What Robert Reich (and everyone else) Gets Wrong about Inflation

Hint: It's not caused by government spending.

Forgive the click-bait-y headline - but it’s true. I have a lot of respect and admiration for Robert Reich, who was Secretary of Labor under Bill Clinton and has been an outspoken and articulate critic of austerity, and growing inequality for many years.

I could not bring myself to watch the Harris-Trump debate, but from the reviews it went mostly as I expected - a solid performance by Harris, and a meltdown from Trump.

In any event, Reich sent out an e-mail (link below) where he said:

“Trump claimed that the American economy under him was better than the economy under Biden and Harris, and that under Harris the economy would be ruined. In fact, under Trump, America lost almost 3 million jobs. And Trump’s unforgivable failure to contain COVID as well as other advanced countries did required massive government expenditures that fueled inflation.

Biden and Harris, by contrast, have presided over an explosion of job growth while inflation has been tamed.”

The issue where Reich is making a mistake - a big one - is in tying government expenditures to inflation.

(You can read his entire piece here).

Tonight’s debate

I do think this is significant - Reich has been a passionate advocate for addressing inequality, he’s talked about challenges for working people for decades, and in the U.S. certainly he would be considered centre left. He’s certainly agreed with Bernie Sanders on lots of occasions.

The fact that a centre left figure like Reich is saying this is about more than inflation. It explains our entire current dilemma.

First, I’ll start by saying people have got it stuck in their heads that when you talk about inflation, they talk about hyperinflation in Germany, where they say prices soared because the German government printed too much money in response to a crisis. That is then attached to the rise of Nazism in Germany. This entire story is inaccurate, as I wrote in this earlier blog post.

What caused hyperinflation in Germany happened after the Allies, has made privatizing the central bank a condition of Germany’s defeat. Then, a rule was created that banks could extend credit and that you could exchange it for Government-issued Marks. It was private banks and speculators that drove German Hyperinflation, which ended immidiately when a new currency was brought in. From 1925-29, Germany had the fastest-growing economy in the world. The Nazis were elected after several years of harsh austerity under the social democrats, and Hitler was helped into power by the support of pro-business Conservatives.

After about 40 years of quasi-Keynesian economics - during which time no lesser person than Republican President Ike Eisenhower said it was un-American to challenge the ideas of the New Deal - in the 1970s, there was an intellectual conservative counterrevolution to Keynes’ New Deal - neoclassical economics, branded as “neoliberal” to make is sound liberal and new, and not what it was, which was a return to the basic economics of feudal aristocracy.

These neoliberal / neoclassical ideas use a lot of intimidatingly complex math to describe what is a model of the economy that’s so crude that doesn’t have money in it.

Dr. Steve Keen explains in his excellent book Debunking Economics:

Solow and Swan tried to build a model for the whole economy based on what a “representative” consumer’s tastes for goods and services, as well as preferences for leisure. Booms and busts would only happen because technology or preferences changed.

“This resulted in a model of the macroeconomy as: a single consumer who lives forever, consuming the output of the entire economy, which is a single good, produced in a single firm, which he owns, and in which he is the only employee, which pays him both profits equivalent to the marginal product of capital, and a wage equivalent to the marginal product of labor, to which he decides how much labor to supply, by solving a utility function that maximizes his utility over an infinite time horizon, which he rationally expects and therefore correctly predicts…

Any reduction in hours is a voluntary act, so the representative agent is never unemployed, he’s just taking more leisure. And there are no banks, no debt and indeed no money”

There are all kinds of sources of “real-time” empirical data.

If you were to think of these formulas as a program or operating system to simulate the real world economy on paper or virtually, their models do not include factories, and customers, banks, financial markets, labour, government or law courts, and people with different amounts of income and wealth, they scaled up one person and made them the whole economy. And there’s no recognition of differences.

That neoclassical economy is one giant person, who lives forever, has unlimited foresight into the future and works at one giant factory. Because they’re the only person, they only work when they want to. What’s supposed to cause the business cycle is new technology, or changes in tastes. There’s no money in this model for a variety of reasons - it’s based on models from the 1700s and 1800s. Money is seen as a symbolic stand-in for real goods and services, and because its real goods and services we use, the economy is treated as a kind of barter economy. The only thing that matters is supply and demand of those goods and services.

While this seems intuitively correct, our intuition is confounded by reality. You can have all the supply and all the demand in the world - if the folks with demand have no money, the folks with supply aren’t selling. It’s not “supply and demand” alone - because that just takes people out of the equation entirely.

It is self-evident that at the “micro” level of transactions, the actual price that is paid depends on the relative bargaining power, financial capacity, the availability of other options, uncertainty and the need or desperation of the buyer and seller to make the deal. These are all real factors at the level of individual transactions whether it is a small purchase or a negotiation between governments or mega corporations.

This affects “price elasticity” - bargaining power. So it’s not just supply and demand - it’s each partipant’s control over supply and control over their demand. A monopoly means total control, which means they can charge that they want.

I wrote a longer post about it here. There’s a famous economic paper about the economy of a prisoner of war (POW) camp, where all supplies were coming from the outside of the camp, and cigarettes were used as currency. Prices were tightly connected to supply and demand, because as a POW camp it was a unique, closed environment.

Prices aren't just about supply and demand. They're about control over supply and demand

It should also be clear that some players in a market are in a position to “name their price,” because they stand at a chokepoint or “narrows” in the economy that others have to pass through to reach the final customer, like farmers from from the coast depending on railroads to get their crops to market.

This is the basis of Warren Buffett’s investment strategy. He said pricing power is more than good management:

In 2011, Warren Buffett said told the Financial Crisis Inquiry Commission,

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Buffett’s investment strategy involves pursuing companies that have pricing power: “...railroads and electricity producers, whose pricing power stems from a dearth of competitive options available to clients. Buffett has also built stakes in firms like Coca-Cola Co. and Kraft Foods Inc., which rely on the appeal of their brands to attract and keep customers.”

Coca-Cola and Kraft are not just “brands”: they are global food conglomerates who dominate entire food and beverage sectors.

Mega companies can often change the price at will. In fact, those are the companies that Warren Buffett likes to invest in. He calls them “extraordinary companies” but they are really virtual monopolies who so dominate the market they can dictate prices to customers.

One of the difficulties with such behemoths is just what was described as the key to Buffett’s investment choices: “there are a dearth of competitive options available to clients.”

Where there is no competition, there is no market, because the price is not being negotiated, it is being dictated. If a company is so powerful that clients and customers are powerless to negotiate on price, it defies the market, rather than embodying it. It allows companies to price gouge. (This is why public monopolies require independent oversight and regulation.)

Over the last decades, there has been a colossal consolidation of ownership, with industries that used to consist of many different brands all being snapped up. There has been consolidation in everything - beer, food, agribusiness, media - the list goes on.

These consolidations mean more consolidation of bargaining and pricing power.

It’s no secret that prices go up in a crisis, because a crisis increases uncertainty. The pandemic simultaneous created intense and critical demands while disrupting supply chains and the capacity to pay.

This is what is actually causing inflation - conflict and opportunism. It’s a well-known and well-documented phenomenon that in some ways is a reflexive response to a crisis - hoarding - even though the action makes the crisis worse.

Eckhard Hein, a Post-Keynesian economist wrote an analysis of inflation during the pandemic and the invasion of Ukraine:

Inflation is always and everywhere … a conflict phenomenon: post-Keynesian inflation theory and energy price driven conflict inflation, distribution, demand and employment - Eckhard Hein

“As will be explained from different post-Keynesian perspectives in this paper, inflation as a persistent process thus requires inconsistent claims of the main group of actors, which may then be modified by inflation expectations. These can be broadly distinguished as follows: (1) capitalists’ claims, including firms, rentiers and landowners, on unit profits or the profit share, including retained profits, interest, dividends, and rents; (2) workers’ claims on the real wage or the wage share; (3) government’s claims in terms of net tax revenues; and (4) the external sector’s claim via the value of imports of the domestic economy. Inflation may thus be triggered by an increase in claims of one or more of these groups of actors, which is not matched by a decline of the claims of any other group of actors.

Inflation may hence be generated (1) by an increase in capitalists’ real profits or profit share claims, triggered by excess demand, changes in the degree of price competition, or higher interest or dividend claims, which will generate profit-driven conflict inflation. It may be generated (2) by an increase in workers’ real wage or wage share claims, triggered by changing bargaining conditions in the labour market (employment, wage bargaining and labour market institutions), which will give rise to wage-driven conflict inflation. It may be generated (3) by an increase in government claims, executed by a change in taxes, social transfers and subsidies, which will generate tax-driven conflict inflation. Finally, it may be generated (4) by a change in the claims of the external sector, hence rising import prices or a nominal depreciation of the domestic currency, which will generate external cost/import price-driven conflict inflation. If the claims of any actor rise, this will only lead to a rise in relative price/wage levels. If other actors accept the related change in income distribution, no persistent inflation will emerge, but just an increase in relative price/wage levels. Only if other actors do not accept the distribution effects of the change in claims, inflation will arise as a persistent process. In this sense, inflation is always and everywhere a conflict phenomenon, and the distinction between different types of inflation (demand-pull, cost-push, imported, etc.), also quite widespread in the post-Keynesian literature, can only relate to the trigger but not to the essence of inflation.”

In fact, as Matt Stoller has reported, in the U.S., investigations into abuse of monopoly power shows that alleged price-fixing in the oil industry was responsible for 27% of all inflation in 2021, that for U.S. rents between 2020 and 2024, up to a quarter of the inflation is due to price-fixing.

Stoller started his blog in part as a counter and to show where Larry Summers, a former economic advisor to Barack Obama is getting it wrong. (Summers reflects the status quo that is driving central bank thinking in North America, which I disagree with).

Stoller wrote

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.’

https://twitter.com/LHSummers/status/1475230223985786889

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.

Consider the two explanations for inflation:

• 1) Inflation is caused by businesses are raising their prices in a crisis. This is showing up as higher-than-usual profits, as customers struggle to pay their bills.

• 2) Inflation is caused when governments borrow to put money into the economy, increasing the money supply. “The monetarist view is perfectly encapsulated by Friedman’s remark that “inflation is always and everywhere a monetary phenomenon.” According to this view, the principal factor underlying inflation has little to do with things like labor, materials costs, or consumer demand. Instead, it is all about the supply of money.”

The actual mechanism of how this is supposed to happen is pretty incoherent, except that it treats all the money in economy as a communal punchbowl, and acts as if the government is diluting it by adding to it.

That is not how money is organized or actually operates in the economy. This is kind of obvious, but whether it’s cash, credit or fiat money, either it’s in an account or it’s some kind of physical form, like cash. It’s not being distributed on a per capita basis.

When government spends, whether it’s running a deficit, a balanced budget or a surplus, it goes where the money is budgeted. It’s not pooled.

It’s also important to point out that there is an ingrained assumption that if a government is running a deficit, that it is spending more than usual, when deficits just mean that an institution is spending more than it is taking in, and that can be happening for multiple reasons.

Deficits also happen because revenues drop, including due to tax cuts. It is possible for a government to practice austerity and run a deficit because they are also cutting taxes, and those tax cuts tend to be regressive - reducing tax rates for people who have high incomes and large amounts of property.

While conservatives used to be much more hawkish on debt and deficits, as “fiscal conservatives” what they’ve actually done is embrace deficits, as “anti-Keynesians”. It is literally the public borrowing and going deeper into debt where the people getting the cheques will have to pay less of that debt back.

That is what modern “fiscally conservative” governments are doing. Governments that generate revenue from property taxes in Canada (cities, provinces) are following a policy that directly amplifies inequality, which are property tax cuts.

Their idea of an economic stimulus is quite literally for the government to borrow money cut cheques in proportion to property ownership, in societies where not only is ownership is incredibly concentrated, many people have no property at all.

Pursuing regressive unfunded tax cuts has a number of broad impacts that multiply well beyond the initial outlay. Imagine a tax cut of $500-million. There will be property owners who receive $7 rebates. There will be property owners who receive rebates of thousands of dollars.

If the last few decades are anything to go by, those folks at the top getting bigger cheques are more likely to buy existing stock than invest in a new and risky venture. So that money is much more likely to go to driving up the price of existing assets, like real estate, or stocks, and not into new capital for a start-up or scale-up company.

So these regressive tax cuts give people more money to drive up the price of existing assets, not into creating new value.

Property tax cuts like these also have the effect of driving up the price of the property, because it increases the amount of a potential mortgageholders income that can be used to service the debt. The supposed relief never arrives, because the space left by the tax cut is filled by the bank, which then drives up prices by offering a larger loan.

The lower the interest rate, the more people qualify and the size of the loan is greater as well. Lowering interest rates means that more debt penetrates further into the population, touching people it hasn’t before. And when interest rates go up, that access starts to dry up.

So, property tax cuts directly amplify inequality, first by the cuts themselves, then add to inequality by driving up the price of property. It’s sold as a money-saver that could somehow bring the price down for first-time homeowners, when it raises property prices.

There is one sector that really benefits from it is the FIRE sector - finance, insurance, and real estate - because it creates windfall gains for them. Mortgages are assets to banks, so it means greater assets, insurers can charge higher premiums, and real estate agents get ever larger commissions - all with the same volume.

The effect is to create a cycle that requires the continual growth of the price of shelter, for the occupant a non-revenue generating and therefore non-productive asset, and an economy based on financing in the form of private morgages.

The consequence of all of this is to drive up the cost of living, as well as pressure on workers to earn more and demand raises in order to pay for rent or a mortgage.

These are the causes of inflation - the very neoclassical policies that are designed to fight it, because it is not a scientific description of how things actually get done in the economy.

Neoclassical economics and neoliberalism just may be the greatest and most sophisticated multilevel marketing scheme in history.

The thing is, there are economists who have been pushing for a better and more scientific economics that at least accurately describes how the economy is functioning in a way that does not rely on so many theoretical assumptions. We have access to unparalleled amounts of data. We do not have to assume, when we can observe.

The Keynesian idea behind “priming the pump” was about addressing not just recessions, but recovering and reforming after a financial collapse, because in financial collapses, the money has not just shifted from one place to another, like a poker match.

The deranged political and public behaviour we’ve seen is being driven by economic desperation that isn’t measured - personal, private debt. We are not in an inflation crisis. We are in an insolvency crisis, and it’s caused by a collapsing private sector due to excess debt, not government.

While right-wing political parties are blaming big government overspending on inflation - and “liberal” economists agree, that is the problem right there.

Joseph Stiglitz, William White, Angus Deaton and Paul Romer are just some examples of economists who are defecting from neoclassical economics and have recognized that the formulas and theories just don’t add up.

Back in January, I wrote about how Christine Lagarde - who used to be head of the IMF and is now President of the European Central Bank warned that economists were a “tribal clique.”

Big Week: European Central Bank President on Economists "a tribal clique" and Bank of Canada changes course

At the World Economic Forum at Davos, LaGarde gave a speech denouncing economists and their models:

“Many economists are actually a tribal clique,” she said. “[They] are among the most tribal scientists that you can think of. They quote each other. They don’t go beyond that world. They feel comfortable in that world. And maybe models have something to do with it.”

“If we had more consultations with epidemiologists, if we had climate change scientists to help us with what’s coming up, if we were consulting a bit better with geologists, for instance, to properly appreciate what rare earths and resources are out there, I think we would be in a better position to actually understand these developments, project better, and be better economists.” 

There is a saying about safety regulations - that every one is written in blood. It was introduced and passed because someone was killed. It’s obvious when you think of it people always call for laws to be enacted after disasters. We haven’t done that with economic disasters since the 1970s.

All of this is vitally important to workable solutions. Parties are splintering and peopls are angry and voting right out of desperation. They just want this misery to stop. They are turning against each other as they fear that they won’t have enough. This is what austerity causes.

Inflation is being caused by collusion and by uncertainty and conflict.

The great news for Reich and the rest of us is that much more is possible under a reality-based economics. It doesn’t mean everything can be done, and it never has. Our limits are all human limits, and one of the things is that people will try to fight it tooth and nail.

We need to challenge the dangerous ideas of neoclassical economics which are utterly failing us at this moment of global crisis. This cannot be addressed without the participation of governments and central banks, because they, and they alone have the legal and financial capacity to address what is ailing the private sector.

If it can be done, it can be paid for. And it doesn’t have to be inflationary.

-30-