Notes On The Front

Profits Driving Inflation

With inflation rising unexpectedly in February (and at one of the fastest monthly rates since the beginning of the crisis) the question being increasingly asked is:  are profits driving inflation?  And the evidence increasingly suggests yes.

It’s certainly not wages.  The IMF’s historical study of the relationship between wages and prices (79 periods of rising inflation, including Ireland’s experience in the 1970s) found almost no evidence of a wage-price spiral – an alleged phenomenon used to justify rising interest rates and wage ‘moderation’ (i.e. real wage cuts).

‘Wage-price spirals, at least defined as a sustained acceleration of prices and wages, are hard to find in the recent historical record . . .’

This is confirmed by Ireland’s recent experience.  In 2022, inflation rose by 7.8 percent.  Wages rose by 3.4 percent.  No wage price spiral there.  If anything, wages have had a disinflationary effect.  But what about profits?

• In the US, the Economic Policy Institute found that in the 18-month period between mid-2020 and the end of 2021, profits made up 54 percent of the increase in prices; wages made up only 8 percent.

• In the UK, Unite the Union reported similar findings in the six-month period between October 2021 and March 2022: 59 percent of price rises due to increased profits; 8 percent for wages.  The further found companies with increasing profits well above pre-covid levels.

• The Australia Institute argued that the economy was experiencing a ‘price-profit spiral’ with wages contributing only 15 percent to higher prices.

The Financial Times recently looked at this phenomenon in an article headlined, ‘Unchecked corporate pricing power is a factor in US inflation,’ (behind a paywall).  They published this graph on the front page.  It shows after-tax profit margins in the US rising higher than at any time since 1945.

The ECB has acknowledged this phenomenon.  Isabelle Schnabel, a member of the Executive Board of the European Central Bank, stated:

‘. . . on average, profits have recently been a key contributor to total domestic inflation, above their historical contribution . . . To put it more provocatively, many euro area firms, though by no means all, have gained from the recent surge in inflation . . . Poorer households are often hit particularly hard – not only do they suffer from historically high inflation reducing their real incomes, they also do not benefit from higher profits through stock holdings or other types of participation.’

And staying with the ECB, Reuters reported that at a recent retreat in Finland for the ECB’s Governing Board:

‘Data articulated in more than two dozen slides presented to the 26 policymakers showed that company profit margins have been increasing rather than shrinking, as might be expected when input costs rise so sharply . . . An ECB spokesperson declined to comment for this story.’

The Irish Times’ Cantillon notes:

‘Some of the surprise stickiness in inflation was coming from goods inflation.  This should have come down with the reopening of supply chains but has remained stubbornly elevated, a trend he (Philip Lane, ECB chief economist) associated with increased corporate profits.  Yesterday his boss Christine Lagarde also raised the notion of companies profiteering on the back of inflation . . . ‘

Eurostat’s quarterly sector accounts gives us an aerial view of profits and wages in the non-financial sector.  Focusing on our EU peer-group (other high-income countries) over the last two years up to the 3^rd quarter in 2022 we find that:

• Profits increased by 25.9 percent
• Employee Compensation increased by 12.8 percent

Profits over this period increased at twice the pace as wages.  We find a similar pattern if we go back over three years – starting in the pre-covid period of 2019.

What about Ireland?  Irish profits data can be as unreliable as Irish GDP.  It incorporates income that is produced in other jurisdictions but booked here to take advantage of our low tax. 

The Central Bank has helpfully published data on prices and profits for the domestic sector (excluding multi-nationals).

These measure year-on-year averages.  On average, profit margins made up over 60 percent of prices.  It should be emphasised that this data relates to the domestically-owned sector – it doesn’t factor in multi-national profits. 

However, it is certainly the case that the multi-national sector is more profitable than our domestic sector.  And if we use corporate tax revenue as a proxy, we find that it has more than doubled between 2019 and 2022, implying that multi-national profits have more than doubled. 

* * *

This price-profit spiral raises a number of questions for policy.  If prices are not being driven by wage-fuelled demand, what is the point of ECB’s interest rate increases?  The Reuters report went on to quote Paul Donovan, chief economist at UBS Global Wealth Management:

’It's clear that profit expansion has played a larger role in the European inflation story in the last six months or so.  The ECB has failed to justify what it's doing [increasing interest rates] in the context of a more profit-focused inflation story.’

It is important to note that rising profits are not uniform across the board.  We have less insight into the sectoral breakdown of profits than we have wages.  The ECB’s Schnabel noted that it is larger, export-oriented firms that are benefitting the most with many smaller firm – in particular, in contact-intensive services (retail. Hospitality, transport, entertainment, etc.) - still struggling.

But there’s a more fundamental question: what is the point of profits?  If profits are being direct into increasing dividends and senior executive pay, rather than its social utility (investment), then economies are suffering from a double whammy:  profit-fuelled price increases and ECB interest rate increases.

Answering that question, however, calls for a far more radical review of how we run our economies.  But the quicker we start that review, the quicker we can begin addressing a myriad of problems, including profit-fuelled inflation.

Policy without Evidence, Strategy without Goals

‘Facts are meaningless.  You can use facts to prove anything that’s remotely true.  Facts schmacts.’ (Homer Simpson)

Fact:  private rental accommodation supply is falling.  Between 2016 and 2021, the number of private tenancy registrations fell by 44,000, or 14 percent.  However, this fact doesn’t tell us why supply is falling. 

Is it falling because the number of landlords leaving the market is accelerating?  Or is the number leaving remaining steady, its' just that new entrants are not keeping pace?  Is there data on churn?

Is it falling because of tenant-protection legislation such as rent control?  The picture is not so clear.  We can get some insight from the Rental Sector Surveys conducted by the Residential Tenancies Board (RTB).  One relevant response from landlords is their future intentions to sell.

16 percent and 28 percent of small and medium landlords respectively are likely to sell the rental properties with three years.  That is not an insignificant proportion.  However, the overwhelming majority of landlords do not intend to sell over the next three years; though it should be noted this survey was published in mid-2021 so intentions may have changed.  And even if they sell, they might do so to other landlords who will maintain the rental stock.

Of the minority that are likely to leave, what are the reasons?  Again, the RTB asked this question.

There are various reasons for landlords leaving the market.  For mid-sized landlords, retiring is the biggest.  A significant number cite reasons related to the value of the house.  The regulatory environment doe not appear to be a major reason.  However, some of those who claim they don’t want to be a landlord anymore might be reflecting a more difficult ‘market’ to operate in (though it might also reflect ‘accidental’ landlords who didn’t want to be in the market in the first place) while ‘high’ taxation is another reason.

In short, there is no simple reason or set of reasons as to why landlords are leaving.  To attribute it solely to tenant-protection measures would be a misrepresentation. 

It also suggests that some measures to incentivise landlords to stay in the market – such as tax cuts – might miss the mark.  if most landlords do not intend to leave in the short to medium-term then tax cuts will come with a high deadweight cost - subsidising most landlords to do something they intended to do anyway without the tax cuts.  If landlords are leaving because they are retiring and want to cash in for their pension, cutting taxes may not have much impact.

The Government is rationalising the decision to end the eviction ban on the basis that continuing the ban would lead to a further loss of supply.  What is the evidence for this?  Ministers and Government TDs keep repeating the fact that private tenancies are falling (true) but assume without much evidence that this is due to regulation.  Could the eviction ban increase the tendency for landlords to leave?  Yes, possibly.  By how much?  We don’t know.  If we get rid of the eviction ban will that help incentivise landlords to stay in the market?  Maybe not as many are leaving because of other reasons.  The whole thing is a fog.

At times, the options available to a government all have downsides.  The skill (the ‘art of politics’) is to pursue the least damaging option while taking steps to ameliorate the next damaging option.  It’s hard to imagine anything more damaging than homelessness.  And if the government is confident that the measures to compensate for the removal of the eviction ban would protect tenants from homelessness, then – on the balance of probabilities – they should wait until such measures are on stream. 

Ultimately, we have two problems.  First, a clear lack of evidence to guide housing policy.  It is so bad we don’t even have robust measurements of how many houses we build each year as Lorcan Sirr and Mel Reynolds recently pointed out.  As such, what few facts there are can be manipulated to support unsubstantiated assertions and poor policy choices.

More crucially, we don’t have a policy destination.  What is the long-term plan for the private rental sector?  Where is the capital going to come from to provide truly affordable rental accommodation?  What is the delivery agency?  Institutional investment may divert to a more ‘profitable’ bond market (and, in any event, they veer towards the upper-end of the market).  Small and medium-sized landlords may struggle to generate the income needed to invest in new-build rental units.  The Government has ultra-modest proposals for cost-rental which still may not be affordable.

We have a relatively short window.  While most landlords don’t intend to sell in the next three years, a high number see it as likely over the medium to long-term.

It is long past time to stop treating rental accommodation as a ‘market’ and start treating it as ‘public good’.  The Nevin Economic and Research Institute’s proposals for a unitary ‘network’ in rental accommodation remains the most proactive and potentially transformative model. Such a model could incorporate private landlords, providing them with a real incentive to remain in the market while at the same time as expanding rental units through public intervention.

In the meantime, there is the danger that policy will be supported with little evidence, and strategies will fail to resolve the crisis for lack of direction or goal. 

And in that situation, facts can become meaningless.