What governments should or should not do during an inflation crisis

Most advanced countries all over the world are suffering from skyrocketing inflation for the most part of the year. Inflation can be defined as a broad increase in the prices of goods and services over an extended period. In this case, prices in consumer goods and energy are the ones that have been most inflicted by the market volatility and the restricted energy supply, partly caused by the war in Ukraine.

As a result, prices of certain products and services are up. The average consumer can now buy less for the same amount of money, which equals a real, though artificial, paycheck cut. In other words, the purchasing power of money has been decreasing. This is a significant concern for every individual struggling to make ends meet and for governments as they try to navigate economies around these times of instability.

But what a government should or should not do in a time of inflation in its effort to alleviate inflation’s consequences for the public and to be able to control market prices to a certain extent?

The first and most direct tool to combat inflation is the monetary policy issued by central banks. Implementing tighter monetary policies, such as higher interest rates and open market operations can reduce the money supply, the present demand for goods and services, the levels of economic productivity, and therefore inflation, too. When interest rates rise, for example, savers can earn more interest on their deposits and at the same time, it gets more expensive to borrow money, discouraging both present consumption and lending. Accordingly, Central Banks can also participate in open market operations, by which federal banks purchase and sell government bonds. Buying bonds injects money into the economy while selling bonds drains money out of circulation. As a result, monetary growth, the value of money, and ultimately inflation are indeed reduced as planned, but while the economy “slows down”.

Under a more fixed monetary policy, like the one in place by the European Union and the European Central Bank, with specific objectives and ways of operation, different tools are really being sought. When major monetary expansion or restriction is not possible or wanted, fiscal policy tools are there to be enforced against inflation.

A very old and much-used way to control prices is by issuing quotas and price ceilings, trying to impose a certain level of prices. But inflated prices are usually caused by a spike in the cost of production or distribution. This means that a product costs more for a reason. Setting a low price significantly alters the gross profit of businesses, making it pointless for them to supply more products in the market under tighter margins. As a result, market supply drops down failing to meet consumers’ demand. Without price volatility, the “black” market would fill the gap between supply and demand, de-facto nullifying the price quotas or ceilings. At the same time, smuggling and illegal trade would skyrocket, strengthening organized crime altogether, as we have witnessed lots and lots of times throughout modern economic history, including during gas quotas or even during prohibition. Although it was more about market restriction rather than price control in these cases, the market mechanism is the same. Therefore, let’s forget about trying to set fixed or max prices.

Other governments worldwide have tried to support their people through vouchers and cash injections, as allowances or stimulus bills to support their income. Although such measures have strong public approval, from an economist’s perspective they usually do more harm than good. At first, as governments do not print money out of thin air, such allowance policies would either lead to more inflation, if they take the form of increased money supply, or more taxes when they originate straight from the budget. Either way, these policies either worsen the existing problem or create another. History has provided us with a handful of reckless spending and money-printing catastrophes that have led to hyperinflation and recession. Because taxing more to provide vouchers and allowances for the very people being taxed to this end is just another socialist magic trick to idealize the role of the governments in the economy. It’s just wealth transfer and cannot efficiently or sufficiently solve a persistent inflation crisis. Thanks, but no thanks. Next idea?

Well, the last and most successful path to combat inflation is by cutting indirect taxes on goods and services and excise duties. In this way, businesses will have the motive to withhold inflated prices and keep them as low as humanly possible to serve their customers better and keep their profit margins intact more easily. At the same time, the economy gets a useful boost to operate more smoothly even in a time of crisis and consumers do see the difference in their shopping baskets. Someone would argue “How can the government replace the lost tax revenue after lowering taxes?”. On the one hand, in a time of crisis states should prefer reducing needless spending over raising taxes, and on the other hand, revenue from indirect taxes in sales, such as the European VAT, are proportional to prices. By cutting indirect taxes and excise duties, while prices are soaring, states can actually stabilize their revenue while limiting price hikes. You can describe this plan as the most libertarian and market-friendly approach to how a government can deal with an inflation crisis, supporting businesses and stabilizing the purchasing power of money of citizens.

You can call the three aforementioned fiscal approaches from the latter towards first as “the good, the bad, and the ugly” on how a government can protect the economy and its consumers from prolonged inflation, under a fixed monetary policy. As for monetary policy, it remains the most direct toll tool to combat or create inflation, though economists still debate its usefulness and effectiveness.

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