Who's afraid of price controls?

Is it time to consider adding price caps to the emergency economics toolbox? The unprecedented surge in energy prices that followed Russia's invasion of Ukraine has prompted much soul-searching in Europe regarding the effectiveness of traditional economic stabilisation policies. In response to this energy shock, the European Union has imposed a general price cap on natural gas, and several member states have capped profit margins, staple foods, and rents, in addition to reintroducing windfall taxes. 

But despite the widespread adoption of price controls and the support of some prominent economists, the economic mainstream remains apprehensive about policies that might disrupt price signals. Nowhere has this reticence been more pronounced than in Germany, where the delayed use of effective price caps could have far-reaching political implications.

In a recent working paper, we argue that economists' fear of price controls is baseless and may have disastrous consequences. Germany serves as a useful case study, given its heavy dependence on Russian natural gas and the direct impact of the 2022 energy shock on its economy.

While mainstream German economists downplayed the effects of the shock and opposed any policy aimed at controlling energy-price inflation, the crisis of 2022 has taken a heavy toll on Germany's economy and society. It led to a short-run output loss of 4%, impeding the country's post-pandemic recovery and triggering an economic slump on par with both the pandemic and the 2008 financial crisis. And for wage earners, the 2022 energy shock represented Germany's most severe economic crisis since the end of World War II. 

That year, Germany's inflation rate soared to levels not seen since the 1970s, significantly outpacing nominal wage growth. This led to a 4% annual decline in real wages – the largest one-year drop in the country's postwar history. In addition to these short-term losses, there is growing evidence that the energy crisis is causing long-term harm to the German economy. The recovery remains sluggish, with output and real wages, respectively, currently 7% and 10% lower than pre-pandemic levels.

According to the International Monetary Fund, Germany was the only developed economy to experience negative GDP growth in 2023, and growth projections for 2024 and 2025 are lower than those for most other comparable economies. These unprecedented income losses, combined with heightened uncertainty, help explain German wage earners' economic anxiety.

Moreover, these trends belie economists' assertions that Germany has weathered the energy shock with surprising ease, as well as Finance Minister Christian Lindner's claim that the time has come for a "normalisation" of fiscal policy. The economic-policy establishment appears far too eager to proclaim the crisis over and impose potentially disastrous austerity measures.

The summer of 2022 is a case in point. Initially, Germany responded effectively to the energy shock by launching an ambitious public procurement program. But policymakers waited too long to introduce energy-price controls. Despite the discontent over declining living standards and the overwhelming popularity of energy-price caps, the German government proposed a gas-price levy (Gasumlage), a measure favoured by economists who opposed price caps. 

The German government's "wait-and-see" approach to the energy-price shock needlessly prolonged a period of heightened economic insecurity and contributed to a sharp increase in support for the far-right Alternative für Deutschland. The AfD's growing momentum began to falter only after the government changed course and introduced an energy-price brake as part of a big stabilisation package, known as Doppel-Wumms ("double-whammy"), in September 2022.

Once introduced, these price caps succeeded in shielding households from the Ukraine shock, but the government never established an effective price cap for the country's industrial base. The government delegated responsibility for designing the energy-price brake to a panel of economists, most of whom strongly opposed any measure beyond simple lump-sum payments to the industrial sector. This meant that manufacturing companies had little incentive to maintain production in the face of skyrocketing energy costs.

It is difficult to overstate the calamitous consequences of this policy. The lack of a coherent industrial strategy, coupled with the decision to tighten fiscal policy in the middle of a crisis, could herald the end of Germany's manufacturing prowess as we know it.

Nevertheless, the question remains: Can we beat back the populist surge? The potential economic benefits of energy-price controls – an effective policy response to energy shocks fueled by endogenous price uncertainty – suggest that the answer is yes. While mainstream economists often reject price controls outright, arguing that they are invariably suboptimal, the price uncertainty inherent to geopolitical mega-shocks like the war in Ukraine underscores the need for governments to reconsider their assumptions.

To be sure, price caps should only ever be used as a last resort. While they provide temporary relief, their effectiveness depends on how policymakers leverage them to address supply shortfalls. Building up buffer stocks of essential commodities is preferable to relying solely on stopgap measures. Nevertheless, buying time is better than allowing supply shocks to wreak havoc on our economies and societies.

Tom Krebs (left) and Isabella M Weber (right). Sketches: TBS