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Inflation isn't the same, always and everywhere.
Every outbreak of high inflation has unique causes and characteristics, so you'd think we should have a range of tools to manage different kinds of inflation, right?
German economist Isabella Weber thinks so.
She's one of the most interesting economists to watch at the moment, and is producing thought-provoking work on the nature of today's inflation.
She's not afraid to draw attention to the related problem of excessive profit-taking during economic emergencies, such as the COVID era.
The hydra-headed nature of profit
But first, have a read of this.
This is what Adam Smith, the 18th-century Scottish economist and philosopher, had to say about high profit-taking:
"Our merchants and master-manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both at home and abroad. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people."
That comes from Smith's treatise An Inquiry into the Nature and Causes of the Wealth of Nations (1776).
It's in Book I, Chapter 9, where he's discussing why he thinks the impact of higher profits working their way through a supply-chain is far more damaging than the impact of wages increasing a little in that supply chain.
He says, in raising the price of commodities, an increase in wages operates like simple interest, but an increase in profits works like compound interest.
Why? Because if every business in a supply chain lifted their prices to increase profits by 5 per cent, the final impact of that increase in profit getting passed down the supply chain would be dramatic.
"In reality, high profits tend much more to raise the price of work than high wages," he said.
Smith is often called the father of modern economics.
I think it says something that he was extremely conscious of the hydra-headed nature of "profit," and that he frequently wrote about "reasonable profit" (which suggests there are unreasonable profits), and he was a bitter critic of monopolies and corporate privileges.
Pricing strategies and high inflation
So, if you're concerned about the extreme profit-taking that's been occurring in today's outbreak of high inflation, does that make you a commie?
It doesn't. It means your intuition is Smithian. You're in thoroughly orthodox company. And you shouldn't be embarrassed to ask questions about it.
And this is where Dr Isabella Weber comes in.
Dr Weber's latest paper, Sellers' Inflation, Profits and Conflict: Why can Large Firms Hike Prices in an Emergency? looks at the question in a unique way.
She says the dominant view of inflation today is that inflation is macroeconomic in origin and it must always be tackled with macroeconomic tightening (lifting interest rates).
But she thinks that's wrong.
"Most economists have considered the return of inflation from the perspectives of the dominant interpretations of the 1970s: inflation originates from macro dynamics, with the (New) Keynesian interpretation positing a matter of excess aggregate demand in relation to capacity on the one hand, and the classic Monetarist postulation of too much money chasing too few goods on the other," she writes.
"In so far as costs are considered to play any role from either perspective, it is purely a matter of inflated wages deriving from tight labour markets. There is no role for profits or the power of firms to set prices in this view of inflation."
According to Weber, those two mental models are unrealistic.
She says it's far more enlightening to look at the pricing strategies powerful firms have been using in this inflationary episode.
Once you do that, she says, you'll appreciate why the current inflation is predominantly a "seller-induced inflation" that derives from micro-economic origins, namely the ability of firms with market power to hike prices (her analysis is focused on the inflation in the United States' economy, but the preliminary lessons she draws may be universal).
Dr Weber says firms with market power typically refrain from lowering prices, but they'll raise prices if they expect other firms to do the same (when they're confident their market share won't be harmed).
And there can be implicit agreements that coordinate such price hikes, such as when everyone realises they're facing a unique opportunity to cash in.
"Sector-wide cost increases can generate such an implicit agreement: since all firms want to protect their profit margins and know that the other firms pursue the same goal, they can increase prices, relying on other firms following suit," she says.
She says the logic of such coordinated pricing behaviour can have a self-reinforcing quality too, in that investors will expect firms to chase higher profits while the sun is shining and will punish firms that don't.
"If firms deviate from this price hike strategy, the threat of share sell-offs by financial investors can enforce compliance with such implicit agreements," she says.
She says it's important to understand that market power is not necessarily constant but can change dynamically in a changing supply environment.
"Bottlenecks can create temporary monopoly power which can even render it safe to hike prices not only to protect but to increase profits," she says.
And widespread news reports of supply chain bottlenecks and cost shocks can serve to create legitimacy for companies to hike prices and create acceptance on the part of consumers to pay higher prices.
Investor and analyst briefings
With that in mind, Dr Weber and her colleague Evan Wasner have looked at the nature of the high inflation in the United States during the COVID era.
And they've based their analysis on a few things.
To analyse the contributions of prices and sales volumes to profits in recent years, they manually compiled quantitative firm-level data from quarterly earnings reports.
"This allows us to trace changes in price setting and compare them to profit margins and total profit flows on the level of specific corporations," they say.
And they combed over analyst and investor briefings, where the executives of major companies give detailed rundowns on their company's record and strategies.
"Since the fourth quarter of 2020 there has been increasing discussions of pricing practices which we draw on in this analysis," they say.
"One clear rule that emerges from earnings calls across the board — and that has previously been noted in the literature on administered prices — is that firms pursue target profit margins and hence increase prices in response to cost increases."
They say the most significant inflationary impulse came from the enormous increase in fossil fuel prices on the other side of the lockdowns, and it helped to set off a chain reaction.
For example, see how Exxon Mobil, the largest non-government-owned oil company in the world, responded to the new economic environment.
Its profits turned negative in 2020 as a result of falling demand and declining prices and volumes.
In response to those declines in volumes, Exxon's earnings reports reveal it shut down its least productive production facilities.
But when oil prices began to rise in early 2021, profit magnitudes and margins immediately turned positive for Exxon and rose through to the third quarter of 2022 despite relatively little volume growth.
And Exxon did not fully reopen its higher-cost production facilities, despite the high prices.
"In the words of Exxon chief executive officer Darren Woods: 'We've created this hole with a lot more capacity coming off-line without a whole lot of new capacity … That capacity is not coming on. So we've got this gap, demand recovers, and we don't have the capacity to meet that, which has led to a record, record-high refining margins,'" Weber and Wasner say.
"The case of Chevron tells a similar story, but with a relatively larger increase in total profits compared to the change in margins. Chevron's CEO, Mike Wirth, informed his shareholders in the fourth quarter earnings call of 2021 that 'the last two quarters have been the best two quarters the company has ever seen. And last year was 25 per cent higher than the best year in our history.'"
They say Chevron prioritised paying out record earnings to shareholders rather than using them for capital investments and "focused on generating returns" rather than expanding production.
"While oil companies are price takers, the pandemic has enabled a coordinated reduction in volumes that would not have occurred otherwise," they write.
"Since all oil companies profit off the low-cost, high-price constellation, incentives to invest and restore production capacities are low."
That's just one sector.
They then discuss how chemical companies, iron and steel mills, wood manufacturers and others responded to the changing economic environment in the pandemic.
A conceptual model
Which brings us to the final section.
Weber and Wasner have created a three-stage model that helps to conceptualise why large firms in concentrated industries in the US could hike prices during the pandemic.
They set it out like this:
- The impulse stage of initial price increases in systemically significant sectors
- The propagation and amplification of the cost shock stage
- The conflict stage when labour tries to regain real wage losses
They start by sketching the process of the shifting from a period of stable prices (pre-2020) to one in which price shocks in upstream sectors function as an impulse that propagates through supply chains, as downstream firms react to higher costs by raising prices to protect their profit margins.
They say in addition to this propagation of cost shocks, firms in some sectors — in particular, ones facing supply-side bottlenecks or product-specific demand shocks — can raise prices by enough to enhance profit margins, resulting in an amplification of cost shocks.
They say workers eventually react in the conflict stage, attempting to protect real wages.
However, in the context of a sellers' inflation kicked off by commodity price shocks, windfall profits and profit protection, this labour conflict is not the origin but the consequence of inflation.
"Furthermore, given the weakness of organised labour in the contemporary US, it is highly unlikely that this conflict stage of inflation triggers a wage-price spiral, as is the case in the classical conception of conflict inflation," they say.
"Labor has struggled merely to return to its pre-pandemic share in national income, rather than surpass it."
You could say the same thing about Australia.
But Dr Weber says this all points to the need to develop new tools to tackle inflation in the future, rather than relying on the blunt and unsophisticated instrument of interest rate hikes.
"In an age of the overlapping emergencies of climate change, the pandemic and geopolitical tensions, shocks are likely to re-occur which can propel an already prevalent inflation dynamic," she says.
"This points to the necessity to develop policy tools to deal with impulse shocks as they emerge in real time."
Will policymakers be up to that task?