The Three Ps behind Truss's Energy Price Freeze?
How did a free marketeer end up here?
Greetings, The War on Prices subscribers,
It’s been a strange few days to be British living in the United States. Yes, you can find wall-to-wall coverage of Queen Elizabeth II’s passing on cable news. But like most Brits, I found the announcement itself affected me emotionally much more than I would have expected beforehand. It was especially poignant to feel so geographically detached from the mother country during that national moment - away from others who “get it” or at least can empathize with the memories and feelings.
I’ve come to more greatly appreciate over time the Queen’s steadfastness and the stability that her reign itself provided, despite not having a “first principles” commitment to constitutional monarchy. And, with my libertarian hat on, I agree with whoever said that perhaps forcing politicians with real power over our lives to bow before another is a helpful curb against delusions of grandeur.
Most of this newsletter was written early on the day the Queen actually passed. It felt wrong to share it before now.
Ryan
The irony is not lost on me that the most ideologically free-market UK Prime Minister since Margaret Thatcher began her premiership with a big, fat price control, underpinned by vast government borrowing.
UK energy bills were set to surge in October and forecast to rise even further early next year, driven by the high wholesale gas price. New Prime Minister Liz Truss this week responded by announcing a two-year “Energy Price Guarantee” for households that will put a ceiling on the unit wholesale price of energy, such that a typical household with today’s energy consumption would see their bill capped at around £2,500 per year.
Practically, this will be achieved by the government paying energy suppliers the difference between the capped wholesale price of energy and the true market price, taking a lot of price volatility risk onto the government’s balance sheet.
Although there is no official policy “costing” yet, this intervention, coupled with an equivalent scheme in place for 6 months for businesses, could well cost over £100 billion per year, according to the Institute for Fiscal Studies. That’s a lot of moolah. Although in net terms (relative to a world of closing businesses and sharp household spending cutbacks) the cost could be lower, committing to the household component for two years at the outset has understandably raised eyebrows.
The economics of price controls
A regular theme of this newsletter will be to echo Tyler Cowen and Alex Tabarrok’s truth that “prices are a signal wrapped in an incentive.”
Gas, right now, is relatively scarce. Energy is thus expensive. Capping retail energy prices below market prices tells consumers a lie that gas is more abundant than it is, encouraging more use than we’d otherwise see.
Yes, even the regulated price that Truss is adopting is still high historically, so there remains significant incentives to cut down on your quantity demanded. But, on the margin, a policy to cap retail prices will still inevitably reduce the incentive to invest in insulation, turn down your thermostat, forgo heating your pool and many smaller energy conservation efforts.
Ordinarily, that’s one reason why a crude price cap in isolation would risk severe shortages, or blackouts. To avoid this supply-demand imbalance, the UK government is therefore “making suppliers whole” through the subsidies. Yet with other countries also adopting schemes for households or businesses, the collective effect could still bid up prices further for all, risking shortages and rationing.
Price controls, in short, are a terribly dangerous policy that economists tend to loathe. Nobody should reach for them lightly.
A better way?
None of this is to play down just how devastating energy costs rising by 80 percent in October and then further next year would have been for UK households and businesses without it. It would have guaranteed a major recession. So, whatever the merits or demerits of the adopted scheme, a massive government policy intervention was priced in. We are arguably in a time of war and this is an unexpected real shock. It is understandable that many would demand the state seek to smooth its effects, using borrowing repaid over decades to mitigate the extreme, unusual situation.
The first instinct of economists, though, would be to avoid interfering with prices and provide cash assistance. The IFS’s Tom Waters (a brilliant analyst and former intern of mine!) tweeted, for example:
His particular numbers might be too high (I presume the £100 billion covers business support too), but are nevertheless striking: the intervention is so large that huge cash transfers could have been given to households for the same fiscal cost.
Even if there were no database for doing this effectively to every household, the government might instead have proxied for it through a) a temporary targeted uplift in benefits to vulnerable households, b) a temporary large, broad-based tax cut - say, a massive rise in the personal allowance and c) a temporary large business tax cut, such as to business rates.
In a world where such an approach worked to get the cash assistance to those who need it, households and businesses would still face the higher market price for energy, but would have been financially insulated from the direct consequences if they had to continue paying for the same units of energy.
One former government minister I spoke to argued for precisely this, saying “at least this way preserves incentives and makes people feel like they have more money (of course, it may also make them realize how big their tax bill is normally).”
Indeed, there are obvious economic advantages to this sort of approach:
It insulates families financially while maintaining the stronger market-based incentive to cut back on energy use, reducing risks of blackouts or rationing;
It avoids huge subsidies for wealthier households with massive energy use to a much greater extent than capping the unit cost; and
It is relatively simple and easy to explain.
And yet, Truss and her team - themselves economic liberals - rejected this course of action. Why? I think it ultimately comes down to “three Ps” - practicalities, possibilities and politics.
Practicalities
While most people agree in theory that financial assistance is more efficient than a wholesale unit cost price cap, it is operationally difficult to get cash to everyone who needs it in practice.
The benefits system provides an obvious outlet for getting cash to many poorer households, but the sheer scale of the price increases are affecting many middle and middle-upper income households too. How, then, to deliver relief? Conservative MP Claire Countinho said at a Centre for Policy Studies event recently “We tried using council tax bands. But it is imperfect. I think we got [to] 80% of households but it isn't perfect." Combining a big income tax cut with a big expansion of benefits was a different option, but would give some people huge cash injections when combined with benefit uplifts.
There’s another issue, though, as raised by Paul Krugman: using the benefit and tax system to provide cash assistance can be a very bad proxy for the very different energy needs of families on the same income. Yes, that was stated as an advantage above - should we really be throwing subsidies to those heating their outdoor pools? But it’s easy to consider much more mundane examples of how lump-sum transfers or distributing by income could throw up problems.
Those in larger, badly insulated homes in rural areas will face very different energy needs to those in expensive, inner-city modern apartment buildings. A lump sum or tax-and-benefit cash assistance scheme based around income levels would inevitably give some people far more than they need to live comfortably and others far less.
To avoid people falling through the gaps, the government would probably feel compelled to reach for other levers too, running up further cost. So, cash assistance would risk becoming a bit like universal basic income. It might look appealing in theory, but would result in many instances where perceived needs are not met. If set at a level to cover all possible circumstances, it would instead be much, much more expensive.
Possibilities
One potential advantage of the Truss scheme (relative to cash relief) is that if the scenario David Smith has described plays out, and the wholesale gas price actually starts falling, then the intervention will quickly become much cheaper for the taxpayer.
Because the Energy Price Guarantee is structured through subsidies to suppliers to cover the difference between the market price and the capped price, the subsidy required would fall if the market wholesale gas price declined. In contrast, you can’t undo a tax cut or recoup benefit payments that have already happened.
That price risk looks symmetric, in principle, of course: if wholesale gas prices are much higher than expected, the taxpayer bill spirals higher and higher under the Energy Price Guarantee too. Yet in reality I suspect the upside risk to borrowing would be there under a cash relief policy choice anyway. The amounts dished out in cash assistance would be seen as predicated on expectations of prices in January. If those prices were much higher than expected, there would be a clamor for more relief still.
This suggests that, although very expensive, the scheme scales itself back if supply constraints ease. As the chart below shows, the price of natural gas has been falling in recent days. So maybe, just maybe, this intervention won’t be as costly as expected.
Politics
Finally, there’s the politics, where I think a few considerations would be in Team Truss’s mind:
Bill shock: if they’d have gone for the let market prices work + provide cash assistance option, households for whom politics isn’t salient would still have been shocked at the sky-high prices when their bills arrived. That would lead to lower consumption of energy, yes, but there would have been inevitable stories of people falling through the gaps of the assistance, or blowing the tax cut, or just not appreciating the hypothecation of relief to bills, and so getting sick in the cold or freezing to death. High energy prices are highly salient and it’s possible there would have been demands for another, additional intervention when bills started landing on doormats next year and some of these stories arose.
Measured inflation: as Tony Yates’ thread explained well, a wholesale price cap doesn’t change the fundamentals of there being a real shock to the economy from a higher wholesale gas price. What this intervention does is insulate the end consumer from this now. As such, it will massage the official consumer price index inflation rate downwards, perhaps by as much as 5 percentage points. This doesn’t or shouldn’t change the monetary policy stance of the Bank of England, because it doesn’t fundamentally change the macroeconomics. But it might be useful politically, with Truss’s team able to say “we’ve got inflation down quickly.”
Benefits creep: it would not have escaped Truss’s attention that when the emergency pandemic uplift to universal credit was reversed, the Resolution Foundation and others said the government was “cutting” support to the most vulnerable. There’s a lesson there: today’s spending becomes tomorrow’s baseline. Removing benefits just before an election would have been seen as perhaps more politically risky than winding down a temporary price control.
Plan B?
Now, I’m not convinced that these arguments mean this scheme is the ideal response. When I spoke to Truss-supporting economist Julian Jessop about it, he said, “Any decent economist could have come up with a better targeted, more efficient and cheaper 'Plan A'. But the chosen 'Plan B' is at least simple, ends the uncertainty for most households and businesses, and won't have to be continually revised if energy prices remain high.” I can understand that sentiment - except perhaps for the “decent economist” bit. Truss has plenty of decent economic thinkers around her, which makes it worth considering why she ultimately chose this route.
One silver lining from this is that Truss has bundled up some supply-side reforms as part of the package, including licensing for more oil and gas, lifting the shale gas moratorium and more. I wrote a month or so ago that one principle she should stick to in all economic legislation was “no relief without reform.” You cannot set the expectation that the government will always step in to insure the public against external shocks, without taking the liberalizing steps to ensure those shocks are less destructive when they do occur.
It’s arguable too that, with much of the media portraying Truss as an unthinking free-market ideologue, doing something early that completely counteracts that perception will give the Prime Minister more leeway and credibility to deliver actual deregulation elsewhere.
Wishful thinking? Perhaps. But make no mistake: this is a massive government intervention, requiring massive government borrowing, both of which Truss is instinctively averse to.
War On Prices Update
In the latest salvo in The War on Prices™ (UK edition) the Scottish government is introducing a private sector rent freeze and a ban on winter evictions. What could go wrong? The drumbeat for the introduction of a rent control regime in Scotland has grown louder and louder for some time and will surely follow this temporary freeze. Back in 2016 I wrote a summary of research into rent controls for the IEA book “Flaws and Ceilings.” It showed that first generation rent controls, such as overall rent freezes, are a disaster - leading to shortages of rentable accommodation, properties falling into disrepair to reflect below-market prices, and huge misallocations, as beneficiaries avoid downsizing and workers become more unwilling or find it more difficult to move to new jobs. Second generation rent controls - which control rents only within longer-term tenancies - are less damaging, so long as rents can adjust to market rates outside of tenancies or the within-tenancy controls don’t bind. But these within-tenancy caps create the expectation that governments can and should control rents, which leads to dissatisfaction when rents rise between tenancies in very hot markets. The longer tenants are granted security of tenure, or the tighter the within-tenancy rent increase ceilings, the more like first-generation rent controls they become. And, naturally, these controls are perceived by landlords as the thin-end of the wedge, leading to a somewhat lower supply of properties regardless.
Relatedly, in The War on Prices™ (US edition), economic realities have fought back in St Paul, Minnesota, where a crude rent control there has had predictably disastrous consequences in just a short time. The policy, approved last November, caps rent increases at 3 percent per year - even after tenants move out. Surprise surprise, if you cap price rises below market rates, you get a lower quantity supplied: St. Paul saw a 31 percent fall in the number of new permitted units this year, against a 38.5 percent increase in the Twin Cities metropolitan area. Yes, there’s lots else going on in housing markets right now, but politicians clearly think their own policy is a contributing factor. The council there are hurriedly trying to amend the regulation, such that new construction would be exempted for two decades, landlords would have complete freedom to set rent levels between tenancies, and landlords coulc cite high inflation as a reason to breach the existing 3 percent cap. D’oh.
Other things
My Times column this week was on how economic “distributional analysis” is weaponized to oppose tax cuts to such an extent that it precludes many good pro-growth tax reforms.
My ConservativeHome column was on why, eventually, Truss will have to grapple with restraining government spending.
It looks as if Ted Cruz has helped sink the anti-Big Tech newspaper industrial policy that Democrats were trying to push through the Senate (and which I wrote about here a few weeks ago). Good.
Until next time,
Ryan