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How to combat inflation?


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The Conversation

Álvaro Bañón Irujo

Professor of Financial and Investment Management

It is not yet clear whether Spain's incumbent government will maintain the battery of measures it has been implementing to combat inflation in 2024. Rather, the measures to mitigate the effects of inflation. We should not attack (or try to attack) the symptoms, but the disease.

Inflation is basically the loss of the value of money. The phrase "I used to fill my shopping cart with fifty euros and now I don't even have enough for half of it" is the best way to express what inflation is. Rising prices. Or, in other words, the worst tax for the poorest classes because the consumption tax is applied equally to rich and poor.

Everything on Economics is explained by supply and demand, including inflation. This episode of high inflation is explained by a spectacular growth in demand (central banks' money injections, the savings bottlenecks during confinement) and a reduction, also considerable, in supply (Asian shutdowns, logistics bottlenecks, the war in Ukraine, the drought). So there has been more demand but also less supply. result? The seller sees that he can ask for more and asks for it. And he gets paid. And the price goes up and they keep getting paid.

How do the measures implemented by governments work?

At best, government measures act as a placebo. In most cases, they act as fuel for inflation. If, for example, the government (at enormous cost) subsidizes each liter of gasoline to everyone with 0.2 euros, the only thing that is achieved is that subsidy goes to the seller or producer.

Why? Because what will someone who sells gasoline and sees that it is bought at 2.2 euros per liter do if he gets a subsidy of 0.2 euros per liter? Will he lower it to 2? No. He keeps it at 2.2 and takes the subsidy saying that the price without the subsidy would be 2.4. Why? Because the demand supports it.

If the Government (with the support of the civil service examination) leave the VAT on foodstuffs (an excellent measure but not anti-inflationary) the same thing will happen. If someone who can sell oranges at 3.10 euros per kilo (with a VAT of 10%), sees that the VAT leave at 5%, he will continue to sell them at 3.10 euros per kilo as long as the demand endures, adding that 5% to his profit margin.

On the other hand, it is useless to apply these measures indiscriminately -without differentiating income- because they are often counterproductive. Moreover, they are extremely expensive. But they sell well, make polite headlines and make it look like the authorities are taking action.

How do we fight inflation?

The issue is to reduce demand and increase supply. On the demand side, demand needs to shrink, and that will only happen if measures are applied that are like old medicines: unpleasant and with delayed effects.

The rise in interest rates is the most obvious one. When I hear at a dinner party the phrase: "Our mortgage payment has gone up and we will have to take fewer vacation days this year", I immediately think "unfortunately, that's exactly what it's all about".

Spaniards need to demand less leisure, less virgin olive oil (and switch to a cheaper one), less gasoline, less hotel nights. Only then will those who sell to them have to compete for their money. Only then will the price of hotels, apartments, or beer go down (or up less).

The question is: how is the price of olive oil going to go down in the supermarket if it already costs six euros? If the supermarket sees that it has to lower the price to compete because consumers are switching to sunflower oil or because they have less purchasing power, it will have to lower the price. And this drop will go at full speed to the origin of the chain because the cost of extracting a liter of oil has not gone up 100% for the farmer, as the final price has.

There is much less olive oil due to the drought and demand is still strong. If the seller at origin has less product, and sees that demand can withstand price increases, he will raise the price. Whatever his costs are. The price will not go down until he has to sell it in competition (not when his costs go down).

What can be done with the offer?

Much more skill is needed in all areas. The task of governments should be to remove barriers to entry in many markets. New suppliers entering a market worries those who are already in it (and that is why they organize themselves into pressure groups). But that is the best thing that can happen to consumers. Whether new supermarkets, banks or passenger transport services.

Therefore, and so that the price of rents, food or transportation does not skyrocket, intervention is not effective. What is really effective is for barriers to entry to be removed and for supply to be allowed to increase. More skill, more competitors and new people in the markets.