Be sceptical of 'Greedflation'
The idea that corporate greed is driving the current bout of inflation is starting to get a lot of attention and seeping into mainstream thinking. ‘Greedflation’ is increasingly being mentioned by politicians, central bankers and in the financial press.
Like any idea, it needs to be given a fair hearing, but I worry it’s becoming accepted as something that is really happening without enough critical thought of the theory and data behind it. Where inflation is still high, there is a danger that governments get tempted by these theories, imposing the ‘easy fix’ of price-controls1 which end up doing more harm than good.
Here I set out a critique of the theory and the data behind ‘greedflation’ and the related ideas of ‘profit-driven’ and ‘producer-led’ inflation.
‘Greedflation’ in theory
A lot of proponents of ‘greedflation’ and related theories do a pretty poor job of actually defining the phenomenon they claim to be seeing. I think the following is a fair definition:
Higher input costs have somehow allowed firms to increase profit margins, driving inflation higher and making it more persistent.
What makes me initially sceptical about this claim, is that basic economic models predict the complete opposite. As this excellent Economic Forces post runs through, in a basic model of imperfect competition, higher input costs lead to higher prices but, crucially, with smaller profit margins.
Of course this is a very simple model. It’s static, in partial equilibrium and it implies that firms are always profit maximising on the basis of perfect information. But even when extending the analysis by modifying some of these assumptions, it’s hard to find a particularly compelling theoretical underpinning for ‘greedflation’:
One possible adjustment to this model is to find a story around changing market structure. The pandemic created all sorts of supply bottlenecks. Perhaps it’s possible that larger companies in some sectors were better placed to maintain supply of key inputs (and perhaps also at lower prices) while smaller firms had to suspend production or shut up shop altogether. This would give larger firms temporarily greater market power which may have allowed them to raise prices, reduce volumes and increase profit margins.
The problem with this argument is that these sorts of supply bottlenecks have been and gone. To the extent that these bottlenecks did change market structure, it was likely a temporary phenomenon and therefore something we shouldn’t worry too much about.
Another possible adjustment to the model is to assume imperfect information, or some non-rational behavioural dynamic informing the way that firms set prices that was somehow changed by the experience of the pandemic. With COVID providing a large reset of wages and input prices, perhaps firms ‘woke-up’ to the ‘true’ pricing power they had and hiked prices and profit margins.
This is of course theoretically possible but I’m very doubtful that firms, across broadly all sectors of the economy, in all major economies were consistently that bad at doing business in the decades before the pandemic.
Ending this discussion of the theory behind ‘greedflation’ it’s also worth noting that conventional New Keynesian economics already incorporates the idea that when a supply shock occurs, firms and workers will fight to protect their real income levels, which leads to persistently higher inflation (until the supply shock abates or until rates reach sufficiently high levels). Crucially, this conventional model doesn’t rely on any changes in market power, pricing strategies or individual behaviour. Nobody needs to become more ‘greedy’, nor does there need to be any change in market structure for higher and more persistent inflation to be generated. It, therefore strikes me as a much more plausible causal channel for the inflation we have been seeing (beyond the initial supply shocks).
‘Greedflation’ in the data
A lot of the supposed evidence of ‘greedflation’ falls into a number of traps:
The most basic error is to use elevated profits among particular firms, or in particular sectors as ‘proof’ of higher profit margins across the economy as a whole and of ‘greedflation’ as a theory. But higher profits in one sector of the economy do not necessarily reflect profits in the economy as a whole. They can also eat into profits in other sectors. e.g. Higher profits made by energy firms were ‘extracted’ from other firms and not just final consumers.
To avoid this problem of only looking at parts of the economy, some economists try and look at Gross Operating Surplus (GOS) in the national accounts data to see a picture of total profits in the economy compared to total compensation of employees. But this can also be misleading. As this Bank of England paper explains, GOS is often interpreted as profits generated by firms but it actually includes depreciation costs and income from housing. When depreciation and housing income is stripped out, the impact of profits on inflation (at least in the UK) looks fairly underwhelming:
Even if evidence of higher profits relative to labour income is observed, that isn’t yet a slam dunk for ‘greedflation’ as it does not necessarily mean that firms have increased their profit margins. When input costs go up, assuming a constant markup, profits increase in proportion to revenues. However, the profit share relative to GDP would actually increase as higher input costs act as a drag on national income. This paper runs through this in more detail.
The current data is littered with base effects as a result of the pandemic. Sampling error almost certainly increased as well. Cherry picking very small snapshots of the data is therefore very unreliable. In fact, if you were to cherry pick the very latest data it would suggest the complete opposite of ‘greedflation’ (at least in the US):
But obviously we shouldn’t do that and then just jump to a conclusion. It’s much better to look over a longer period. If you do so, the profit share of inflation doesn’t seem particularly remarkable.
5. Finally, even if you found robust evidence of higher profit margins across the economy over a reasonable period of time, that would not be enough for the ‘greedflation' theorists to claim victory. The ‘greedflation’ theory is specifically about the supply side. It says that firms increase profit margins on the back of increases in input costs. But increased profit margins could also be be the result of increased demand which is not greedflation but is just conventional economics (more demand means being able to charge higher prices for the same quantity sold). It’s very plausible, and quite likely that the huge fiscal and monetary stimulus that we saw did increase demand. You would have to decompose any increase in margins into demand and supply to give a robust estimate of ‘greedflation’.
It is important to make the distinction between ‘price controls’ and ‘price subsidies’. Price controls are where the Government decides the maximum price that a company can charge for a product. As a result price controls force companies to forgo profits. A price subsidy is where prices are decided in the market, but the Government covers some of the cost. An example of this would be the energy price cap in the UK. Unlike the price control, the price subsidy doesn’t force the firm to forgo profits.