Inflation isn't because of greedy CEOs, in the boardroom, with fat margins. Nor unions, in the negotiation room, with exorbitant salary demands.
Opinion: It has to be the silliest game of Cluedo going. Who caused the cost of living to blow out?
This week, the NZ Council of Trade Unions, First Union, and ActionStation (a left-wing version of the NZ Taxpayers' Union) released a report claiming that rising profits drove inflation.
It follows on from a BusinessNZ study earlier this year claiming that input price increases, rather than company margins, have driven most of the increase in prices.
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But that’s not how this works. That’s not how any of this works.
Both reports are accounting decompositions. If overall prices went up, some part of that increase will tally to higher input costs, or higher wages, or higher company margins. The accounting decomposition breaks up the overall price increases into those underlying components.
But no accounting decomposition can tell you why any of those prices changed – only that they have. They do not and cannot tell any kind of causal story.
Suppose your income went up by 50 percent and your spending rose to match it. An accounting decomposition of what you spent your money on could tell you what proportion of your spending went on different things. But the ultimate driver of the overall increase in spending wasn’t the fraction spent on any of those underlying categories. It was that your income increased and you decided to spend a lot of that increase.
Accounting decompositions, like those provided in both reports, cannot find the real culprit.
If you think that greed is fundamentally responsible for inflation, the ‘greedflation’ hypothesis underlying stories pinning the blame on corporate profits, what then drives cycles in greed?
Did New Zealand firms become far less greedy when the Reserve Bank began targeting inflation? What made them greedier in the mid-2000s when prices were rising quickly? Did a cohort of philanthropists take over the commanding corporate heights in the early 2010s when inflation edged below the bottom of the Reserve Bank’s target range?
It is not a satisfactory explanation.
Or think about international comparisons. Inflation in the US and Canada jumped from 2021 but is now back at around 3 percent. Did North American firms abandon greed en masse well before New Zealand’s companies? If so, why?
It is generally safest to assume that companies are always greedy – or profit-maximising. It is weird to think greed follows cyclical patterns.
If greed is a constant and always with us, then it makes little sense to use it to explain changes in inflation. A constant cannot explain something that varies considerably over time.
But it is easy to see how people can come to the opposite conclusion.
Consider an illustrative example – the used car market. I will use US data because it is illustrative and easier to come by.
From 2000 to 2020, the US consumer price index for used cars and trucks dropped. In 2000, the price level was about 1.6 times higher than it had been in 1982-1984, the base year for the index. In early 2020, that price level was only 1.4 times higher than in the base year. The real price of cars dropped over the period.
Covid completely disrupted new car manufacturing from mid-2020. Manufacturers could not get the necessary chips, and queues of backorders piled up. But it did not change the stock of used cars in the US.
Because new cars were hard to find, fewer cars entered the used car market. Owners held onto them for longer. And people who would have bought new cars and could not wait had to shift to the used car market instead. The supply of cars into the used car market fell at the same time as demand for used cars went up. And the price index for used cars jumped by almost 60 percent in just over a year.
Consumer price index for used cars and trucks (US city average)
If you knew what was going on in the overall market, the cause is obvious. At the same time as monetary and fiscal policy meant people had a lot of money to spend, it got harder to source new cars.
But suppose you just know the local used car dealer who had a lot of inventory on-hand when the surge in demand for used cars hit. That dealer would have had a lot of opportunity to increase prices. How much could the dealer charge? As much as the market could bear – and that would be increasing week on week. You might think that dealer was being greedy.
If you ran a decomposition of the sources of the increase in used car prices, dealer margins would have gone up before the dealer’s input costs. So it would look like ‘greed’ drove the increase in prices. And when the dealer’s input costs went up as people demanded more for their trade-ins, it could look like households had become greedier too.
But the ultimate cause wasn’t car dealers suddenly becoming greedier. And it certainly couldn’t be used car dealers exploiting market power: used car dealers are as close to perfect competition as you might find in the real world. Instead it was a surge in demand combined with restricted supply.
And if you had imposed price controls on used cars to restrain greed, the only result would have been empty dealer lots.
When overall demand for goods and services exceeds total output, the first thing that happens is that firm inventories run down. Too much money is chasing too few goods, so the owners of the goods in short supply increase prices to avoid running out.
That initial increase in prices means companies’ margins and profits are higher – at least initially. The cost of the stuff they have in inventory has not changed, but the price they can sell it for increases.
But replenishing inventories means hiring more staff and buying more machines. And when the increase in demand is economy-wide, rather than specific to one company or sector, most companies are trying to increase capacity. Companies competing against each other to hire more workers and to buy more machines pushes up those prices: wages and machines.
Eventually, wages and prices again find a balance – with dollars being worth less in real terms. Along the way, it can look like profits are driving inflation, or like wage demands are driving inflation. But as the economist Noah Smith put it, “This is merely an accounting exercise; it doesn’t tell us what caused what, or how. As so often in this debate, the 'greedflation' proponents take correlation as proof of causation.”
It wasn’t the greedy CEO, in the boardroom, with fat margins.
And it wasn’t the unions, in the negotiation room, with exorbitant salary demands either.
It was a substantial surge in demand, driven by loose monetary policy and inappropriately large fiscal stimulus, chasing after too few goods.
