapping emergencies, more shocks are sure to come. Policymakers need to be prepared to react before the next one unleashes widespread inflation again. Interest rate hikes are not the answer

At the end of 2021, The Guardian published one of my first newspaper commentaries, in which I criticised the rush to use interest-rates hikes to combat inflation and reminded my readers of the history of a long-neglected alternative: strategic, targeted price controls. At the time, this was judged to be an act of heresy.

The history of price stabilisation goes back centuries, from the mists of classical China (my own research focus) to the major crises of the past century: World War II, the Korean War, and the stagflation of the 1970s in the United States. In each case, price-stabilisation policies served as emergency measures aimed not just at “fighting inflation,” but at doing so in a fair and socially stabilising manner. Their primary purpose was to attack profiteering (from wars, famines, and disasters) head-on. They have tended to work in highly concentrated markets, and when implemented before inflation spirals out of control, while performing poorly otherwise. And when carried out in democratic societies, through a mobilisation of the population behind a common project of price restraint, they have been massively popular – especially when weighed against the alternative of austerity.

But by late 2021, that history had dropped out of the common sense of economics. My intervention hit a nerve. Right-wing and libertarian social media erupted in fury, and even many liberal and progressive economists found strong words to reject my intervention. At the University of Chicago, students received an exam asking what a “real economist” would say about price controls. To my detractors, a company’s right to set any price that it can get away with (“whatever the market will bear”) was sacrosanct. Price hikes had to be endured if we wanted them to go away sooner rather than later. If a policy response was warranted, the only way to address rapid price increases was either to wait it out or impose high interest rates, even though these ultimately would crush small businesses, workers, and indebted households. “There is no alternative” – or so they said.

From theory to practice

In February 2022, my colleague, Sebastian Dullien, and I set out to establish that there are indeed feasible alternatives to macroeconomic tightening. We proposed a fiscally financed price cap on basic household consumption that would preserve market prices at the margins. This led to another round of criticism from economists. But our proposal also received strong endorsements from a wide range of interest groups.

Fast forward to September 2022, when I found myself appointed to a German government commission charged with designing a price-stabilisation policy to address the energy crisis following Russia’s invasion of Ukraine. There, we developed the so-called “gas-price brake,” and the key principles that I had been advocating were subsequently enshrined in German law.

Germany is not alone in implementing a price policy. Across Europe (and in the United Kingdom), governments have implemented various forms of price controls to contain the war’s fallout in global energy markets. The European Union has enacted a gas-price cap, the G7 has imposed a price ceiling on imported Russian oil, and the US government has leaned on the price of oil by releasing supply from its Strategic Petroleum Reserve.

Moreover, leading economists have rushed to endorse selective, targeted price controls. By January of this year, Paul Krugman of the New York Times, for example, was suggesting that it might not be so foolish after all to respond to price explosions with price policies, even though he had criticised this approach earlier. (It remains to be seen whether the University of Chicago will be revising its exam.)

As my co-authors and I illustrate in a new working paper, sectoral bottlenecks and price shocks in systemically significant sectors, especially oil and gas, played a major role in today’s inflation. As prices rose, so did many profits, creating effects that have since reverberated through the economy as other sectors scrambled to make up for higher costs, and as workers demanded cost-of-living adjustments. Now that a previously stable system has become unstable, higher interest rates can only add fuel to the fire. That is why it is so important to avail ourselves of more socially acceptable alternatives.

Consider the US. During the pandemic shutdowns, when oil prices were collapsing, producers closed their highest-cost wells. But when demand recovered, the recovery in supply lagged. Producers saw that they could keep costs down and prices up by leaving the less-productive wells closed. The result was a massive windfall. Gasoline prices briefly hit $5 per gallon, on average, and the fossil-fuel industry’s profits broke new records.

In this type of situation, an oil-producing country can pursue selective price controls – without even resorting to fiscal transfers. Far from hindering production, this approach can spur higher output. As long as a price policy assures a sufficient margin per barrel, producers will find that producing more is the only way to earn a higher gross profit. This is the dirty secret that most economists have refused to acknowledge, but which practical price fixers have discovered time and again. If done right, a price-control policy’s effect on output can be the opposite of what textbooks predict.

Of course, things get more complicated when you are dealing with economic warfare. Whereas a Texas oilman is in the game for one reason, Russia has other objectives aside from money. Following the G7’s and EU’s decisions to cap the price on imported Russian oil, the Kremlin responded by threatening to cut output. Whether it will do so, or by how much, remains to be seen, given its dependence on revenues from hydrocarbons.

Another complicating factor is climate change. One might ask whether it is even desirable to bring down the price of fossil fuels, given the need to accelerate the shift to renewables. On the other hand, consumers and many businesses face serious constraints when it comes to changing their consumption patterns radically in the short run. Tragically, the same communities that are hit hardest by both climate change and fossil-fuel pollution are also among the main victims of oil-price shocks.

Fortunately, combining a price cap with a sufficiently high marginal price, as the German gas-price brake does, can both preserve production incentives and protect basic consumption needs from a price shock. It also prevents the kind of explosive fossil-fuel profit growth that we saw last year. By making Big Oil more attractive to investors (compared to renewables) and strengthening the vested interests that have long denied that human activities have spurred climate change, such windfalls are counterproductive for an urgently needed green transition.

A new stabilisation paradigm

The new openness toward the strategic use of targeted price controls is welcome, because it acknowledges that inflation is not always purely macroeconomic in origin. Managing the kinds of micro shocks in essentials that we have suffered in recent years requires expanding our toolbox of stabilisation policies. A window for new policy thinking has opened; there is a bit of fresh air coming in. Now that we have dispensed with old shibboleths, we can take another look at economic history to reconsider conventional wisdom and develop fast, fair, effective ways of managing new kinds of economic instabilities.

A new stabilisation paradigm is urgently needed. We are living in a world of overlapping emergencies – climate change, a pandemic, mounting geopolitical tensions – and more shocks are sure to come. Policymakers need to be prepared to react before price shocks ripple through the whole system again, leaving inflation and widespread social and economic harm in their wake. Such efforts must focus on the sectors that matter most. As my co-authors and I show, an input-output analysis can be used to identify systemically significant prices, thereby helping policymakers prepare for future emergencies.

In an age of radical uncertainty and disruptive change, economics must move beyond the old playbook. There are no ready-made solutions or magic bullets that will solve the unprecedented problems we face. For economics to be part of the solution, it needs to remain amenable to more ideas, old and new. To confront the enormous economic-policy challenges of our time, there can be no substitute for a culture of openness toward different approaches.

*Isabella M. Weber, Assistant Professor of Economics at the University of Massachusetts Amherst, is the author of How China Escaped Shock Therapy: The Market Reform Debate (Routledge, 2021). Copyright: Project Syndicate, 2023, published here with permission.