It is a strange opinion that profits—or for that matter wages—“drive” inflation, but it does help an economist maintain a spirit of tolerance and see a pedagogical opportunity in every error. A Wall Street Journal reporter is at it again with a story of yesterday titled “Outsize Profits Helped Drive Inflation. Now Consumers Are Pushing Back.”
The reporter (or perhaps his editor) writes as if it were obvious:
Extraordinary corporate profits were a driving force in last year’s surge in inflation, a pressure that is now easing rapidly as customers push back.
I wrote about that strange idea before (see “Not Very Sophisticated Thinking About Inflation,” EconLog, May 3, 2023), but I just discovered a similar story from the same journalist who had inspired my first reaction. I will not repeat everything I said in my previous post, but let me emphasize a few points with a special focus on yesterday’s story.
If increasing profits were “driving” inflation a year ago, why didn’t businesses “drive” it earlier? Why don’t they always drive inflation to increase their profits? Indeed, why don’t they “drive” hyperinflation to make hyper-profits?
The reason is simply and rather obviously that “they,” which means each individual business, cannot charge the prices they want to increase profits. The journalist implicitly counters that it is because consumers have just now started “resisting.” But why don’t they always resist? A passing knowledge of economics suggests the answer: consumers do always resist. A consumer tries to get the lowest price possible and each business tries to get the highest price it can charge. Competition (which is entailed by free markets) drives prices down to a level where the typical business earns only a normal return on capital; otherwise, other businesses would enter the market (which is what a free market implies). Consumers who think that the price is too high don’t buy; suppliers who think that it is too low put their money elsewhere.
Another question: Why, instead of profits or wages (which are the price of labor services), isn’t it the price of green peas that drives inflation? Absurd, of course, for that is just one of millions of prices. But it’s the same if you take the price of any other good or service. It is all prices together that “drive” inflation; more exactly, their simultaneous increase is inflation (as opposed to up or down changes in relative prices). Why do all prices rise together? In other words, what drives inflation? That is the real question (of which I said a few words in my previous post). Saying that it is this or that price that causes inflation confuses cause and effect: the cause is inflation; the effect is that all prices rise–over and above their relative changes.
Profits, that is, returns higher than the normal return necessary to attract capital, is a residual: whatever remains after revenues and costs have been accounted for is left to the owner (the “residual claimant” as the theory of the firm calls him or them). But it is a bias of the ex-post accounting mind to consider a residual as a cause of the total.
Consider the following analogy, even if it is imperfect like all analogies. You bake a delicious cake for yourself. It then strikes you that some people may want it more than you do. You go to a homeless tent settlement and tell the occupants: “Cut for yourself the pieces you want,” thinking that you will eat whatever is left if anything. Strangely (given that your beneficiaries don’t pay anything for your charity), a residual piece is left, which you happily gobble. It doesn’t make economic sense to say that the cake was all eaten because of your piece, that your selfishness “drove” the complete eating of the cake.
Without theoretical guidance, wrong questions are asked and wrong answers are given. Trying to explain why consumers did not resist inflation earlier, the WSJ story opines, citing “many economists,” that consumers were confused by “the surge in energy and food prices” after the Russian invasion of Ukraine:
Many economists think that the second surge, coming on top of the pandemic, led to such confusion among consumers about where prices should be that they briefly became more accepting of above-cost price rises.
Consumers are never “confused” about “where prices should be”; each one is individually concerned about the prices he pays. Every consumer wants to pay as little as possible and never more than what the good is worth to him. Those who doubt the rationality of ordinary consumers should consider how quickly the price increases of brand-new cars after the pandemic rapidly led many of them to turn to the used-car market (see my post “Do Used Car Prices Vindicate Adam Smith,” February 11, 2022). It is remarkable how efficient ordinary people are in their private activities if they are free, often more than armchair social analysts can be in their pronouncements.
The reporter also writes:
There is a broad consensus among economists that the role of profits in fueling inflation is one feature of the recent inflationary episode that made it different from the 1970s.
I don’t know about the supposed broad consensus, but I note that seven months ago the journalist invoked only “some economists.” The broad consensus seems to be mainly among those whom journalists interview. To be fair, our WSJ friend does mention a few economists, including “researchers of the Bank of England,” who may softly disagree with the supposed “consensus.”
T0 crown this theory-less analysis, it is even not clear that profits are actually decreasing: see Justin Lahart, “How Rising Profits Could Prevent the Economy From Faltering,” Wall Street Journal, December 3, 2023. Good economic analysis does not provide a magic crystal ball, but bad analysis muddles the present as well as the future.
It seems to me, although I have no hard evidence, that economic voodoo has never been as prevalent in the financial press (at least in the Wall Street Journal and the Financial Times) as it is now. I just ran into another example, again in the Wall Street Journal of this morning (perhaps because it is my major breakfast newspaper!), where the author calls “deflation” the decrease of some prices, the mirror error of calling “inflation” the increase of some other prices: “Goods Deflation Is Back. It Could Speed Inflation’s Return to 2%,” December 3, 2023).
READER COMMENTS
Craig
Dec 3 2023 at 3:45pm
The whole concept of greedflation is entrenched in leftist thinking. Robert Reich bloviates about it constantly.
https://robertreich.org/post/705458064464183296
“If we measured corporate profits more often and more reliably, Americans might start to get the full picture about what’s driving inflation to historic highs — the power of big corporations to raise their prices higher than their costs are rising.”
“economic voodoo has never been as prevalent in the financial press (at least in the Wall Street Journal and the Financial Times) as it is now.”
Not entirely sure about prevalence but its nothing new under the sun. But note a Friedman quote: “If you listen to people in Washington and talk, they will tell you that inflation is produced by greedy businessmen or it’s produced by grasping unions or it’s produced by spendthrift consumers, or maybe, it’s those terrible Arab Sheikhs who are producing it.” – https://www.heritage.org/budget-and-spending/heritage-explains/the-real-story-behind-inflation
And of course to expound everyone knows the true voodoo economics is supply side, right?
Ahmed Fares
Dec 3 2023 at 7:29pm
This from Don Boudreaux at Cafe Hayek:
https://cafehayek.com/2022/05/unprofitable-analysis.html
Craig
Dec 3 2023 at 7:40pm
The Professor makes a valid point. Whether firms engage in unconscionable price gouging or anticompetitive dumping, they seem to be damned if they do or damned if they don’t
Jose Pablo
Dec 4 2023 at 1:35pm
What does “unconscionable” mean when referring to “price gouging”?
Brandon Berg
Dec 4 2023 at 12:42am
Inflation drives profits. Obviously when nominal GDP increases, nominal profits will as well, but a less obvious way inflation drives profits is inventory appreciation. Firms buy products to resell, or various inputs to production, and then, at a later time, sell the inventory. During the intervening time, prices rise, resulting in appreciation of the inventory, and firms realize a profit on this appreciation.
When inflation is running low, profits from inventory appreciation are low, and contribute relatively little to total profits. Firms may actually lose money as inventory depreciates. But when inflation is running high, these can be quite substantial.
We know the value of profits realized through inventory appreciation. The BEA subtracts them from corporate profits when calculating GDP, because capital gains are not counted in GDP:
https://fred.stlouisfed.org/series/CIVA
Note that these are annualized quarterly figures. Also, negative numbers indicate that corporations realized profits on inventory appreciation, since this is the adjustment made to GDP to exclude those profits.
Knut P. Heen
Dec 4 2023 at 5:50am
You are right. It is important to understand the difference between accounting profits and real profits. If you buy a shirt for $100 in year 0 and sell it for $110 in year 1, you get an accounting profit of $10 (even if the inflation was 10 percent and the real profit was zero).
Jose Pablo
Dec 4 2023 at 2:41pm
It is even worse than that.
Your “real profit” would be negative since the cost of equity is nowhere to be seen in the P&L (the cost of debt, by contrast, is there), but it is a very real cost to bear in mind when allocating resources (not less, at least, than the cost of debt).
Knut P. Heen
Dec 5 2023 at 3:30am
You are right. I did not want to make the example too complicated. There are also taxes on the nominal profit.
Jon Murphy
Dec 4 2023 at 7:25am
Well, this is fascinating.
I would have thought the inflation inventory effect would have a muted effect on profits since holding inventory is a cost for businesses and thus they want to move it at quickly as possible. And perhaps that is still the case; for example, in Q42022, inventory valuation accounted for $100 billion in profits, or 3.5% of total corportate profits.
Still, 3.5% isn’t nothing.
Craig
Dec 4 2023 at 7:42am
It also goes the other way though as well.
https://www.wsj.com/articles/inflation-puts-spotlight-on-companies-use-of-last-in-first-out-accounting-11656322200
“Concerns about rising inflation and slowing growth are putting the spotlight on an accounting method U.S. companies use to lower their federal tax bill by inflating their costs, which also squeezes their quarterly earnings.
Companies including grocery chain Kroger Co. in recent weeks have said their use of last-in, first-out accounting, or LIFO, has increased costs and dented earnings.”
Pierre Lemieux
Dec 4 2023 at 10:47am
Brandon (and others): Inflation is a rise in the general price level. Of course, the value (price) of inventories increases but it does not change in relative prices since all other prices in the economy are pushed up (compared to what they would have been otherwise). For example, as the value of inventories increases, the nominal interest rate increases and so does the (opportunity) cost of storage, while the value of account receivables decreases. Inflation must not be confused with an increase in real demand for firms’s production (any more than with changes in relative prices).
Thomas L Hutcheson
Dec 4 2023 at 8:41am
It was true before Fredman said it, but Inflation is a monetary phenomenon. Non-monetary shocks “cause” inflation only the the extent that the Central Bank decides that inflation of a certain amount is the lowest cost way of dealing with the shock. [Knowing that there are always an average level of gazillions of micro “shocks” economic events means that the Central Bank has an inflation target that is not zero.]
IF a group of firms discovered a new way to increase their prices (AI pricing algorithm? :), the central bank would be wise to allow enough inflation to allow this change in relative prices rather than let it cause customers in he aggregate not to be able to pay the prices and unemployment develope. But that still means that its the Central Bank that causes the inflation.
And all of Pier’s question would still be valid about how firms were able to execute the new algorithm at the same time at a stuffiest scale and why now and not before.
Jose Pablo
Dec 4 2023 at 2:38pm
That’s a very interesting and useful way of looking at why inflation is always a monetary phenomenon (since it is always up to the monetary authority to “neutralize” the inflationary effect of changes of relative prices due to shocks).
Thank you, Thomas
Thomas L Hutcheson
Dec 4 2023 at 10:13pm
I’m just repeating Freidman.
Jose Pablo
Dec 4 2023 at 6:02pm
Can your argument be used to justify why a 2% inflation target (halving the value of fiduciary money every 36 years) is better than a 0% inflation target?
If I understand you right, a 0% inflation target wouldn’t let the Central Bank the option of allowing “this change in relative prices rather than let it cause customers in the aggregate not to be able to pay the prices and unemployment develop“
Thomas L Hutcheson
Dec 4 2023 at 10:45pm
My argument is that some prices cannot fall in absolute terms if a economic shock occurs that requires reallocation of reauorces/changes in relative prices, the only way that can happen is for some to go up by varying amounts and some to remans the same. That is the average price level has to rise if no prices could rise that means market not clearing; transactions will not occur and we get unemployment of goods and services with the downwardly inflexible prices.
That is the argument for a Big Shock — COVID and recovery or maybe oil-grain pieces after the Ukraine invasion. But even without any Big Shock, there is a Brownian movement of small economic events that also require changes in relative prices so the economy would need a low average level of inflation to allow these mini shocks to be accommodated. So I say the central bank should try to have a non-zero target rate.
Put the two together and you get FAIT, a low average target inflation rate with flexibility to go temporarily higher for extraordinary shocks.
I’ve spelled it out in the simple case prices are either downwardly fixed or perfectly flexible, no upwardly fixed prices, no consideration of the costs of inflation in inhibiting longer term contracts (which sort of takes care of money as store of value issue) the Cantillon effect — the real effects of whatever instrument used effect the inflation, etc.
Pierre Lemieux
Dec 6 2023 at 3:51pm
Thomas: Are there many examples of inflexible retail (or even world market) prices? And are they unregulated, free-market prices?
Jose Pablo
Dec 4 2023 at 2:23pm
The argument that “profits” can drive prices up can be only based in a profound ignorance of the real numbers on a “typical” P&L.
Unfortunately, P&Ls are designed to put the (residual) bottom line under the limelight. That makes a lot of business / accounting sense, but it is terrible from the PR perspective. A fact frequently abused by left leaning writers.
A new form of P&L will be much more informative for these discussions. This “new P&L” would be designed to show “who” is getting “how much” out of every $100 “really” paid by the client (taxes included).
Below are the numbers for American Airlines 2019. The results are similar for other utility and airline companies (even worse in Europe due to VAT).
The results are striking, of every $100 “really” paid by the client:
1 – The government takes $30-35 (sale tax, different “other taxes” particularly abundant in the airline and energy industries, payroll taxes (employer and employee) and corporate taxes)
2- The employees take around $15-20 (salaries, medical insurance … payroll taxes would be included in the “government part”)
3- The suppliers take around $30 (this part could be split among the other categories).
[Other suppliers, relevant in this case: fuel and infrastructure use fees, take an additional 15-20%]
4- Debtholders take around 2-3%
5- Equity holders take around 3-5% including dividends, shares buy backs and retained earnings.
Obviously, the methodology can be modified and fine-tuned (ie part of the debt and equity holders take also ends up in the government hands), but the exercise will illustrate that even a 50% increase in benefits would mean (ceteris paribus) no more than around a 2% price increase.
Another interesting conclusion from this “new P&L” would be that if the government fully nationalize the airline industry, the government revenue from this activity will increase by less than 15% (and this under the very unlikely hypothesis that the government-controlled airlines will be equally efficient). It isn’t worth the hassle!.
What the “new P&L” would clearly expose is that our model clearly resembles a “government owned” economy that has hired shareholders and managers to manage the companies on its behalf, in exchange for a 15% fee, which is “variable” depending on shareholders and manager’s performance.
The “accounting P&L” that we use is clearly distorting our view of “reality”.
Pierre Lemieux
Dec 4 2023 at 5:01pm
José: I think there is another phenomenon going on here. Double-entry business accounting is meant (and it must be the case since its invention more than six centuries ago) to present an auditable picture of a firm’s profits (and shareholders’ value) in such a way that stealing from the owners is difficult to hide; and, as a corollary, it is difficult to make an error in calculating profits and shareholders’ equity. It is not meant to explain what generates the prices at which a firm sells its wares for. More generally, accounting (including national accounting, central bank accounting, etc.) only provides a still picture of past transactions and can only indirectly (with economic or financial analysis) help us to find causes and try to forecast the future.
An indication is that, on the basis of simple accounting identities (in business accounting, there is one “fundamental equation of accounting”), true by definition, accounting always provides an answer to any accounting question; the answer is tautologically true, although sometimes it requires some creativity to find. (Still accountants are not known as the most creative intellectuals in the world.) I don’t remember which economists (in my memory, it’s Kenneth Boulding, but I am not sure) said that, from this point of view, accounting is like religion–and, we might add, like any narrow ideology.
Jose Pablo
Dec 4 2023 at 5:54pm
‘”It is not meant to explain what generates the prices at which a firm sells its wares for. “
Precisely so. And yet that what it is frequently (your post as an example) used for.
Being this the case, it would be of some value presenting a “non-GAAP” statement, answering the question “who is taking home the money you pay for this company products/services”
I find it iluminating. Shareholders are (most of the time) working for a pitance (around 1/7 of what the government is taking) And getting all the bad press is included in this mearge variable fee.
Pierre Lemieux
Dec 4 2023 at 7:03pm
José: Yes. They do this on some gas pumps, don’t they?
Jose Pablo
Dec 4 2023 at 7:48pm
Some utility companies have done this too as part of PR campaigns.
In general, the “bad press” is worse in capital intensive industries where the profits look “fatter” to the untrained eye.
Following GAAP, the net income line does not take into account the amount of capital required to “earn” that income, but the bigger the amount of capital required the bigger the income has to be in order to provide an adequate return on equity.
Saying that the shareholders of these companies have “huge/bigger” profits is like saying that Walmart employees earn a lot of money. Which is strictly true since there are 2.3 million of them.
All these distortions disappear when you look at profits as the (meager) % of revenues that they are for utility companies.
Craig
Dec 6 2023 at 11:51am
Very true, someday tell a leftist that if they spend a $1 at Walmart the state governments collectively get more in sales taxes than $WMT shareholders get in profit. True because its a low margin business.
Ahmed Fares
Dec 4 2023 at 4:13pm
Matthias
Dec 4 2023 at 10:55pm
I mostly agree, but I wouldn’t be so absolute in the statements:
Not all business try to make as much profit as possible. And not all customers try to pay as little as possible.
But economic theory is robust even in the face of those people.
(To give an example: I have a favourite coffee shop that I go to. And as long as their prices stay reasonable enough, I won’t switch, even if their competition across the road would slash prices to zero.
Just like I wouldn’t drink Heineken beer, even if it was free.
But in other parts of my budget, I often go with the lowest bidder without thinking twice about it.)
Similarly, some companies pride themselves in paying the highest wages they can sustainably afford. Especially some privately held companies in Germany.
Even a public company doesn’t have to maximise profits, they just have to do what shareholders demand, and shareholders are free to demand whatever they want.
It’s a reasonable model to assume that all companies try to increase profits. But it’s not required to be universal in neither practice nor theory.
(And, yes, the question is ‘why would greed suddenly get worse? And why would customers only fight back now?’)
Richard Fulmer
Dec 5 2023 at 11:28am
The greed-causes-inflation and the profits-cause-inflation explanations are little more than conspiracy theories. They require that all the producers and retailers in the world got together and decided to raise prices at the same time. None of them cheated on the agreement and dropped their prices to gain market share.
That kind of coordination and enforcement requires government coercion – in this case, global government, since Americans buy quite a bit from overseas.
A far simpler explanation is that the Fed printed a bunch of money to pay for Trump’s, Biden’s, and Congress’ spending sprees. Of course, neither Trump, Biden, nor Congress like that explanation, so they’re in the market for economists willing to spin plausible alternatives that lay the blame elsewhere.
Comments are closed.