Higher oil prices no reason for inflation

Price controls do not quell inflation, and abolishing price controls won’t accelerate inflation. Many politicians and readers will disagree. They are dismayed by the restoration of old taxes on crude, petrol and diesel in the Budget, and the consequent increase in prices. They fear that if petroleum product prices are even partially deregulated later this year, as recommended by the Kirit Parikh Committee, prices will rise even more sharply.

Last month, I supported the committee’s recommendations and said they would not be inflationary. Many readers protested that higher petrol and diesel prices would cause cascading prices for all transported items, stoking high inflation.

Actually, no. India has price controls on petrol, diesel, cooking gas, kerosene and a host of other items. Yet consumer price inflation in India is 15%, the highest among G-20 countries. By contrast, the USA has no price controls, and its consumer inflation in January 2010 was just 2.6%. Core inflation (which excludes energy and food prices) was only 1.6%. US energy prices as a whole rose 46%, with petrol up 51%, but these high prices did not cascade into other items. Even when oil hit a record $ 148/barrel in July 2008, US inflation (excluding energy and food) was just 2.5%, although fuel oil was up 61% and petrol 37.9%.

Some readers ask, why compare India with the rich US? Okay, let’s look atAsian countries. Most of them also have price controls on oil. But the Philippines has deregulated oil, though temporary price controls can be imposed for 90 days after natural disasters like typhoons. Consumer inflation in the Philippines in February 2010 was only 4.3%. Excluding energy and food prices, it was just 3.0%.

Remember, crude has doubled from $40/barrel a year ago to $ 80/barrel today. Yet countries without price controls, which have passed on the full cost to consumers, have far lower inflation rates than India. Clearly the theory of oil prices cascading into everything else is a myth. Cost-plus pricing may have been common in the bad old licence-permit Raj, but not in a deregulated market.

Why not? The simplest explanation comes from Nobel Laureate Milton Friedman. He said inflation is always and everywhere caused by money, and nothing else. Comparing price inflation to the inflation of a balloon, he said that if you squeeze one part of the balloon, you simply create a bigger bulge elsewhere. Price controls are like squeezing part of the balloon, he said. They cannot check inflation, since the underlying cause is the pressure in the balloon, which corresponds in the real world to the supply of money.

Suppose, he said, the price of oil shoots up (as in 1973-74 and 1979-80). If people have to pay more for petroleum products, they will have less money to spend on other items, whose price will then fall. On balance, he argued, prices will be unchanged unless the government increases money supply, thus providing enough funds for people to pay more for the same goods.

I am not a pure monetarist like Friedman. I agree with him that money matters, but money alone is not what matters. Other factors like drought, monopolistic practices, faulty government policies and trade barriers also cause inflation. Yet Friedman’s theory goes some way towards explaining why the US, Philippines and other countries without price controls do not suffer high inflation. Going by the same logic, oil deregulation in India will not add to inflation, though obviously it will not cure inflation caused by drought.

Oil subsidies in India— in the form of under-recoveries by oil marketing companies — have been as high as 2% of GDP. This is outrageous since government spending on health is just 1% of GDP. Studies (like Ghani and Devarajan, World Bank, 2006) have shown that 92% of the LPG subsidy in rural areas goes to the richest 40% of people, while the poorest one-fifth get no LPG at all. The richest one-fifth of rural folk corner 27% of the kerosene subsidy, while the poorest one-fifth get just 14%.

Critics say petrol and diesel cannot be called subsidized in India, since they cost more than in the US. Well, the central subsidy is more than offset by heavy state taxes. But Indian prices are far lower than in Europe or Japan. Those countries levy heavy taxes because oil is non-renewable, imported, polluting, and carbon emitting. Cheap oil encourages traffic congestion. Hence oil eminently deserves heavy taxation to discourage consumption and yield revenue for welfare spending.

India should aim ultimately for the European path. For starters, it should deregulate oil prices. This will not be inflationary.

2 thoughts on “Higher oil prices no reason for inflation

  • 2010.Jun.21 at 12:42

    Controversy regarding deregulation of petrol crises seems having more political tone as compared to economic mileage. If we delve details of international polices in US we will realize that they have deregulated fuel prices and make it as market dependent commodity.
    According to Friedman Economy is balloon if you squeeze at one end it will bulge in new area. So only deregulating measures in form of Petrol, diesel –kerosene.
    Even though it is driving instrument in economy petrol is pollution, fueling and putting extra burden in environment. The saved corpus of huge subsidy can be diverted into other economic deficit areas like health and education. In India huge subsidy to oil PSU only suffices upper strata of rural people. Needy beneficiary are eroded and not able to bear fruits.GOI should take appropriate decision to come at conclusion and should shift from policies of protection towards false lower class, and divest needed corpus to real underprivileged people.

  • 2010.Apr.29 at 12:46

    Rise in international oil prices is good for India if it is due to the situation created by india/ sub continent. Middle East countries are enjoying the cheap labor available from sub continent and Philippines. As long as there is competition among the labor exporting countries, the wages in middle east would not improve to benefit these countries. The NRIs from Middle East are contributing 80% of foreign currency remittances to bridge the trade deficit. Nearly five million Indian expatriates are living in Middle East countries. Many are employed in the lower strata of society such as garbage pickers, sanitation workers, servants in households, camel herders, construction labors, etc. These people are working away from their families in foreign lands just for earning money like machines. The foreigners look at all Indians in a belittling attitude. Is it the image of India our government wants to create? These labor importing countries are thriving by enjoying cheap labor available from Indian subcontinent and Philippines. We should learn from China. Though its living standard of its people is not so good but its poverty is not showcased in every part of the world. It is high time that India should ban its citizens working abroad in filthy jobs such as sanitation, garbage picking, garbage processing, house hold servants, etc.

    Also India should take lead in forming an organization “Onsite Services Exporting Countries (OSEC)” with Philippines, Pakistan, Bangladesh, Nepal, Srilanka, Ethiopia, Atria, etc. similar to OPEC. Minimum wages should be fixed for every trade in line with developed countries (Europe & North America) wage indexes. This may increase the oil prices further higher but entire benefit will be accrued by OSEC countries and their image in the comity of nations will improve drastically. These countries cannot sustain present living standards without cheap expatriate services. Skilled cheap labor is not available anywhere outside these OSEC countries. More over westerners would not prefer to work in these countries due to entirely different religious and cultural practices. Increase in oil prices is also advantageous to OSEC since the non conventional energy resources available locally will become more economical to exploit & create local new jobs.
    It is now the correct time for India and other labor eporting countries to take advantage of their strong economies to reap maximum benifits.


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