The argument that corporate greed causes inflation makes an elementary economic mistake.
The argument that corporate greed causes inflation makes an elementary economic mistake.
B laming corporate greed for inflation is back, apparently. Recent stories in the Wall Street Journal, Business Insider, and Bloomberg have brought renewed attention to the theory that inflation is caused by corporations raising their prices to make excessive profits, and some officials at the European Central Bank have commented on it.
This explanation of inflation is an example of reasoning from a price change, and it is incorrect.
The “greedflation” theory goes like this: Inflation is high because corporations are raising the prices they charge consumers beyond their increases in input costs. Corporations are doing this to pad their profits. They’re able to get away with it because supply constraints have created an implicit agreement between corporations to raise prices. Consumers are aware of this implicit agreement, which increases their expectations of what prices will be, so they play along.
It is true that corporate profits are high. It is also true that prices are rising. But taking those facts as evidence of the “greedflation” theory is reasoning from a price change.
Economist Scott Sumner is famous for saying, “Never reason from a price change.” It’s an elementary economics mistake that even very well-trained economists slip up on every once in a while.
Here’s what Sumner means. If you observe that the price of milk has gone up, should you expect the quantity of milk consumed to go up or down? The correct answer is not, as some might say, that consumption of milk will go down. The correct answer is that we need more information.
If the price of milk went up because cows got a terrible disease and couldn’t produce milk, or the milk delivery-truck drivers went on strike, or some other factor negatively affected the supply of milk, then the quantity of milk consumed would go down.
If the price of milk went up because a new fad diet encouraged drinking a half gallon per day, or lots of people started making their own ice cream at home, or some other factor positively affected the demand for milk, then the quantity of milk consumed would go up.
As a result, if the only information you have is a change in the price of milk, you can’t say whether it will cause the quantity of milk consumed to go up or down. You need to know why the price changed. That’s why you should never reason from a price change.
Let’s leave the market for milk and look at the macroeconomy. Prices are rising. Is the cause that companies found a new way to pad profits? Or is it that consumers are demanding their products more?
The story of the Federal Reserve’s expansionary monetary policy combined with the federal government’s expansionary fiscal policy would suggest that demand is higher. And the data back that story up.
Look at personal consumption expenditures since the end of the Great Recession:
Actual consumption (in blue) is way above a linear estimate of the pre-pandemic trend (in red).
Or consider the gap between actual nominal gross domestic product (NGDP) and the neutral level of NGDP, as estimated by the Mercatus Center. As of the first quarter of this year, actual NGDP was still exceeding neutral NGDP by 5.76 percent. That means monetary policy is still expansionary (and yesterday’s rate hike was welcome). Mercatus’s median projection suggests that NGDP will not return to the neutral level until about 2026.
“What actually seems to be happening is that families and businesses are sharing the spoils of the post-pandemic economy,” the Economist explained in a piece examining greedflationists’ claims. “Red-hot demand, linked in part to massive stimulus programmes in 2020-21, is the true source of price pressure — and can sometimes result in margins expanding.”
Prices aren’t going up because corporations have squeezed consumers. Prices are going up because consumers, enabled by expansionary monetary and fiscal policy, have increased their consumption. It makes sense for demand-led inflation to lead to an increase in profits in the short run.
We already saw this cycle play out in its entirety in the market for ocean freight. In 2021, ocean carriers made enormous profits as a result of a surge in demand. The quantity of ocean freight increased because new carriers entered the market, and now the price has come back down, and carriers’ profitability has fallen commensurately. It seems unlikely that ocean carriers’ greed increased in 2021 and decreased in 2022.
The ultimate source of disagreement is, as usual with inflation, whether you think it is demand-driven or supply-driven. Given the trends in consumption and NGDP, and what we know about the expansion of the money supply and the increase in government spending, it seems pretty clear that demand is now in the driver’s seat. Higher demand can cause a price increase just as easily as reduced supply can. That’s why you never reason from a price change.