Note – this was going to be a video, but the day after writing it up I already saw better posts on it here and here and also here. However, the text I wrote is kept below as it adds an occasional additional point – so feel free to read those posts and this one 🙂
The increase in prices in the US over the past year has been generating considerable angst – and comments that “price controls are needed to deal with inflation, due to corporate greed”. This has led to lots of people saying things on Twitter, with individuals who different people may see as authorities taking very different views on the topic:
Aaron Hedlund on Twitter: “Did I miss the macroeconomics lectures where they teach that antitrust (https://t.co/EWD1CjAOpp) and price controls (https://t.co/oskR2ATzpu) are effective inflation-fighting strategies, or is economic illiteracy just running rampant again in some corners of the popular press?” / Twitter
How about we step back from the name calling to try to think about what these terms mean and what people are saying – as in the end it is likely people are talking a little bit past each other, and when that happens the rest of us can just get confused!
Are we talking about inflation?
To start with, is what we are observing at the moment “inflation”? This is a point that often gets missed, but it is essential to understanding the distinction between different points of view.
In the United States (where a lot of this discussion is ongoing), the consumer price index has increased by 6.8% between November 2020 and November 2021. There are three things happening here that give us our general context:
- A relative surge in demand for goods while demand for services is more mild
- Supply chain disruption
- Relatively higher price growth in the US than in other countries.
The increase in prices occurred in the face of post-pandemic supply chain disruption and significant fiscal and monetary stimulus – which has supported consumer demand. With some degree of nervousness about using public facing services, relative demand for goods is at an all time high – and so the already interrupted supply chains into and around the US are struggling.
Michael (Asian Century Stocks) on Twitter: “If you’re betting on higher container shipping rates, aren’t you just betting on a continuation of COVID-19? Goods demand is likely to decrease into a recovery https://t.co/bjianLII5m” / Twitter
Given a shortage of goods the increase in demand has translated into higher prices – a mechanism that is common for any type of rationing.
Furthermore, looking through the price categories, pricing pressures exist all across the set of goods and services for sale – yes energy and used car prices have risen by more, but price increases appear to be quite widespread.
This tells us that there has been a generalised increase in prices rather than just an increase “specific key sectors” as the article suggests. So this indicates that there is likely something increasing “all prices” rather than just the selected prices the article suggests targeting.
Furthermore, the lift in the US is higher than other countries have experienced – suggesting that there is an element of this that is US specific:
So that general lift is inflation right? Well not necessarily – and that is where everyone has been a bit slack. Inflation is “persistent growth in the level of prices”. If the supply chain interruption is temporary then this is a one-off price level change – which isn’t what we normally think of when talking about “inflation”.
This distinction often gets muddied as we care about the change in our ability to purchase goods and services – but the distinction is central if we are to think about the nature and role of monetary policy.
You may have heard of team transitory who are the individuals who believe it is supply chain interruption that is the primary cause of higher prices. This team does not anticipate future inflation once supply chains begin to function “normally” and in that context, a period of weaker price growth would be likely in the future once that occurs.
However, Elizabeth Warren recently took part of team transitory in another direction – by pointing out that measures of corporate profitability have increased. How is this relevant – we will get back to this soon I promise – but for now just remember that the view of imposing price controls is partially from this team.
Furthermore, even those in team transitory that do not believe in price controls are more sympathetic to leaving monetary conditions stimulatory (i.e. bond purchases and lower interest rates) and further government borrowing and stimulus payments. Why – because it is a temporary supply shock that has pushed up prices, and so allowing higher prices temporarily to prevent a decline in output/unemployment is seen as appropriate. At the very start of COVID, this was consistent with how Gulnara described the role of monetary policy in the face of such a shock – and a related lift in prices due to the Fed looking through supply chain disruption can be seen as consistent and reasonable.
A supply shock reduces income, and looking through the shock and allowing a one-off increase in prices (as opposed to trying to reduce demand to bring prices down) is seen as a fair way of distributing the shock – at least as far as monetary authorities are responsible for such things.
There is a different team of economists out there who see matters quite differently. Noting that the quantity of goods sold far exceeds anything seen in the past, this group views the focus on “supply chain disruption” as overstated – instead supply chains are overwhelmed because there is excessive demand. I see the article uses “team stagnation” which is a dumb name trying to discredit the idea – it is “team permanent”.
If monetary and fiscal conditions remain expansionary in the face of excessive demand, then prices will continue to grow – leading to expectations of future price growth among individuals and firms. These expectations then filter into price and wage setting behaviour, and become self-fulfilling – generating persistent growth in all prices. This is inflation.
The feather in team permanents hat is the differential change in inflationary pressures in the US relative to other “similar” countries. If prices are rising more quickly in the US than in other countries with similar supply chain disruption, then the additional price increase may well be due to greater domestic demand – and may be expected to persist generating true inflation and higher inflation expectations.
To this group a portion of the current increase in prices is inflation – as it is the start of a persistent process of rising prices.
Price controls, margins, and the price level
If we are experiencing genuine inflation then price controls are, to be frank, an incredibly dumb suggestion. Even when Tobin spoke in favour of such controls in 1981 (Economist Tobin on Inflation: How It Started, How to Stop It – The Washington Post) this was based on the view that it was not excessive demand generating the inflation – but the interruption of the oil price shocks.
<iframe src=’https://d3fy651gv2fhd3.cloudfront.net/embed/?s=cpi+yoy&v=202112101416V20200908&d1=19700103&d2=20220103&h=300&w=600′ height=’300′ width=’600′ frameborder=’0′ scrolling=’no’></iframe><br />source: <a href=’https://tradingeconomics.com/united-states/inflation-cpi‘>tradingeconomics.com</a>
There is a point here. Both of the teams noted above agree that the underlying supply shocks have consequently reduced incomes – and that higher prices are a part of determining who bears the reduction in “productivity” in some sense due to this shock.
A desire to then “control prices” is a wish to avoid the current distributional consequences. However, it is not costless.
If prices are not allowed to rise to ration the increase in demand, then something else will have to give – fewer goods and services will be available, the relative price anything without a rationed price (i.e. black market sales) will change, the intervention will create uncertainty about voluntary exchange, and finally once the controls are removed prices will simply rebound. The suggestion that selected prices are frozen is especially disconcerting as it will incentivise firms trying to reclassify products out of scope and lead to pricing pressure leaking out to other products while these products are arbitrarily rationed.
Contrary to the related articles that appear to suggest this isn’t true, we have endless examples of this occurred across the world – Venezuela, Argentina, the United States through the 1970s, New Zealand under Muldoon with freezes occurring between 1976 and 1984 (The wage and price freeze, 1982–1984 – Law and the economy – Te Ara Encyclopedia of New Zealand).
If instead we are viewing this as a one-off price change, then is the argument different?
If it was, it wouldn’t be the argument in the article linked above – which seemed to ignore the rationing that occurred for years following WWII as a natural part of the same issue, where the supply chain was shifting from significant central direction (to produce war equipment) to the private provision of consumer goods. The supply chain in the current situation has not had to change what it produced, or have been destroyed by a disaster, it is instead struggling under a mixture of higher costs and high demand.
Higher prices are the rationing mechanism at play given where the balance of supply and demand is – if we fix prices de facto lower the quantity of purchases further, then some individuals who value the goods at a very high price now would not be able to receive them. So far, no rationale. Furthermore, as the suggestion is to target specific “selected prices” – this will lead to increased demand for substitute products, leading to the pricing pressure leaking to other items. Given the rationale of targeting products who experience a price increase this is likely to lead to a poorly timed game of whack-a-mole with prices, all while the proximate cause of inflation – excessive aggregate demand – is ignored.
Such price fixing exacerbates the issue at hand – which is that households cannot get the goods and services they want given their real incomes. If instead of fixing prices we ensure that underlying fiscal policy is appropriately set to set a floor on individuals incomes, and that competitive issues are sufficiently dealt with to allow individuals to have sufficient power when they consume or go to work, then the distributional consequences are likely to be less severe.
If it is demand that is driving up prices, then the rationing functions over time – the high prices now push people who can wait to delay purchases, internalising the fact that supply chains are currently struggling. If prices do not reflect that, then in a rationed environment such products start to be allocated on the basis of luck and other forms of power – it will not reverse out the supply shock, and for some who complain goods are two expensive now it will simply make the goods unavailable.
Power dynamics and corporate profit
The concern about power dynamics is highlighted by the focus on corporate profit and “price gouging”. The idea here may be that producers are using this as a way to collude on higher prices and margins. As a result, there may be a way to undermine this collusion and increase quantity and reduce prices – solely benefiting households.
Now this is likely not an argument about monopoly or heavy concentration itself. The argument that a monopoly is taking this as an opportunity to charge customers more has to contend with the counter argument – if they could normally charge customers more why don’t they? Arguments that rely on “gouging” need to explain why this gouging doesn’t normally occur, and if it is a result of current scarcity why the price signal itself isn’t appropriate – after all, not having access to the product is the same as it having an infinite price to the consumer.
If the argument is just that demand is “currently high” then how is that different to stating that we should reduce aggregate demand which is what team permanent is saying? There is a distinction between their being demand for a specific product due to a crisis – and there being general high demand. And this article appears to confuse the two.
To try to make the best argument for this view about price fixing we need a coordination issue, we need some idea of oligopolistic firms and price setting.
The Green and Porter (1984) model of price setting among oligopolists may give us a solution here – during states of “high demand” oligopolists may collude and hold up profits, but when general demand falls they are unsure if they are being betrayed or if the economy is slowing. Given this they are more likely to “punish” by cutting prices when the economy slows. Here we have clear information of a “high demand” state, and so firms have agreed to collude.
The issue with this model is that is just doesn’t fit the data – rather than being pro-cyclical prices are often found to be counter-cyclical (i.e. Why Don’t Prices Rise During Periods of Peak Demand? Evidence from Scanner Data – American Economic Association (aeaweb.org)).
This result isn’t just in the annals of economic estimates – it is something you can see all the time by going to the supermarket. I’ve seen it for Nurofen (Why do supermarkets cut the price of medicine when people are getting ill? – TVHE), during COVID I saw it for toilet paper (Understanding Wellington and toilet paper – TVHE). Why?
That is where an alternative theory comes in, Rotemberg and Saloner (1986). If there are “high” demand and “low” demand states then the benefit associated with defecting from collusion is greater when demand is high – as a result, when demand is high and people are fully informed it is high, a price war and lower profitability is likely.
So why are corporate profits high, if our view of an observable demand shock would lead to lower profitability?
One way to do this would be to go back to view this predominantly as a supply shock rather than a demand shock, implying that post-COVID can be viewed as a low demand state. But that just isn’t consistent with the evidence relating to the quantity of goods being sold.
And that tells me that this IS an interesting puzzle – it isn’t about inflation itself, it is about the magnitude of the increase in corporate profits coming out of a pandemic during a period of elevated demand.
When I see a puzzle the first thing I want to do is look at the data more carefully.
Profit and the national accounts
In such a case the first thing I’d want to look at is what the data is – we are being told this is profit, but I know that national accounts don’t always match up with what we think. The key item I see here that interests me is the “Expenses exclude deductions for bad debt, depletion, and amortization“ – so bad debts that were written off, and assets and stock that was lost, are not included in expenses … and so form part of profit!
Inventory valuation adjustment (the IVA mentioned in the profits title) should have captured the majority of this loss as shown in the IVA figures:
However, such revaluations tend to be fairly conservative. When combined with non-inventory write-offs in the period, this suggests that some of the increase in profit will only represent these costs to the business. As these are largely fixed costs we may still be surprised that firms have passed them on – however, if the costs were necessary to crystalise in order to being operating in a post-lockdown environment and businesses were liquidity constrained such pass-through may seem plausible.
Furthermore, if the current environment is very risky businesses may be unwilling to take on investment unless they are sufficiently rewarded for taking on the risk of their investment being sunk – which would also lead to higher profit levels.
A disaster that interrupted supply chains and destroyed inventories, and in the aftermath saw corporate profit rise when such losses are not recognised feels as if a major cost and risk parts of the cost shock is not being counted in the corporate profit figures. In an uncertain environment firms will want certainty about cash-flow, and will want to hold liquid assets in case they are faced with another shock – exactly the same way households function in such an uncertain environment.
Now it is useful to ask what else we would see in the data if this was an explanation. We would expect dividends to not change, while undistributed income and net private savings surges – as the undistributed income is essentially “invested” to pay for the costs noted above. Sure enough, this is exactly how the data looks:
However, this does tell us that corporate firms were able to pass on these costs – which itself suggests that there is more going on. To understand this further we need to recognise that it is a bit strange to focus only on corporate profits and not the income of other capital and labour owners. So let’s take a look at that.
From September 2019 (pre-COVID) corporate profits have risen 29%. Over the same period compensation of employees rose 12%. These are all in current prices (Q3 2021, Table 1.14. Gross Value Added of Domestic Corporate Business in Current Dollars and Gross Value Added of Nonfinancial Domestic Corporate Business in Current and Chained Dollars: Quarterly | FRED | St. Louis Fed (stlouisfed.org)). With all incomes increasing and limited capacity to make goods and services this sounds a lot like a general “demand” shock driving up prices – a focus on only one income measure was hiding that!
The 17% percentage point gap between corporate profit growth and compensation of employee growth could plausibly be explained by increased risk in the trading environment, and “missed costs on business” in the national accounts figures that are being investigated. In this way, when we look at all the numbers as a whole it looks like a smaller puzzle – and more like there is a surge in domestic demand in the United States.
Ok why do I care
The distinction between this being a “supply shock” and a “demand shock” matters for what we would see as appropriate central bank action. If there is truly excess demand then tighter conditions are warranted – if it is mainly about supply disruption and a “price level shock” then there is less need for tighter monetary policy, and more of a need to communicate to manage inflation expectations.
Working through the data, the higher level of corporate profitability – and all incomes – makes the argument that this is a demand shock relatively stronger, rather than weaker. The argument given for price freezes does not support price freezes, but instead supports the tightening of monetary and fiscal policy the author says is inappropriate.
This is the key with economics – the author recognises this but there are other, unsaid, arguments in the background.
It appears the author is pushing for price freezes believes that there should be more government spending and investment in specific sectors, that the size of government should be larger, and that more resources should be directed by the state – and this is a legitimate position that they can take, and a legitimate position for people to strongly agree or disagree with. They are not thinking about inflation vs no inflation, but are instead worried about the political economy associated with reducing demand – and it occurring through reduced government spending.
In this world underlying “true” inflation is a tax, and this is a politically expedient way to have a greater tax burden to fund underlying expenditure. I would prefer the author was instead transparent and stated that they want more spending and taxation, rather than arbitrary calls to freeze prices based on corporate greed – but by obfuscating trade-offs they may feel that the world they desire is more likely to happen.