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Today I am writing about how big business is benefitting from and helping to drive inflation. This piece was prompted by Larry Summers, who attacked the idea that the pricing power of firms has anything to do with inflation. Inspired by Summers, I did some back of the envelope calculations to see how much inflation is being captured by corporations in the form of profits.

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And now…

Larry Summers and the Profit-Price Spiral

The hottest topic in political economy right now is inflation, because inflation in the price of consumer goods and services, as well as financial assets, is determining who has access to resources. Cost increases are now running at 6.8% annually, and since wages are only growing at between 3-4%, that means real wages are going down for most Americans. Financial assets are rising even faster, and that’s also a problem. Housing prices are up by roughly 20% on an annualized basis, meaning that it’s harder to afford a house.

A few days by ago, prominent pundit Larry Summers did an interesting twitter thread on the problem. Summers has significant credibility on the matter, because last year he was suggesting that inflation would kick up, and sure enough, it did. Summers isn’t the only one who got this call right; in February of 2020, I wrote we’d see shortages, before the pandemic became evident, which is something the White House picked up, and there are plenty of people like former Fed Governor Tom Hoenig, who have warned of asset bubbles for a decade. But whereas I was early in warning of serious problems, and Hoenig made broader claims for a decade, Summers was specific and accurate. Summers has gotten a lot wrong in his career, but he nailed this prediction.

But there are dueling theses at work as to why inflation has risen. My belief at the start of the pandemic was concentrated market power and thin supply chains would induce shortages, and that indeed happened. One remedy for that, though not the only one, are antitrust rules that prohibit price-fixing, price discrimination, and monopolization, which often cause higher prices. (Other remedies include re-regulating shipping, which Congress is doing.) Summers, however, doesn’t see the problem in terms of market power. His view of inflation is that government spending is driving price hikes by giving Americans too much purchasing power. He is so hostile, in fact, that he has pronounced the idea of market power as a causal factor a form of ‘science denial.’

Lawrence H. Summers @LHSummers

The emerging claim that antitrust can combat inflation reflects “science denial”. There are many areas like transitory inflation where serious economists differ. Antitrust as an anti-inflation strategy is not one of them.

Summers’s whole thread is worth reading, but what’s most interesting is how his thesis seems to cut against what CEOs are telling investors (as well as what he himself said in July, when he said concentration could be inflationary). Wall Street is explicit that margin expansion is the big story of the pandemic. “What we really want to find are companies with pricing power,” said Giorgio Caputo, senior portfolio manager at J O Hambro Capital Management told Bloomberg. “In an inflationary environment, that’s the gift that keeps on giving because companies can pass along their pricing on the way up, and don’t necessarily need to get it back on the way down.”

Margin expansion is one factor that has pushed the stock market to an all-time high, with large firms doing much better than small ones. Bloomberg has noted that behind this are corporate profit margins, which are at a 70-year record. All of which leads to an interesting question. How much of inflation is a result of market power, and how much is due to some other set of causes such as government spending or thin supply chains? Let’s do some rough numbers.

Just before the pandemic, in 2019, American non-financial corporations made about a trillion dollars a year in profit, give or take. This amount had remained constant since 2012. Today, these same firms are making about $1.73 trillion a year. That means that for every American man, woman and child in the U.S., corporate America used to make about $3,081, and today corporate America makes about $5,207. That’s an increase of $2,126 per person.

Still, in order to know just how significant that amount is relative to inflation, we have to figure out how much inflation is costing the average American. A rough way to get that would be to take the total amount America produces annually, which is the Gross Domestic Product, and multiply that by the inflation rate. That’s $23 trillion of GDP times the 6.8% inflation rate, which comes out to $1.577 trillion, or $4,752 per American.

Taking all of this together, it means that increased profits from corporate America comprise 44.7% of the inflationary increase in costs. That means corporate profits alone are absorbing a 3% inflation rate on all goods and services in America (44.7% of 6.8% annual inflation), with all other factors causing the remaining 3.8%, for a total inflation rate of 6.8%. In other words, had corporate America kept the same average annual level of profits in 2021 as it did from 2012-2019 and passed on today’s excess to consumers, the inflation rate would be 3.8%, not 6.8%. And that’s a big difference, indeed it is the difference between Americans getting a raise, and seeing real wages decline. (It also could explain why inflation is lower in Europe - corporate profits there were very good in 2021, but not as good as in the U.S. And in Japan both inflation and corporate profits were low.)

It gets worse, because this calculation assumes that all 6.8% of the inflationary increase in prices is new. But of course, inflation isn’t zero in normal years, the Fed has an inflation target of 2%. In 2019, inflation hit 1.8%. So if you take the pre-existing inflation rate in 2019 of 1.8% and back that out of the numbers, then it turns out that 60% of the increase in inflation is going to corporate profits.

3% to corporate profits + 1.8% preexisting inflation + 2% from government spending/supply shocks = 6.8% total inflation rate

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Now, there are plenty of methodological objections to this exercise. First of all, after-tax profits can come from margin expansion via price hikes, but they can also come from lower taxes, reduced funding costs or efficiencies in production. Let’s go through these different possibilities. It’s not a tax story, because corporations are paying a bit more in taxes than they were in 2019. It’s not a financing story, as corporations do have lower funding costs since the Federal Reserve’s interventions last year, but the total amount of corporate debt has gone up. Finally, productivity is bouncing all over the place, increasingly by a gigantic 11.2% during the immediately onset of the pandemic as layoffs began, and dropping by a massive 5.2% last third quarter as supply chain and labor turmoil hit. So it’s probably not productivity. Moreover, even if these factors were dominant, it shouldn’t matter, as there’s no reason firms couldn’t pass along lower financing costs or higher productivity to consumers. Plus, the story from Wall Street is consistent. It’s price hikes fattening margins.

Beyond these methodological questions, there’s also a reasonable argument that profit increases are not a function of market power. Summers, like most economists, would say that higher profits are a result of higher demand. Higher profits are necessary to entice new firms into a market and raise production. On a rainy day, for instance, being able to charge more for umbrellas means that there will be more umbrella sellers, which is what you want when it’s raining. It’s why economists tend to dislike rules against profiteering, even in emergencies. Price gouging, they believe, transmits important information. In this case, higher profits would help businesses plan to invest more in factories, and induce market entry in case incumbents don’t do that investment.

Still, it’s interesting to note which firms are raising prices, and why. We don’t have that much information on a macro-level, because there’s no systemic investigation using proprietary pricing data from private firms. Anecdotally, it’s obvious that certain industries like beef are seeing a mix of market power and cost pressures. Peter Goodman, for instance, just wrote a fantastic article in the New York Times on how meatpackers - a four firm oligopoly - are prospering by raising prices to consumers (and being sued for colluding to do so), while the cattle ranchers who sell to them - a decentralized group - are not. There is very little entry of independent packers into this industry, despite high margins. How common is this dynamic across industries, where controlling distribution enables a firm to raise prices, using inflation as a story to tell their customers?

One interesting set of data comes from Digital.com, a survey research firm that went out and asked retail businesses about inflation. 56% of retailers told Digital.com that “inflation has given them the ability to raise prices beyond what’s required to offset higher costs.” And these price hikes are concentrated among big retailers, with 63% of large firms using inflation to more than offset costs vs 52% of small and medium size businesses. And of “those who have increased prices, 28% of large enterprises increased prices 50% or more, compared to 6% of small and medium size enterprises.” So size, and presumably market power, matters. And one person’s profits are another person’s costs, because firms buy and sell to each other. So when firms raise prices to increase profits, then this increases costs for those who buy from those firms, and accelerates the expectation of more inflation elsewhere. Profits, in other words, are also driving inflation.

It’s not just retail. Inflation is a story that larger firms are using to raise their prices and change pricing behavior. For example:

The global auto industry is an oligopoly, with 14 firms controlling nearly all of the major brands. And that opens the opportunity for exploiting pricing power. “We will consciously undersupply demand level[s],” said Harald Wilhelm, Daimler’s chief financial. Daimler is even noting that forcing customers to wait for their luxury cars “makes the customer experience even greater and better.”

The story can get more pernicious. Here’s economist Hal Singer, explaining how inflation can be a convenient cover for price-fixing, which of course raises prices.

Hal Singer @HalSinger

Just wrapped a price-fixing case in which an executive admitted to issuing fake news stories about inflation to throw journalists off the scent. No change in concentration needed. Larry has zero understanding of antitrust. Just read his piece on worker power vs. monopsony power.

So basically, Summers is partly right on the cause of inflation, but overstates his case when it comes to antitrust. It’s true that some inflation was inevitable with the Covid demand shock and lots of government-supported purchasing power, but not this much. We have a supply chain mess and lots of government spending, both of which pushes up costs naturally. Monopolized markets allow firms, especially big ones, to raise prices faster than costs. And then that in turn pushes up costs and expectations, leading to more price hikes.

Replace Build Back Better with an Anti-Inflation Agenda

The policy solutions to address this problem look very different, depending on what you believe. Summers thinks austerity is the way to get at inflation, which is why he has been pushing to restart student loan payments, as taking money from young people means they won’t spend it on goods and services. He also wants to eliminate tariffs and Buy America provisions so that there are more cheap imports from China.

Would these solutions work? Well, certainly austerity will reduce inflation, as will a recession, though at a very high cost. Inducing more imports, I suspect, won’t work. I’ve interviewed a few business people dealing with China tariffs; they told me they raised prices when the tariffs hit, but won’t lower them if the tariffs go away. That’s because prices aren’t based on cost, but market power. Lower tariffs on Chinese imports will simply flow to more profits for middlemen, not lower prices for consumers.

If it’s true that a concentrated economy is allowing firms to exploit the current pricing environment to raise margins, then a different set of policy solutions should flow from that.

The first is to strengthen laws against price-fixing. The courts have radically cut back on the ability of plaintiffs to bring such cases in concentrated markets. As antitrust lawyer Eric Cramer noted, in the Valspar decision in the 3rd circuit in 2017, judges actually said that firms in a concentrated industry are allowed to raise prices in a coordinated manner, as long as there’s no public proof they are working together overtly to do so. A plaintiff who attempts to bring such a case and investigate whether there is a formal agreement will now have his or her case dismissed before it even gets to trial. The 7th circuit found a similar result over container board price hikes in a heavily concentrated market. That’s crazy.

If Congress strengthened the Sherman Act to overturn these decisions, that would help lower prices. Similarly, in the 1970s, the FTC tried to bar coordinated price hikes that occur in concentrated markets, even if there’s no explicit agreement in place. Barring this kind of price fixing would be quite powerful. Another variant of this would be, as Hal Singer suggests, to trigger an automatic price-fixing investigation for any concentrated industry that raises prices above 15% over December 2020 levels. Basically, it should be very easy to bring a price-fixing suit, but only in concentrated industries.

The second is to impose an excess profits tax. Excess profit taxes are a common approach to emergencies like war, and they reduce the incentive to price gouge. You could define an excess profit by the amount the firm is making above what that firm used to make on the same line of business. Not only would such a tax reduce the incentive for price gouging, but it would encourage highly profitable firms to put cash back into new factories and production, for fear their newfound profits would otherwise be taxed away.

The third is to strengthen the antitrust laws against monopolistic conduct and concentration in general, which is likely driving some part of inflation. Even very cautious economists buy this story (though Larry Summers doesn’t). Obama-era antitrust economist Fiona Scott Morton, for instance, gently corrected Summers on his assertion that no economist could connect concentration and inflation, suggesting that less concentration can actually induce more investment when there’s an economic shock. Her view makes sense, since the more firms in an industry, the more likely one of them is to use a period of high margins to grab market share by expanding production. The New York state abuse of dominance bill would accomplish this by prohibiting unfair methods of competition that often lead to higher prices.

Finally, since large firms raise prices more than small firms, then a revival of provisions against price discrimination would likely reduce consumer prices. Summers doesn’t believe this, praising Amazon and Walmart as price deflators even as Amazon is being sued by the D.C. Attorney General for systemically inflating prices across the economy. So this would be a good place to get data, which is what the Federal Trade Commission is doing, looking at how suppliers and distributors allocate goods between large firms like Walmart and small retail stores.

How much will these changes help? It’s hard to say. The potential is quite real. In 1939, Franklin Delano Roosevelt’s Antitrust Division was so feared that merely announcing an antitrust investigation would cause prices in a market to fall by 18-33%. Since profit margins are massive today, there’s no reason we couldn’t see similar results if we shifted our legal framework to outlaw the kind of behavior likely occurring throughout the economy. Of course, doing so would require making different political choices. Since we live in a democracy, that’s always possible.

Thanks for reading.

And please send me tips on weird monopolies, stories I’ve missed, or comments by clicking on the title of this newsletter. And if you liked this issue of BIG, you can sign up here for more issues, a newsletter on how to restore fair commerce, innovation and democracy. And consider becoming a paying subscriber to support this work, or if you are a paying subscriber, giving a gift subscription to a friend, colleague, or family member.

cheers,

Matt Stoller

UPDATE: I mischaracterized Larry Summers as a prominent pundit. He is also a failed Federal Reserve Chair candidate. My apologies for the error.

Corporate Profits Drive 60% of Inflation…

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