The Guardian reported,
A new report claims “resounding evidence” shows that high corporate profits are a main driver of ongoing inflation, and companies continue to keep prices high even as their inflationary costs drop.
The report, compiled by the progressive Groundwork Collaborative think tank, found corporate profits accounted for about 53% of inflation during last year’s second and third quarters. Profits drove just 11% of price growth in the 40 years prior to the pandemic, according to the report.
Is this true? Unraveling this mysterious relationship between corporate profit and inflation is easy once we clearly define what profit and inflation are. This allegation that corporate profits accounted for 53 percent of inflation is a result of using wrong definitions and reasoning by mainstream economics researchers.
First, let us see what inflation is. As Henry Hazlitt explained in his article “Inflation in One Page,” inflation is “an increase in the quantity of money and credit. Its chief consequence is soaring prices. Therefore inflation—if we misuse the term to mean the rising prices themselves—is caused solely by printing more money. For this the government’s monetary policies are entirely responsible.”
Faulty reasoning by mainstream economists occurs because of their faulty way of mistaking the price rise effect of inflation as inflation itself. They are putting the cart before the horse. Rising prices is only one of the chief effects of inflation, not inflation itself.
Another mistake that mainstream economists make is that they use the long disproved Marxist “production cost/labor theory of value” to explain the rise in the prices of consumer goods, as is the case with this research done by the Groundwork Collaborative think tank. Production cost (corporate profit) doesn’t determine the prices of consumer goods. The subjective value of the consumer determines those prices. In this article I do not have the space to discuss this very important subjective value theory. I advise my readers to study the literature of the Austrian School of economics.
They also mistake individual commodity price fluctuation for inflation. In a market economy, prices of various commodities are always changing. Such price fluctuation doesn’t reflect the mythical general price level that mainstream economists use to measure inflation.
Also, if corporate profits explain the rise in prices of consumer goods—what mainstream economists call inflation—then what explains the rise in the prices of producer goods? The same corporate profits? We need to remember here that inflation not only increases the prices of consumer goods but also producer goods. When the supply of money rises due to the Fed’s easy money policies of creating dollars out of thin air, it dilutes the purchasing power (value) of all existing dollars in the economy. And because dollars are legal tender money (a common medium of exchange), they will buy less of both consumer and producer goods (i.e., looking from the goods side it will look as if their prices have gone up). Actually, the dollar is losing its value and so buying less of everything against which it is being used in market exchange.
We next look at profit. Here is Ludwig von Mises explaining profit:
In the capitalist system of society’s economic organization the entrepreneurs determine the course of production. In the performance of this function they are unconditionally and totally subject to the sovereignty of the buying public, the consumers. If they fail to produce in the cheapest and best possible way those commodities which the consumers are asking for most urgently, they suffer losses and are finally eliminated from their entrepreneurial position. Other men who know better how to serve the consumers replace them.
If all people were to anticipate correctly the future state of the market, the entrepreneurs would neither earn any profits nor suffer any losses. They would have to buy the complementary factors of production at prices which would, already at the instant of the purchase, fully reflect the future prices of the products. No room would be left either for profit or for loss. What makes profit emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market, are too low. Thus the total costs of production—including interest on the capital invested—lag behind the prices which the entrepreneur receives for the product. This difference is entrepreneurial profit.
As Mises explained, an entrepreneur will earn (corporate) profit only if he successfully anticipates this mismatch between the present prices of producer goods versus the future prices of the consumer goods that these producer goods will help produce. The difference between the prices of producer goods and consumer goods is profit.
Once we define profits clearly, we can see corporate profits are not responsible for causing inflation. It is, in fact, inflation that affects the profit calculation of an entrepreneur by raising the prices of both consumer and producer goods. Prices of consumer goods are rising because some of the consumers—let’s say from the state of California—are receiving freshly printed dollars, which they are using to bid the prices of consumer goods higher. Those who are at the end of this market process are facing higher prices and seeing their dollars’ purchasing power diluted. Those same dollars are also chasing producer goods, raising their prices. Some entrepreneurs can judge this gap between producer and consumer goods in a better way than others, and so they are making profits. The mainstream researchers are forgetting that many unsuccessful entrepreneurs aren’t properly judging this gap, and so they are making losses and going out of business. Are these corporate losses also causing inflation/deflation?
All in all, the present study by the Groundwork Collaborative think tank represents the classic case of spurious correlation. Spurious correlation is when on the face of it there seems to be a causal relationship between two variables, but the theory says there isn’t any. Mainstream researchers in the present study forgot the basic statistical caveat that “correlation doesn’t mean causation.” If they used the right definitions of both inflation and (corporate) profits, then they would’ve seen that it is the US Federal Reserve that is creating inflation, which in turn is affecting corporate profits.
