ExplainSpeaking: What is Greedflation? Does India also have it?

“May I remind you, Minister, that you are seeing a deputation from the TUC in fifteen minutes, and from the CBI half an hour after that, and the NEB at 12 noon.’

My feeling of despair increased. ‘What do they all want – roughly?’ I asked.

‘They are all worried about the machinery for inflation, deflation and reflation,’ Bernard informed me. What do they think I am? A Minister of the Crown or a bicycle pump?”

Hilarious as it is, Hacker’s desperation underscores a common notion: Simple questions in economics can appear to have very complicated answers. Take for example the issue of inflation, what causes it and how to contain it.

What is inflation — and disinflation, deflation and reflation?

To begin with, inflation (or the inflation rate) is the rate at which the general price level rises. When it is reported that the inflation rate was 5% in June it implies that the general price level of the economy (as measured by a representative basket of goods and services) was 5% more than what it was in June 2022.

There are two other key terms: disinflation and deflation.

Disinflation refers to the trend when the inflation rate decelerates. Suppose it was 10% in April, 7% in May and 5% in June. This is disinflation. In other words, disinflation refers to a period when even though prices are rising (or inflation is happening), it is happening at a slower rate each passing month.

Deflation is the exact opposite of inflation. Imagine if the general prices level in June was 5% lower than what it was in June last year. That’s deflation.

Reflation typically follows deflation as policymakers try to pump up economic activity either by government spending more and/or interest rates being reduced.

What causes inflation?

For the most part, there are two main ways in which inflation happens. Either prices get pushed up because input costs have risen — this is called cost-push inflation — or they are pulled up because there is excess demand — this is called demand-pull inflation.

If crude oil prices went up by 10% overnight — say, because of a supply disruption — then the general price level will be pushed up because energy costs have gone up.

Similarly, if demand goes up suddenly and far in excess of supply, then prices can be pulled up. Suppose RBI cuts interest rates sharply and you and all your friends find that buying a house is now quite affordable, since EMIs have fallen, then the sudden surge in demand for new houses will pull up home prices because new houses cannot be made immediately.

How is inflation solved?

If inflation is because of excess demand, the central banks raise interest rates to bring overall demand in line with overall supply.

However, oddly enough, if inflation is due to cost pressures, even then the central banks raise interest rates. Of course, raising interest rates does nothing to boost supply. Still central banks do what they can: contain demand because that is all they can do.

The idea is to prevent something called the wage-price spiral.

What is the wage-price spiral?

If prices go up, it is natural that workers will ask for higher wages. But if wages go up, it only fuels the overall demand, while doing nothing to boost the supply. End result: inflation surges further because while a worker has more money, so does his colleague. When they go to the market then the only thing that changes is the price of the good — in other words, inflation rises.

Raising interest rates slows down overall economic activity and demand, often leading to job losses. Through this rather unjust and iniquitous method, the central banks prevent a wage-price spiral and consequent inflation.

But what if prices were going up not because workers were getting higher wages but because their masters — the companies — were making more profits?

Imagine a scenario when there is a natural disaster or a pandemic and airlines start charging sky-high prices for tickets. Same holds for sellers of anything of value — water, lodging, food etc. It is a common enough occurrence that prices go up sharply when a crisis hits.

To an extent, this is understandable. If the input costs have gone up, a businessman or a company will be forced to raise their prices otherwise they cannot sustain their business. In such a case, higher sales in terms of rupees do not lead to higher profits because even the input costs have increased.

But what if a crisis reveals something completely different? What if a crisis turns into an opportunity for businesses to make what are called supernormal profits? This can happen when the price mark-up is far in excess of the increase in inputs. It can also happen when businesses do not bring down the market prices even when the input prices fall.

If corporate greed is what is leading to higher inflation then the whole monetary policy prescription appears even more unjust and ineffective than imagined previously.

What is Greedflation and is it happening in developed countries?

Greedflation simply means (corporate) greed is fuelling inflation. In other words, instead of the wage-price spiral, it is the profit-price spiral that is in play.

In essence, greedflation implies that companies exploited the inflation that people were experiencing by putting up their prices way beyond just covering their increased costs and then used that to maximise their profit margins. That, in turn, further fuelled inflation.

In the developed countries — in Europe and the US — there is a growing consensus that greedflation is the real culprit.

Look at CHART 1. It shows that in the US, corporate profits (as a proportion of the national income) have spiked to the highest level in the past 100 years.

Josh Bivens, the chief economist of the Economic Policy Institute, wrote the following in a piece last year: “The price of just about everything in the U.S. economy can be broken down into the three main components of cost. These include labor costs, nonlabor inputs, and the “mark-up” of profits over the first two components… Since the trough of the COVID-19 recession in the second quarter of 2020, overall prices in the NFC sector have risen at an annualized rate of 6.1%—a pronounced acceleration over the 1.8% price growth that characterized the pre-pandemic business cycle of 2007–2019. Strikingly, over half of this increase (53.9%) can be attributed to fatter profit margins, with labor costs contributing less than 8% of this increase. This is not normal. From 1979 to 2019, profits only contributed about 11% to price growth and labor costs over 60%, as shown in Figure A below.”

Philip R. Lane, Chief Economist of the European Central Bank, recently stated in a podcast that while the biggest driver of high inflation that Europe witnessed in 2022 (since the start of the war) was the spike in energy costs but there was very little contribution of higher wages. There was, however, an extra and significant injection of inflation from rising profits of firms.

A study by the International Monetary Fund (IMF) — titled ‘Euro Area Inflation after the Pandemic and Energy Shock: Import Prices, Profits and Wages’ — published last week found that profits contributed even more than higher import prices: “…we show that import prices account for 40 percent of the average change in the consumption deflator over 2022Q1 – 2023Q1, while domestic profits account for 45 percent. The increase in nominal profits was largest in sectors benefiting from increasing international commodity prices and those exposed to recent supply-demand mismatches.”

However, it does blunt the findings for lack of adequate data: “While the results show that firms have passed on more than the nominal cost shock, and have fared relatively better than workers, the limited available data does not point to a widespread increase in markups.”

Latest financial reports from the US and Europe continue to show that firms — across the board — seem to be making more profit than what their overall sales should merit.

“Almost all big companies have now published their first-quarter results, and investors should like what they saw. The S&P 500’s average earnings-per-share may have fallen 1.4% year over year—the second quarterly decline in a row—but Wall Street was expecting a deeper 5.9% drop at the start of the quarter, making it the largest forecast beat in a year. Stoxx Europe 600 earnings-per-share were forecast to grow 2.1% and have instead jumped 18%,” wrote Jon Sindreu in The Wall Street Journal.

Whether it is Abercrombie & Fitch or Procter & Gamble or Coca-Cola or Ryanair or any of the carmakers — net profits continue to soar despite tepid sales numbers.

What are the policy implications?

In his 2022 piece, Bivens said this raises a big question mark on notions that high inflation is because the economy is “overheating” (read, that everyone is so flush with funds that there is just too much demand in the economy).

“Evidence from the past 40 years suggests strongly that profit margins should shrink and the share of corporate sector income going to labor compensation (or the labor share of income) should rise as unemployment falls and the economy heats up. The fact that the exact opposite pattern has happened so far in the recovery should cast much doubt on inflation expectations rooted simply in claims of macroeconomic overheating.”

A natural conclusion for him was taxation. “…one effective way to prevent corporate power from being channeled into higher prices in the coming year would be a temporary excess profits tax,” he wrote.

Isabella Weber, UMass Amherst economics professor, who has been talking about price controls — and has received much criticism from mainstream economists for that — for a while, also supports the idea of windfall profit taxes on companies. She also supports some kind of legislation that bars price-gouging.

The trouble with these solutions is two-fold.

Firstly, as the IMF study also noted, there is still some doubt that every firm has exploited consumers and fuelled inflation. Not to mention other studies such as “Rising Prices, Rising Markups?” (Christopher Conlon et al, 2022) which did not find any link between higher inflation and the mark-ups that firms used.

Secondly, who decides what is justified increase and what is price-gouging?

Is this happening in India?

A look at the corporate profits since the pandemic throws up a very noteworthy trend.

CHART 2 shows the net profits of listed companies and is sourced from an analysis of corporate profits by the Centre for Monitoring Indian Economy (CMIE). As can be seen, profitability is at a record high.

Net profits of 4,293 listed companies reached Rs.2.9 trillion in the March 2023 quarter. This is over 3.5 times the average quarterly profit earned by listed companies till before the pandemic of 2020. The average net profit of listed companies in the nine quarters of December 2017 through December 2019 was Rs.0.83 trillion.

In other words, the Indian corporate sector has generated superlative profits in the post pandemic period. Profits during recent times have been nearly thrice the profits corporates earned earlier. “The pandemic, it seems, has done good to corporate profits,” stated Mahesh Vyas, the CEO of CMIE.

It is interesting to note that the continued high profits can’t be because of increased formalisation anymore. “If the gains from the formalisation of the economy were the result of a more efficient tax regime under GST and the fatality of the shutdown delivered to the vulnerable, then those gains are now a thing of the past,” states Vyas.

Similarly, he states, the gains from high commodity prices are also largely behind us.

Higher profits then can come only from:

* higher sales (with the same profits margins)

* higher profit margins (with the same level of sales)

* or a combination of higher sales and higher profit margins

So what is contributing to higher profits?

According to CMIE, “sixty per cent of the growth in net profit can be attributed entirely to the increase in profit margin. The increase in sales contributed an additional 36 per cent and the rest was a bonus from a combination of the two”.

Do these higher profits point to the existence of greedflation in India?

Data shows the existence of a sharp spike in profits. So, prima facie, agrees Vyas as well, there is a very good chance that corporate greed also played a role in spike the inflation rate in India.

Until next time,

Udit