The Way the World Works: Economics vs. Reality

The frenzy over inflation ignores the deeper ailments facing our societies that began long before the pandemic, and that a pliant political class has yet to address.

Here: A cost-of-living-crisis in England, the US, some parts of Europe, because energy prices have risen by around 50% and cost-of-living index by around 5% in just a few months; multiple warnings by certain economists that we are at the cusp of a – horribile dictu – “wage-price-spiral”, with the governor of the Bank of England pleading with workers not to increase their wage demands (!).

There: “Super profits” by energy companies (e.g. Mobil $26b, Shell $20b, OMV $6b), financial reversing back into companies, where only a few months ago portfolios were being purged of fossil assets. Shell was reprimanded by investors that its carbon-neutrality strategy was not ambitious enough.

The policy response: To dish out heating subsidies to poor households, always too little; to put pressure on Central Banks to raise interest rates, in spite of the consensus that inflation in large part is due to supply-side constraints that no interest rate hikes will solve; to overlook the super profits of energy and financial companies. Otherwise, silence, partly excused by the Covid crisis.

A bad case of political failure

Two issues come to mind: yes, energy prices have spiked considerably, but much less than in 1974 and 1981. But policy hysteria today is ten times that of decades ago – why?

And, two months ago, there was consensus that carbon must finally be priced “to the market”, that higher fossil prices are the only way to wean our economies of excessive carbon emissions. Now, as soon as supply restrictions occur and prices go up, caused by geopolitical uncertainties and unwillingness of OPEC countries to increase supply, the lamentations set in: We are impoverishing households, the poor freezing to death, the economy in danger of collapse.

Our leaders have been unable to prepare us for the realities of climate change; the price increases have caught them off guard. In contrast to the Covid crisis – which was and is a novel one that came upon us suddenly (even if predicted by scientists) – the climate crisis has been in the public consciousness at least since the Paris Accords of 2015, and for many, far longer. And the social crises – the ever-increasing income and wealth inequality, the pressure on wages, the precariousness of work, and now the political disregard for “system-essential” workers in health, care, infrastructure and retail trade, who have kept things going during the crisis – has been building for decades.

Is it incompetence? Or the final capture of policy-making by vested profit interests?

A traditional wage-price spiral? Or something else?

The traditional economic discussion about the wage-price spiral runs as follows: Given the scarcity of labor in certain sectors – in spite of still high unemployment rates (Europe) and unprecedented withdrawals from the labor market (USA) – workers manage to obtain wages beyond their productivity increase; employers shift these cost increases onto prices, which in turn triggers the demand for higher wages, and so on, and so forth. The traditional narrative mistakes the sequence for cause: higher wages – higher prices – still higher wages – higher prices. Only a brutal hike in interest rates, which would cause a deep recession, will “right the wrongs”, i.e. put labor in its place, break the demand pull, and restore so-called “balance”.

An alternative narrative is much more probable: The ever increasing political power of financial markets and business leads investors, frequently speculators, to demand excessively high returns. Let us remember former Deutsche Bank boss Ackermann’s dictum that 15% is a “fair return”. If we assume that profit rates must be earned by the “real” economy (roughly in line with real GDP growth), we see that 15% can be earned only by exploiting the real economy, i.e. workers. And in our Western economies, with a few exceptions, real wages have barely risen over the past 30 years. It seems that today businesses have to earn a double-digit profits, and count their capital market financing as a fixed cost as much as labor, raw materials including energy and semi-manufactured goods.

In the good old days (i.e., before the 1980s), profit was the residual, once these costs were deducted from revenue. Today, profits are a cost factor with Ackermann’s “fair return” built in. Prices are maxed out to deliver to investors, and labor costs, as the major variable, are squeezed. For consumers this means higher prices.

What I am trying to say is this: Given the extra-ordinary increases in profits both in the financial sector and from selling goods and services, and given the increasing buy-backs of shares (i.e. returning profit to shareholders/investors), why don’t policy makers induce, or even force, these companies to pass along some of these profits to their customers? And why don’t companies willingly pay fair wages to their most valuable asset, i.e. their workers? What about “stakeholder value,” which supposedly drives company behavior today far more than Milton Friedman’s shareholder value of the 1980s?

Why must we have excessive price increases (in energy, freight rates, semi-conductors, etc.) which governments then have to compensate with taxpayer money, when these companies frequently manage to evade taxes altogether? Every day we read how wealth inequality has increased, how the rich (both individuals and companies) have increased their wealth even during the Covid crisis. But no policy maker on either side of the Atlantic dares to challenge what has become a perverted economic system that does not provide for the many, but only enriches the few.  And forces populist policymakers to spread around a bit of (taxpayer-funded) largesse, in order to partially compensate for the enrichment of the few.

A wake-up call for a new model

Policy debates today happen only at the margin, with a bit of tweaking here and there. These debates do not call the whole system into doubt. We increasingly talk about our “Western liberal order”, as if competition kept prices down, as if workers received a fair, more-than living wage, as if income distributions had not deteriorated, as if the lobbying power of business were non-existent, as if labor unions (weak as they have become) were pursuing “special interests”.

We ignore these crises at our peril – the climate crisis, the fractioning of social cohesion, the capturing of the state by profit interests, all of it. So far, only a few academics and activists point to these systemic failures and their possible effects. Instead, the arguments are about “party-gate”, and prime ministers’ hairstyles, about office romances. What we hear far too little about are appropriate policies that go beyond Sunday speeches and contain hard implementation milestones.

The recipes of the 20th century no longer suffice: A mountain of financial, climate and social debt has been built up, and we are in danger of being flooded by it.  While politics remains asleep, beholden to vested interests.

Kurt Bayer
Kurt Bayer is Senior Research Associate at wiiw. His research interests focus on crisis prevention and resolution, industrial and innovation policies, anti-corruption and transparency and EU economic policy.

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