Thursday, October 16, 2014

A Tale Of Two Cities: Why Price Gouging Is Good

Today, Antwerp is the largest city in Belgium. In July of 1584 it was part of the Dutch Imperial States; it was also under siege by the Spanish. As with all such military operations, the besieged city eventually started running out of food. As food became more and more scarce, prices of food began to rise. The leaders of the city were outraged that people would charge their fellow man such unreasonable prices for such a basic need, so they enforced a strict price ceiling forbidding anyone from selling food at too high a price. This policy was successful in keeping food prices low – until they ran out of food. Antwerp surrendered on August 17, 1585.
While the price controls were not the sole reason that Antwerp fell, they certainly contributed as they ensured that the beleaguered city would be short on food. Prior to the seemingly humanitarian regulations, food prices got quite high. This signaled to those with food outside of Antwerp that they could make a sizeable profit by smuggling food into the city past the Spanish siege, and so they decided it was worth the risk. Smugglers braved the possibility of being captured or killed because the price was so high. When the price was made lower by law, they stopped smuggling. The low prices not only resulted in a decreased supply of food, they caused consumption to be higher than it should have been, given the situation. Had prices been allowed to rise such that the people of Antwerp could only afford a bare minimum, the high prices would have rationed the food supply and they would have stood a chance of outlasting the Spanish attempt to starve them out. With prices at their pre-siege levels, however, why not consume as you did prior to the siege? After all, if you don’t buy up a lot of food now, others will, leaving you without any in the near future. Since Antwerp’s controls on so-called price gouging led to city’s defeat, the policy was, to put it mildly, quite detrimental.

In Raleigh, North Carolina in 1996 a crowd of people cheered as two men were arrested. Their crime: selling ice to the people in the area who had lost power due to Hurricane Ira. To be more specific, they were arrested for selling ice at a price that the government deemed too high and, therefore, was deemed “price gouging”. As the police impounded the supply of ice and took the men away, one cannot help but wonder why people clapped. There is no arguing that these ice sellers were charging relatively high prices for their ice, and they were most likely motivated not by selfless benevolence but by greed. The interesting thing is, though, that it doesn’t matter; they were the only ones bringing ice to the people who needed it to keep their medications and food from spoiling.

The high price, which many people willingly paid before the endeavor was shut down, sent a signal to the surrounding areas that they should bring their ice into Raleigh. In a free market, that would have happened, but North Carolina decided to “protect” its citizens from exorbitantly high prices. The result: the price was irrelevant because there was nothing to buy. The shelves were empty. It didn’t matter how much you needed ice for your medications, there was none to be had. This fact leads to a second essential function of free prices which is especially important during disasters: rationing.

There were thousands of people who wanted ice, but some of their needs were greater than others. Since prices were not allowed to rise, however, the ice went to those who got to the store first, and was not available at any price to latecomer who may have needed it for an essential purpose. If prices had been allowed to rise, and if sellers from the surrounding areas had received the signal that Raleigh needed ice and they could enrich themselves by providing it, then distribution of the ice would have reflected the subjective valuation of that ice by different people. The person who wants to keep their ice cream cold may decide to let it melt rather than pay $20 for a bag of ice, meaning that there would still be ice available for the person behind them in line who had to keep their insulin cold.

The unreasonable practice of depriving citizens of essential resources in the name of protecting them is not confined to a peculiar North Carolina law or 16th century empires. Twenty-eight states and the District of Columbia currently have “price gouging” statutes on the books. These laws should be repealed so that price signals can coordinate the flow of resources to their most valued use, especially in times of crisis.

Another version of this article was published on Rightly Wired.

Sunday, October 12, 2014

Inflation Is Not Good; Deflation Is Not Bad

As the world economy continues its sluggish recovery, it’s fitting to look back on the monetary policy the Federal Reserve pursued in an attempt to pull the economy out of recession. The Fed drastically increased the money supply through multiple rounds of “quantitative easing” among other programs. The hope of such policies is to increase overall demand in the economy in order to encourage banks to lend money and consumers to spend. The extent of the monetary inflation can be seen in the graph below.
Increasing the money supply almost always leads to price inflation, which the Fed has been desperately trying to create since the economic downturn in 2008. The exact extent of inflation is disputed, with many claiming that real inflation rates are much higher than those reported by the government, but the real question is why the Fed is so afraid of deflation that it is willing to take such drastic measures to ensure inflation. An analysis of the economic consequences of monetary inflation and the price inflation it causes shows that there is not any general benefit to inflation. Instead, it benefits some people at the expense of others.

Even if the effect was desirable, inflation does not result in a long term increase in overall demand. When new money is introduced to the economy, it creates an excess supply of money so that people will act to decrease the amount of money they are holding by spending it on producer and consumer goods. This doesn’t happen in a vacuum, though. The increased demand for producer and consumer goods causes an increase in price, just as all rightward shifts in demand curves do. The result is a decrease in the purchasing power of money until prices rise high enough that people decide to hold money again instead of spending it. This effect is exacerbated by the fact that the excess supply of money incentivizes producers to restrict production causing a leftward shift in the supply curve, further increasing the prices of producer and consumer goods. In short, an increase in money stock does not change the fact that the money market tends toward equilibrium, so the influx in demand caused by monetary inflation will be diminished by a rise in prices. There is, therefore, no general benefit to inflationary policies.

It must be noted, however, that money is not neutral. That is, changes in the money supply do have effects on the real economy because prices all move independently and at different rates. As this happens, price signals are distorted by the uneven flow of the money through the economy.

While society as a whole is not helped by inflation, there are benefits isolated to certain well positioned individuals through Cantillon effects. When new money enters the economy, it must do so at a specific place and time, so some people get the new money before others. The equilibrating process of an increase in prices, described above, takes place as the money moves through the economy, not all at once. So those who get the newly created money early will get to spend it on goods whose prices have not yet risen so that they will possess goods which are relatively more valuable in the marketplace after prices rise. This results in redistribution of wealth as those closer to the point of injection (often those in the financial sector) get wealthier at the expense of others.

The advantage given to those who acquire the new money first comes at a cost, as some people are harmed by the nonuniform introduction of new monetary units. Those who are on a fixed income, for example, are faced with reduced purchasing power to pay higher prices for the goods they need. Creditors are harmed as the money they are paid by debtors is worth less than it was when the loan was agreed upon, making them less likely to lend money. As usual, distorting the price system provides benefits for some at the expense of others. Inflationary monetary policy gives increased purchasing power to the well-connected and those in the financial industry while decreasing the purchasing power of creditors and those on fixed incomes.

As we have seen, monetary inflation is not an economically beneficial policy. The Fed continues to engage in inflationary behavior, however, because it fears deflation most of all. To many people, deflation is synonymous with economic downturn and depression. This fear, however, is contradicted by history. From 1880-1886 prices fell by an average of 1.75% while real income rose 5% in the same period. Large increases in productivity can cause prices to fall, but if they fall more than real income, then people are better off not worse.

The United States monetary policy should be to maintain a stable money supply rather than stable prices. By allowing freely fluctuating prices, economic signals can be effectively transmitted to producers and consumers. A stable money supply means an end to monetary inflation and the resulting Cantillon effects that benefit the few at the expense of others. The Fed should stop playing games with the money supply which have no societal benefit and which are potentially dangerous.

Another version of this article was published on Rightly Wired