In a previous post, I argued that setting interest rates by government fiat is akin to price controls. But why are price controls harmful?
Let’s take the example of the price of oil. Without government intervention, prices would be set by supply and demand. One of the key reasons we have seen the price of oil rise in recent years is due to increased demand from nations like China and India, which are rapidly industrialising. These rising prices send signals to producers and consumers alike. Producers will consider increasing supply, seeing the higher profits on offer, and the possibility of fulfilling new demand. Consumers on the other hand will consider reducing their use of oil in order to save money – perhaps they’ll use public transport or buy a more fuel efficient car.
However, as the prices keep rising, consumers get increasingly angry and demand that “something must be done” and politicians, always eager to offer their “solutions”, blame the greedy oil companies and decide to implement price controls.
The government decides that a barrel of oil cannot sell for more than $100. Consumers rejoice, the oil companies grumble, and life carries on as normal, but with cheaper oil. Right?
The problem is that this artifical price does not match the true supply and demand, but fools industry and consumers into thinking the new price does. As a result the demand for oil is as high as before, but since it is now cheaper, more oil is bought than before. But this increased purchasing does not induce a higher price, and shortages follow. Without the price to inform producers and consumers of the real supply and demand, things get out of kilter. To make things worse, the lower profits the oil companies now earn means they are likely to produce less oil, exacerbating the shortages.
This happened following the collapse of Bretton Woods in 1971, and the resulting inflation (in reality as result of the increased money supply) led the Nixon administration to introduce various price controls. Long queues at petrol stations across America followed as they began to run out.
It can all happen in reverse as well. If a price floor is implemented rather than a ceiling, often in the name of protecting a struggling industry, surpluses follow. This is because prices are maintained at levels above that which consumers are prepared to pay.
The fundmental flaw of price controls is that they do not allow prices to act as signals relfecting the underlying reality.
If the orange crop fails in Florida, prices will go up. This process both reduces the producers losses, and means only the consumers who truly need oranges will get them. Forcing a lower price would prevent the most urgent users of oranges from getting them, as the shortages follow, and also would likely bankrupt the orange growers.
Examples of the ruinious effects of price controls can be found throughout history.
It should then hardly come as a surprise that setting interest rates by fiat – not even setting a floor or ceiling as in our examples above, but choosing a rate to suit politicans and bankers – will have disastrous effects across the economy, given that interest rates are the price of money and money is one half of every transaction.
Imagine what would happen if a group of ten people got together in a room and decided what the wholesale price of oil should be.
How the Bank of England actually sets interest rates I’ll explain in a future post.
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