Capacity constraints, inflation and economic management

Economic management is not an exact science. One wag once wrote that an economic reform usually has precisely the opposite effect of what was intended. A bit of an exaggeration but nonetheless a reminder that the best of good intentions can go badly wrong.

Yet the problems at this stage of a boom in an emerging market are well documented and highly repetitive. For however open and fair an economy the introduction of excessive growth - in this case due to a massive spike in oil revenues - will produce particular strains: notably capacity and supply constraints and accompanying inflation.

This is most obvious in housing rents. There is a limited housing stock which can not be expanded overnight. A boom produces strong demand for housing and so rents rise, unless the government steps in to cap rentals.

Capping rents

A government cap on rents is an effective policy at a late stage in a boom to prevent huge rent rises from crippling local residents.

However, if it becomes a long-term policy it will distort the local construction sector by making it uneconomic to build housing units as building costs will rise even if rents do not. This will make the shortage of homes even worse, and encourage landlords to neglect their properties.

Rent control is why parts of New York look like slum dwellings, and that is a shame in one of the world's richest cities. But private sector real estate investors have to make a profit to survive and if that process is interrupted then there are market consequences.

Indeed, probably the most effective economic policy in a boom period is the maximum liberalization of an economy and the elimination of old barriers to free trade and investment. It is much easier to do this when an economy is booming and everybody is doing well, and the long term gain from greater efficiency is well documented in economic theory.

Rationing policy

For example, one response to a shortage of building materials and high prices is to introduce a control on price inflation. But this will then shift the onus of limited supply on to some kind of rationing criteria instead of price as it does nothing to tackle the underlying issue of lack of supply.

Far better is a free market approach which will allow the sourcing of building materials from anywhere in the world at the lowest cost. A similar approach can also be applied to skilled labor. Much better to recruit worldwide than insist on finding suitably qualified nationals of the country concerned as they may not exist.

In fact one reason for the strength of the current economic boom in the Middle East is a generally free market approach to labor, a notable contrast to the closed economies of the Western world whose economies go short of IT professionals rather than import them from certain nations.