Higher Oil Prices

No Reason For
Inflation
 do not quell inflation,
and abolishing price
controls won’t
accelerate inflation.
Many politicians & audience members 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.
I support the committee’s
recommendations and say they
would not be inflationary. Many
politicians protested that
higher petrol and diesel prices
would cause cascading prices
for all transported items,
stoking high inflation.
 Actually, 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%.  
 Now some of you may ask, why compare
India with the rich US? Okay, let’s look
at Asian 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.
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.
 Presented
By

Anupam Prashant Mujumdar

R430209009