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Analysis We know of 'shrinkflation' but what role is 'greedflation' playing in our economy?

Economist Victor Duggan wonders if it is a profit-price spiral that is driving inflation.

INFLATION REALLY STARTED to pick up in the second half of 2021. Coming out of the pandemic, as the economy recovered, demand and supply were out of whack.

Buoyed by pandemic-era government supports, but still cautious – or restricted! – in going to pubs or restaurants or consuming any services that require close human contact, we were still buying more stuff. Replicated the world over, this meant a relatively high demand for goods and snarled supply chains. This caused prices to rise.

In early 2022, Russia invaded Ukraine, sending oil and gas prices through the roof. This quickly fed through to higher energy prices, at the pump and in our electricity bills. More slowly, it fed through to higher prices for everything that uses energy as an input.

That is to say, almost everything. The annual inflation rate seems to have peaked at 9.2% in October 2022 and was expected to fall throughout 2023 as interest rate increases sapped demand and dampened prices. After prices spiked by 1.6% in February alone, only modest progress has been made so far, with annual inflation still at 8.5% as of last month. Still, in the absence of further energy shocks, the expectation is that inflation will moderate as the year progresses.  

Shifting sands

Naturally, workers responded to rising prices by demanding higher pay. With what economists call a ‘tight’ labour market – low unemployment, lots of vacancies – employers have had to pay up, at least to a certain extent. Average hourly earnings were increasing by 5.5% in the final three months of 2022, not much more than half the rate of price inflation at the time. Similarly, the State pension and welfare rates failed to keep pace with inflation.

So, collectively, we are experiencing the most significant and synchronised decline in living standards since the dark days of 2008-9. ‘Once-off’ government measures are sticking plasters over gaping wounds.

Even still, economists working in central banks are prone to worry about the dreaded ‘wage-price spiral’, where workers’ demands for higher pay in order to claw back disposable income feed through to higher consumer prices. This may have happened in the 1970s, but there is little evidence it is happening in the here and now.

What is striking is that central banks have begun to sound the alarm around price gouging and profiteering. They are no longer just worried about a ‘wage-price spiral’, but about a ‘profit-price spiral’. For example, speaking after the European Central Bank’s monetary policy meeting on 16 March, its President, Christine Lagarde, voiced concern that “many firms were able to raise their profit margins in sectors faced with constrained supply and resurgent demand”. In the minutes of its previous such meeting, published a couple of weeks earlier, participants warned that “developments in profits and markup warranted constant monitoring and further analysis on an equal footing with developments in wages.”

Ireland’s own central bank recently noted that “higher profit margins” were contributing more to price increases than were rising wages. Businesses raise prices because they can. You may have heard of “shrinkflation”? This is “greedflation”.

So, what does the data say?

It is easy to point to anecdotal examples of price gouging: the extortionate price of a pint or of hotel rooms. We hear of energy companies recording record profits and supermarket chains announcing similar in this country. But, what about profit margins at the level of the entire economy? As a rough proxy for economy-wide profit margins, economists look at the ‘gross operating surplus’ as a share of ‘gross value added’. In particular, they look at this measure in ‘non-financial corporations’.

By one such measure, profit margins in Ireland (78.3%) were nearly double the Eurozone average (41.1%) in 2021.

If you are thinking that that sounds suspiciously high, you would be right. As is well known at this stage, Irish national accounts are hopelessly contaminated by the activities of our huge multinational sector, sometimes even by business not even carried out in Ireland. Total profits declared in Ireland are thus inflated, resulting in significant corporation tax receipts despite – or because of! – having one of the lowest tax rates going.

Let’s dig deeper: if we strip out the multinational sector and firms that have redomiciled in Ireland, we see that profit margins at Irish businesses increased by a fifth in the three years to 2021. They remained stable in 2020 despite the onset of the pandemic and continued to surge in 2021 as inflation took off. Roughly speaking, the average Irish business outside the financial sector was making €15 profit for every €100 they registered in sales in 2018. This gross profit margin had increased to €19 by 2021.

When data for 2022 is published later this year, we will get a good sense of whether profit margins continued to power ahead as inflation surged higher, or whether they dropped back towards historic norms. 

Let’s look at another example. After dipping at the height of the pandemic, the cost of renting a home in Ireland surged again in the face of chronic supply shortages. Private rent is one of the biggest components in the consumer price index and, for people that rent a home, it eats up a huge chunk of their income. Rent inflation topped out at 12.9% in July 2022 and was still a red-hot 10.6% in February 2023.

So, landlords driving up market rents is a prime driver of increasing consumer prices more broadly. Yes, their costs may have increased, particularly as mortgage interest rates rise, but the reason rents continue to surge is, again, that demand and supply are completely out of whack. Landlords raise rents because they can.

What can be done?

In the private rental sector, supply shortages have gone from bad to worse. The introduction of Rent Pressure Zones hasn’t made a blind bit of difference at an economy-wide level. It is true that there is no quick fix, no silver bullet; but these clichés ring hollow a decade into our latest housing crisis.

The Taoiseach recently speculated that we could be short a quarter of a million homes. There is much weeping and gnashing of teeth about the plight of part-time landlords abandoning the market, cashing in on investments that have doubled in value over the past decade.

Soundings from government suggest we haven’t learned from the mistakes of the past and that they will re-introduce enticing tax deals for property investors in budget 2024. What we have now is buyers competing with renters for the same limited housing stock. What we really need is more homes of all types: social housing, private purchase, cost rental and private rental.

In the broader economy, what we need is more competition. Just as building more houses should feed through eventually to lower rents and property prices – or at least slower inflation! – more suppliers in any market tend to be good for consumers. It is worrying for example that, with the exit of Ulster Bank and KBC from the Irish market, the number of banks has dwindled. Perhaps surprisingly, in this context, our banks have been slower than some European counterparts to pass on ECB rate increases to variable rate mortgage holders. This may have something to do with the State’s continued significant ownership role in our banking sector. On the other hand, our small businesses still face relatively high costs for bank financing.

Other simple initiatives that could bring relief to consumers would be to increase transparency in legal costs and benchmark pharmaceutical prices to lower international prices could also bring relief to consumers.

More broadly, the government should empower the Competition and Consumer Protection Commission (CCPC) to carry out a ‘State of Competition in Ireland’ study, similar to a recent exercise in the UK.

This could set out a roadmap for reforms to boost competition and bring down consumer prices. Recommendations by the European Commission and OECD to further strengthen the CCPC’s investigative and enforcement powers should also be implemented quickly so that sharp practices can be rooted out.

Victor Duggan is an economist.  

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