If you think economists say crazy things, you’re not alone. Speaking about our soaring cost of living this week, Treasury Secretary Dr Steven Kennedy told a Senate committee that “the solution to high prices is high prices”. But then he said this didn’t apply to the prices of coal and gas.
How could anyone smart enough to get a PhD say such nonsense? He even said – in a speech actually read out by one of his deputies – that this piece of crazy-speak was something economists were “fond of saying”.
It’s true, they are. If they were children, we’d call it attention-seeking behaviour. But when you unpick their little riddle, you learn a lot about why economists are in love with markets and “market forces”, why they’re always banging on about supply and demand, and why (as I’ve said once or twice before) if economists wore T-shirts, what they’d say is “Prices make the world go round”.
At the heart of conventional economics – aka the “neo-classical model” – lies the “price mechanism”. Understand this, and you understand why the thinking of early economists such as Adam Smith and Alfred Marshall is still influential a century or two after their death, and why, of all the people seeking the ears of our politicians, economists get more notice taken of their advice than other professions do.
The secret sauce economists sell is their understanding of how a lot of seemingly big problems go away if you just give the price mechanism time to solve them.
A market is a place or a shop or cyberspace where people come to sell things to other people. The sellers are supplying the item; the buyers are demanding it. The seller sets the price; the buyer accepts it – or sometimes they haggle or hold an auction.
If the price of some item rises, this draws a response from the price mechanism, which is driven by market forces – the interaction of supply on one side and demand on the other.
The price rise sends a signal to buyers and a signal to sellers. The message buyers get is: this stuff’s more expensive, so make sure you’re not wasting any of it.
And see if you can find a substitute for it that’s almost as good but doesn’t cost as much. If you’ve been buying the deluxe, big-brand version, try the house brand.
On the other side, the message to sellers is: since people are paying more for this stuff, produce more of it. “I’m not in this business, but maybe now the price is higher, I should be.” If the price has risen because the firm’s costs have risen, maybe we could find a way to cut those costs, not put our price up and so pinch customers from our competitors.
See where this is going? If customers react to the higher price by buying less, while sellers react by producing more, what’s likely to happen to the price?
If demand for the item falls, and the supply of the item increases, the higher price should come back down.
Saying the solution to high prices is high prices is a tricky way of saying market forces will react to the price rise in a way that, after a while, brings it back down again.
When demand and supply get out of balance, market forces adjust the price up or down until demand and supply are back in balance. The price mechanism has fixed the problem, returning the market to “equilibrium”.
This is the origin of the old economists’ motto: laissez-faire. Leave things alone. Don’t interfere. Interfering with the mechanism will stop it working properly and probably make things worse rather than better.
There’s a huge degree of truth to this simple analysis. At this moment there are thousands of firms and millions of consumers reacting to price changes in the way I’ve just described.
Kennedy admits that “there are many conditions that underpin” this do-nothing policy, but “in most circumstances Treasury would support such an approach”.
There certainly are many simplifying assumptions behind that oversimplified theory. It assumes all buyers and sellers are so small they have no power by themselves to influence the price.
It assumes all buyers and all sellers know all they need to know about the characteristics of the product and the prices at which it’s available. It assumes competition in the market is fierce. And that’s just for openers.
However, Kennedy said, the circumstances of the price shocks caused by the Ukraine war are “different and outside the frame” of Treasury’s usual approach. Such shocks bring government intervention in the coal and gas markets “into scope”. That is, just do it.
“The current gas and thermal coal price increases are leading to unusually high prices and profits for some companies,” he said. “Prices and profits well beyond the usual bounds of investment and profit cycles.
“The same price increases are leading to a reduction in the real incomes of many people, with the most severely affected being lower-income working households.
“The energy price increases are also significantly reducing the profits of many [energy-using] businesses and raising questions about their viability.”
In summary, Kennedy said, the effects of the Ukraine war are leading to a redistribution of income and wealth, and disrupting markets. “The national-interest case for this redistribution is weak, and it is not likely to lead to a more efficient allocation of resources in the longer term,” he said.
(The efficient allocation of resources – land, labour and capital – is the main reason economists usually oppose government intervention in the price mechanism. Markets usually allocate resources most efficiently.)
The government’s policy response to the problem could take many forms, Kennedy said, but with inflation already so high, policymakers “need to be mindful of not contributing further to inflation”.
This suggests that intervening to directly reduce coal and gas prices is more likely to be the best way to go, he concluded.
