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’srecommendations 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