The most common explanation for inflation is that it is caused by increased demand, which in turn is caused by increased disposable income for consumption, i.e. workers having higher wages.
In fact, in the decades of the 1970s and 1980s, when aspects of an economic orthodoxy were formed that still dominate today, the unions were, together with the OPEC countries, the convenient “culprits” for inflation.
In a way this combined a monetarist perspective – particularly popular with those who later came to be called neoliberals – that is, a perspective that saw excessive money circulation as the problem with hostility to unions and the organized labor movement.
This also explains why a perception has since been formed that whenever there is an increase in inflation, the only solution is to raise interest rates by the Central Bank in order to slow down the economy, increase unemployment and thus hold back the rise in wages. In fact, unemployment in particular was repeatedly considered a key driver of an anti-inflationary policy, culminating in the need to determine the unemployment rate below which inflation rises.
Part of this logic is the notion that inflation is basically a demand-side phenomenon, that it is the result of excess demand (created either by an excessive increase in money in circulation or (or in combination) by an increase in wages).
To this was added the perception of one or another exogenous factor that could cause a disruption of supply or lead to a sharp increase in some commodities for momentary reasons, as for example happens with energy crises.
What has been underestimated in all this discussion is the supply side and mainly how much inflation we can have by trying to maintain high profit margins or even expand them. That is, it underestimated the impact that price increases can have on inflation when there can be no profitability through the main mechanism that is supposed to increase profit margins, which is productivity growth through organizational and technological cuts that ultimately reduce the actual cost of production.
The ECB discovers the problem with corporate profits
Against this background, it is of great interest that it seems that the ECB is also starting to face this very question. And this is because there has been a growing number of data and research showing that for the large increase in inflation in the gradual “opening” after the pandemic, salary increases cannot be considered “guilty” because in general they remained at levels lower than inflation, element which in some cases meant they had real income losses. However, it is also questionable whether wages historically trigger inflation.
On the contrary, it was found that in 2021 and to some extent in 2022 what was observed was an attempt to widen corporate profit margins. This was reflected in the US in particular in a significant increase in the share of corporate profits in GDP in 2021, at levels higher than in other periods.
But also in the Eurozone, consumer goods companies expanded their average profit margin last year to 10.7%, considerably higher than in 2019, the last pre-pandemic year. And analyzes have shown that they have had a higher share of inflation than wages and taxes.
Let’s not forget that this also has to do with the way corporate cultures are shaped in modern economies. The increasing weight of financial companies and the way they treat the concept of return on an investment and the pursuit of high profits for shareholders creates a favorable climate for more aggressive price increases, rather than investments that will expand the margin in the medium term. profits through cuts in productivity.
All this puts the ECB in a somewhat awkward position, as until now it has mainly been moving in the direction of anti-inflationary policies with interest rate increases, which, however, also carry the risk of exacerbating any recessionary dynamics and probably cannot so easily deal with an inflation fueled by the drive for increased profits.
What anti-inflationary policy for a profit-fueled inflation?
And the perplexity is heightened when it is realized as much as it is that this kind of inflation will not be so easily subdued by traditional anti-inflationary weapons. Obviously, one could assume that an attempt to significantly reduce demand through expensive borrowing, recession, rising unemployment will eventually cause businesses to “put water in their wine” and cut prices or stop raising them. But, it won’t be that fast and the actual cost can be high.
On the other hand, the other solution, which is to intervene on the supply side and try to hold down prices, even by intervening in them, is quite beyond the way a whole tradition of non-intervention by the state has been shaped. Because it may be considered whether “household basket” type measures can be implemented in European countries, but the concept of price intervention, profit restriction or “repricing” remains foreign to those who plan economic policy. But this does not negate the need to consider measures that actually address the root of the current rise in inflation.
