Once again on profit inflation: a follow-up on Marc Lavoie’s blog
Guillermo Matamoros
PhD candidate in Economics, University of Ottawa
Monetary Policy Institute Blog #82
“It should be clear from history that workers and their wages are not a menace to price stability. Yet what ought to be a concern is that, although the labour share has been relatively stable since the GFC, it remained at historically low levels that created an important power imbalance between workers and firms that has persisted at least until the pandemic.”
The controversy surrounding profit inflation is alive and well. Quite recently, Marc Lavoie’s blog spurred plenty of discussion among heterodox economists for a particularly good reason. As an indisputable authority within heterodox economics, Lavoie makes use of post-Keynesian pricing theory to contest profit inflation as one of the drivers of the current inflation surge affecting several countries starting in 2021.
The profit inflation argument has received a lot of attention among heterodox economists (and even some mainstreamers). It basically argues that incumbent firms took advantage of the pandemic and war-related supply-chain bottlenecks and energy price pressures to raise their markup rates, thereby further contributing to the pandemic inflation and causing windfall profits.
However, Lavoie claims that “in general, the rise in profits and the profit share can be explained without resorting to an explanation based on firms taking advantage of the situation and raising markup rates.” To do so, he proposes an alternative explanation of why profits rose significantly since 2021 together with inflation.
He divides his argument into two parts. First, he points out that simple profit margins measured as the ratio of unit price-unit labour cost tend to be pro-cyclical for Kaleckian reasons because unit labour cost includes overhead labour cost and not only direct labour cost. Up to a certain point, overhead labour cost is independent of the number of units produced (e.g., the cost of hiring a community manager or a web developer). When the economy bounces back rapidly and production goes up, such as in several countries sometime in 2021 and 2022, overhead labour cost is spread over a greater amount of units produced such that unit labour cost goes down and the profit margin automatically rises, even if firms do nothing with their markup rates.
Post-Keynesian theory says that firm markups are often calculated as a margin over ‘normal’ unit cost, that is, the unit cost associated with a ‘normal’ capacity utilization rate. As such, markups would be relatively independent of changes in capacity utilization and of fluctuations in economic activity, thereby markups would indeed portray market power. The problem is that it is not easy to get data on ‘normal’ unit cost to compute firm markups, so researchers must estimate it somehow.
Second and more importantly, only a fraction of the unit cost by firms comprises labour cost. A second and particularly important cost component is unit material cost, which is made up of intermediate and raw materials. If unit material cost increases more rapidly than unit labour cost, the ratio of unit price-unit labour cost rises, whereby profit margins and the profit share go up while firm markups remain constant. According to Lavoie, this process is “consistent with the increase in the profit share which has been observed as a consequence of the covid pandemic and the war in Ukraine.”
I could not agree more with Lavoie’s argument from a theoretical point of view. Nevertheless, there is an important missing aspect pertaining to the available evidence. Therefore, I have decided to write up this piece as a follow-up, whose purpose is to connect the theory with a bit of data to shed more light on the current inflation issue.
For starters, Figure 1 shows US CPI inflation and oil price (WTI) for the period 1960–2022. Assuming oil price as a proxy for unit material cost — which I argue is reasonable given that it mimics the behavior of other material cost indexes, Lavoie’s argument perfectly matches the evidence of the pandemic inflation surge. It is clear how unit material cost is pushing inflation up from 2021 and, presumably, this would be explaining the corresponding increase in profits. However, this story is incomplete if we do not look back to the previous experience. Notably, the early-2000s oil price boom was comparable to the 2021–2022 boom but it was not accompanied whatsoever by growing consumer prices. CPI inflation remained very low from the mid-1980s all the way to the year 2020 regardless of the behavior of commodity prices, whose prices grew massively from the early-2000s to around 2015 and then peaked again in 2021.
My point is that just before the Global Financial Crisis (GFC) and right after the Covid 2020 shock, there is a growing unit material cost but a quite different CPI inflation response in each period. Before the GFC, following rising material costs, firms did not respond by increasing overall prices; since 2021, however, firms did raise prices significantly when confronted with a comparable material cost pressure. Perhaps being somewhat more in line with the argument by Weber and Wasner, the difference lies in the effects of the supply-chain bottlenecks on market power by firms and their decision to raise prices. I maintain that their decision to keep raising prices is ultimately dependent on market power i.e., it is based on their ability to shift forward their cost increments to other economic actors while retaining or even increasing their profit share.
But why did inflation not pick up during the 2000s’ material cost boom? I believe that, due to the historically weak bargaining power of workers, firms were basically able to compress real wages as observed in Figure 2 with the steep fall in the labour share in the 2000s. It is true that the labour share (or its alter ego, the profit share, which I calculated as the ratio of the GDP deflator and unit labour cost) depicts a downward (upward) trend since the beginning of the period in the 1960s, but it is also true that the decline in the labour share becomes steeper precisely in the 2000s. In contrast, since the GFC, the labour share stopped from falling and has remained roughly stable (except for the abrupt 2020 pandemic jump).
On the other hand, the supply-chain bottlenecks associated with the pandemic and the war prevented firms from compressing real wages to maintain (or even increase) their markups without raising prices too much, as they did in the 2000s, but the bottlenecks did not stop them from jacking up prices, thereby triggering and then further fueling the 2021–22 inflationary process. At the end of the day, firms were exerting their market power in both cases, it is just that, only during the extraordinary circumstances of the pandemic, did they respond by continually raising prices.
It is important to point out that, although some people in the mainstream, like Bernanke and Blanchard, have recently refuted the story of a wage-price spiral, there is still the argument that workers might potentially become a threat soon if they keep pushing wages up. But this narrative is also missing the point that, as a recent study from the IMF concludes, there is truly little historical evidence of wage-price spirals. For instance, if we look at the evolution of the labour and profit shares in the US in Figure 2, inflation episodes are not characterized by a growing labour share (or declining profit share).
Even going as far back as the 1960s’ inflation surge, in which there is no evident unit material cost pressure (that is, not until the 1970s with the oil shocks, as can be seen in Figure 1), the labor share was instead falling (and the profit share rising) when looking at Figure 2. Furthermore, high inflation continued in the 1970s and early-1980s and the labour share kept gradually going down over time. To be fair, high-inflation periods in the US are rare so that only the 1960s-1970s inflation episode could be compared to the current inflationary process in terms of the CPI evolution.
Apart from that, the current low and relatively stationary labour share suggests that it is still to be seen whether the pandemic-related consequences will significantly increase the bargaining power of labour in the long-run. So far, if workers’ bargaining power has been strengthened lately as a generalized phenomenon — although one can be skeptical if looking at the labour share and other bargaining power indicators — it might have happened instead before the pandemic and after the GFC, when a case can be made for a shift in fiscal and monetary policies towards a more employment-focused strategy in the US due to, in part, the fears of deflation and secular stagnation. At present, however, the evidence points at real wage improvements only for certain low-wage workers.
Afterall, it should be clear from history that workers and their wages are not a menace to price stability. Yet what ought to be a concern is that, although the labour share has been relatively stable since the GFC, it has remained at historically low levels that created an important power imbalance between workers and firms that has persisted at least until the pandemic. Raising real wages and the labour share should be a crucial policy concern if we want to live in more equalitarian societies. The task is directing policies towards a stronger high-employment focus, thereby limiting the excessive market power of firms and their ability to protect their profit share literally ‘at all costs.’
To conclude, Lavoie raised critical issues pertaining to the role of material cost and the cyclicality of price-unit labour cost ratios in the current inflation surge. As a follow-up to his points, it was important to bring up as well some historical evidence to point out that there is still a lot we need to learn about inflation, but especially about the role of market power by firms and price-setting in triggering an inflationary process.
