Wednesday, November 09, 2011

How to decontrol the price of oil

We know a lot about price controls from the field of exchange rates. Here's an argument from way back, in 1998:
When change comes to a stabilised currency, as it must, that change is painful. Change in the long term is inevitable. The random walk doles out a little change every day, which is less painful than sudden large changes. 
...
Currencies which are random walks yield a deeper sort of stability. The steady pace of small changes every day generates realistic expectations about currency risk and continual realignment in production processes in the economy. It avoids sudden changes, and keeps the currency out of the domain of politics. The random walk regime is sustainable without incurring serious distortions in the economy.
In the field of exchange rates, India understood these arguments, and moved to a floating exchange rate. In March 2007, the INR/USD volatility moved up to roughly 9% and from early 2009 onwards, RBI stopped trading in the currency market. This was the biggest achievement of the UPA in economic reforms: In the 2007-2009 period, we got to a market determined rate on the most important price of the economy.

These same ideas are useful in thinking about the price of petrol. A large jump of Rs.1.8 per litre attracts attention. It is far better to let the price fluctuate every day. Ultimately, the price has to adjust. We suffer a lower political cost by letting it adjust every day (through the depoliticised market process). If we bottle up the small changes, then we have to make large changes. These are a bad use of political capital.

2 comments:

  1. Sir,

    Isn't it same with the food prices. We do not have sudden announced changes in many food items, but then also we have people sticking to weekly inflation figures and making issue out of it. We are talking about people who could not tolerate P.M.'s statement on how the inflation ifs also an indicator of increasing prosperity.

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  2. Mr Shah,
    What about the price of natural gas? Not sure how India regulates that, but I would love to read an article on it/its effects.
    If you're not planning on writing on gas anytime soon, do you have any recommendations of where I should go to read up on it?

    Best,
    Ushma Shah

    University of Pennsylvania
    shahu@sas.upenn.edu

    ReplyDelete

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