How to turn a price shock into inflation

A friend in Greece sends this article on how to deal with high energy prices. The temptation echoes throughout Europe, and likely the US as well.

Greece may benefit from a range of European Commission emergency measures aimed at tackling rising energy costs, EU Energy Commissioner Dan Jorgensen indicated ....

… Jorgensen signaled that Athens can make immediate use of a European Commission “toolbox” that includes state subsidies, tax reductions and flexible support schemes for households and businesses.

The proposed tools – including price caps on gas, expanded long-term energy contracts and relaxed state aid rules – could help shield vulnerable households and stabilize electricity costs. Jorgensen also pointed to the need to ease the link between gas and retail power prices.

Well, I’m glad that the EC has a pre-prepared “toolbox” of terrible ideas so that Member States don’t have to come up with terrible ideas all on their own.

How does a relative price shock — energy costs more than other goods—turn in to overall inflation? Largely by policy responses to the energy shock. Europe invented a doozy in the last price rise and looks set to do it all over again.

People are using 10 gallons of gas a week, at $5 per gallon (sorry, US units and California prices). Available gas goes down to 9 gallons a week. The price starts to rise to $6 per gallon. Left alone, people find ways to use less gas, with the price as an incentive.

The worst combination of these “tools” would be if the government says “we will pay for the extra cost.” So, you still pay $5 per gallon, and the government chips in the extra $1. Sounds good. Can you spot the problem?

Yes, with no incentive, people still use 10 gallons a week. There are still only 9 gallons around. Where does the price settle? Infinity.

Now, the “tools” are not quite that idiotic, though close. Suppose the government says “we’ll pay your extra expenses.” You still have to pay $6 at the pump, but the government gives you a check for $10 to cover the extra cost. People feel the marginal price, so do cut down on gas. But they use some of the extra $10 to buy other goods. That’s how a gas price rise turns in to general inflation. This is exactly how Europe responded the last energy price shock. And got general inflation.

“Price caps.” The government says, gas stations have to sell at $5. Welcome back to the 1970s. Long hair, silly clothes, and gas lines around the block.

“Ease the link between gas and retail power prices.” What do you think that means? Obviously, another witch hunt on “price gougers,” price controls and “windfall profits” taxes by another name. The emperor Diocletian tried that. It didn’t work then either.

The commissioner stressed the crisis is driven by high prices rather than supply shortages, noting Europe has significantly reduced reliance on Russian energy imports.

And dear commissioner, where did the high prices come from? Is there nothing going on in the Persian Gulf of note?

This is a media report. I sincerely hope the commissioner is misquoted. The point of my post is simply to remark on the fallacy of the ideas, which are pretty common.