Have You Been Wondering Why High Commodity Prices Haven’t Created a Wage-Price Spiral?
Dow Chemical: A Canary in the Coal Mine?
By blackhedd Posted in Dow Chemical | Economy | federal reserve | inflation | wage-price spiral — Comments (14) / Email this page » / Leave a comment »
I’ve been writing here about high inflation for nearly a year and a half. I think the Federal Reserve has been running an extremely accommodative monetary policy for quite a long time, much longer than the mainstream press has been screaming about high food and oil prices.
But why we aren’t seeing the classic sign of hyper-inflation, a wage-price spiral? Wage increases are the channel through which inflationary pressure metastasizes to the point that it can destroy an economy.
That isn’t happening this time, for a lot of reasons, all of which are interesting. But there is one in particular that is worth calling out because it illuminates a key aspect of tax policy.
In short, businesses are unable to pass increased factor costs on to consumers.
Keep reading…
A key feature of the last large inflation experienced in the US, which ran with interruptions roughly from 1965 till past 1980, was the feedback loop in which workers responded to the high cost of living by demanding, and receiving, wage increases.
In those days, the union movement was stronger than it is now, which suggests that it may have been easier for workers to demand higher wages in the face of higher consumer prices. But that’s only part of the story.
Today, the real story is that the price increases felt by consumers across the economy are relatively mild.
Business people have been extremely reluctant to pass their factor-cost increases on to buyers of finished goods. Most of these cost increases are commodities. You all know that energy prices are higher, but so are prices for everything from grain to shipping hulls to iron ore.
Supply and demand always explains price increases in one sector of the economy compared to others. But when everything is going up in price around the world with no displacement in demand from high-priced items to lower-price substitutes, as is generally the case today, you know you’re dealing with a monetary phenomenon. The Federal Reserve is printing too many dollars and the Treasury is issuing too much dollar-debt. And since the dollar is the world’s money, the resulting inflation is global.
But again, in past inflationary episodes, businesses would generally tend to pass price increases along till they hit consumers, who would then demand higher wages and salaries, as well as moderating their consumption, which tended to bring things back into balance.
But businesses now are tending to suck up factor-cost increases and drop them to their bottom lines. The global increase in commodity prices is showing up as reduced corporate profitability.
Why would a business choose to be less profitable rather than pass on their cost increases to their customers? Because the most important thing that the managers of most publicly-owned businesses can deliver is market share. The top line matters more than the bottom line. And once you lose market share for whatever reason, it’s nearly impossible to get it back.
But how is it rational to emphasize revenue growth over profitability? Because current tax policy favors capital gains and disfavors corporate earnings. When a business makes money, the government taxes it twice, first at the corporate level and again when it gets distributed to the owners of the business (that would be you and me and the other public shareholders).
But stock-price appreciation isn’t subject to immediate taxation. And you can borrow against an appreciated asset to make use of the capital, and deduct the interest expense, which makes holding the capital asset even more attractive.
Perhaps the sharpest example of this effect is with oil refiners. You’ve seen how people howl when gasoline goes to $4/gallon. Well, that’s only about a third again more than it was a year ago. But meanwhile, the price that refiners pay for crude oil has tripled. The difference is coming out of their hides: the profitability of oil refiners has fallen drastically.
But again, you don’t dare raise prices any more than absolutely necessary, because you’ll lose market share.
What brought me to this was something striking that happened a few days ago, and has been bothering me ever since: the Dow Chemical Corporation, of Midland, Michigan, just announced a second round (in as many months) of double-digit price increases to their customers.
Dow Chemical is in a lot of businesses but one of the biggest is petrochemicals. They’re part of a long chain of intermediate products that turn crude oil into resins, plastics, and many other things.
And since their cost for feedstocks has been getting so much higher, their only choice was to increase their prices or temporarily exit certain businesses (which they have also been doing).
That’s a sign that the cycle of containing inflationary pressure inside the balance sheets of corporations may be coming to an end. At a certain point you can’t keep eating higher costs.
Now I think many people are unaware that, going into the current recession, the balance sheets of many large American corporations were extremely healthy, and this has muted the impact of the credit crisis on the real-world economy. Before last year, businesses had been building up large reserves of cash, which ordinarily is something you really avoid doing. (Shareholders don’t pay CEOs to put cash in the bank.)
But they did it, and now many businesses have a large cushion to work with as they’re forced to absorb higher costs. At some point, the cushion gets thin, and Dow Chemical’s actions may be a sign that we’re nearing that point.
What would I do if I were making the rules? Sharply reduce the tax rate for all business income, and eliminate all taxes on goods manufactured for export. Get rid of the tax-code distortions that lead businesspeople to emphasize top-line growth over profitability.
-Francis Cianfrocca
Have You Been Wondering Why High Commodity Prices Haven’t Created a Wage-Price Spiral? 14 Comments (0 topical, 14 editorial, 0 hidden) Post a comment »
...are in extremely tight circumstances right now because of reduced property tax revenue. Their challenge is going to keep all of those teachers, firefighters, sanitation workers, librarians and tax collectors employed in the first place.
One thing that could make you right is increased federal support for state/local governments (aka, Democratic political machines). This was a salient feature of all of Hillary Clinton's economic proposals, and is built into the housing-bailout legislation currently in Congress.
According to this morning's employment report, government hiring is still rising sharply. As soon as that starts to slow down, you'll know this recession is the real thing.
not a Democrat politician in a Democrat controlled state; it won't be their constituencies they're taxing, and property taxes are only one of many forms of revenue. Michigan's woes are a good example and despite it all, they can't or won't resist the unions.
In Vino Veritas
is that, at least with the manufacturers, they were private businesses. They could argue that the supply of money was not infinite and therefore wages were constrained by something (sure, they could raise prices, but eventually you raise them enough and people stop buying, meaning no money to pay people - in fact no reason to have employees at all).
Government is not so limited. When it runs "short" it raises taxes. True, local government may be more constrained - but as noted, the answer is to go to the state and feds, who do have general taxing authority, to get extra aid.. The government cannot go out of business the way a private manufacturer can, which makes the consequences all the worse in this scenario.
Excellent as usual, blackie
It's a bit embarrassing, though, that as per this:
http://online.wsj.com/article/SB121503712865524297.html?mod=opinion_main...
that the ECB seems to get it while the Fed doesn't.
One thing I'll add here that I should have added to last evening's missive about Ukraine and Russia and such. One other thing Ukraine has been doing to try to link with the free world and NOT with Russia has been to quasi-peg the Hyrvna to the Dollar; I say "quasi" because the exchange rate does vary (it's presently 4.68 to 1; it was about 6 to 1 way back 3+ years ago during my first trip to Ukraine), but as you can see from those numbers the change hasn't been nearly as drastic as the exchange rate erosion vis-a-vis most other currencies. The depressing upshot is that by this action of faith by the Ukrainian monetary authorities, the Fed's easy money policy is being imported into Ukraine as inflation, at a rate now of some 16% per annum. This is not a way to win friends and influence in a sensitive part of the world. Various other countries are suffering from a similar situation.
...are a buy compared to European ones, because Trichet seems to be showing the willingness to dump Europe into a recession in order to avoid inflation.
That's the tradeoff that Ben Bernanke is extremely leery of making. He knows darned well that he's created a historic pulse of inflation (and you're 100% right, a whole raft of countries besides Ukraine have imported it). But his worst nightmare is to replay the Great Depression, with severe reductions in industrial output and big job losses. So he and Trichet are dancing on opposite sides of the knife-edge.
By the way, watch the markets carefully today, as Trichet steps up to the microphones to explain today's decision to raise the benchmark euro rate to 4.25%. Depending on what he says, we may see massive complementary moves in the currency/bond markets and the commodity markets.
Depending on what he says, I wouldn't be surprised to see oil hit $150 today.
Actually, reading your spot-on comments about the mess that Bernanke and the Fed have gotten themselves into.... reminded me of a saying we have up here: "Four-wheel drive will let you get stuck in places that you can't even GET TO with two-wheel drive"....
The wires are reporting that he downplayed expectations for more rate increases, apparently stating that there is no bias in either direction at this time.
This is not bad news, and in the absence of good news, I'll take it. This is a holiday-shortened trading day, and people will probably put a negative spin on it as they get flat going into the long weekend.
The msm has been amping up fear in the economy ever since clinton left office. This makes people less likely to take action that may cost them their jobs.
You pointed out the situation with the refiners where they were being forced to eat the costs. No different with labor.
Someone pointed out the public sector is where this will crack. That seems likely. The sector encourages a sense of security in labor and has enshrined collective bargaining up to and including illegal work actions.
capacity and jobs. The strategy is to stop the losses on today's opeations, which are losing money every day despite crowded planes. Except perhaps for Southwest, market share is becoming a secondary consideration. And they don't pay dividends!
As far as employee givebacks, which subsidized travel in the post 9/11 recession/bankruptcy era and continued into the recovery, the unions are going into this with one thought- Fuhgheddaboudit!
BTW, blackhedd, I'm on Long Island this weekend, reconnecting with my yute. I mean, youth!
Folks,
The price of oil, food, and other commodities has gone up, but rather than general inflation, I see deflation with a weakening dollar. The reason I see deflation , is that, under the classic Austrian definition, there is a net contraction of money and credit. When that house that sold for $1 million, with 100% financing, is foreclosed, and sells at auction for $595K after a year (or more!) of no payments, credit has been destroyed. This has been happening on a huge scale, with other forms of credit also contracting (banks pulling unused credit lines wherever they can, and the coming clampdown on credit card lines of credit). In a general inflation, real estate joins the party. Not now, and not for a while. As a commercial real estate broker, I can tell you that underwriting standards for all types of lending are tightening rapidly, which means that prices for property will continue to fall, as the ability to leverage capital declines.
Moreover, in this environment, not many employees would be well advised to ask for a raise, unless they can prove that they have earned it with increased productivity, because the key to being able to get a raise, is to have another job to go to if the boss says no. If both boss and employee know that there's no alternative job for the employee to go to, the employee will probably not ask for a raise, and the boss would certainly not grant one. So no wage spiral.
So while the Fed was to blame for the peak of the credit cycle with its loose policies, I can't blame them now for holding rates at 2%. If they were to try to prop up the dollar by matching the ECB, they could tip banks into FDIC receivership -- which would be a very expensive way to reduce oil prices. Better to handle the weak dollar on the Treasury and budget side, by reducing government spending. Reducing capital taxes would also help.
McCain is explicity better than Obama on both of those fronts. Perhaps that is why the ECB is keeping the dollar low, and OPEC is keeping oil high -- they want to do all that they can to ensure an Obama win. But when he throws up trade barriers and increases capital taxes, they may rue the day.
Much is being made about record oil company profits and the impact of speculation on the price of oil.
Bad U.S. oil companies buy, on the margin, in world auction markets from oil suppliers (Iran, Venezuela, Russia, Saudia Arabia, etc.) where our bad speculators have less than the largest role. Forget about the role of speculators in making an orderly market. (Sidebar: As I recall, in the early '70s the then weak dollar was caused by bad currency traders.)
By enriching these suppliers and sending our dollars overseas for them ferriners to recycle them by buying up declining market value U.S. assets with discounted dollars, we are surrendering our energy security while bashing everything American. WTF.
You must explain you're comment; ..."going into the current recession.." Does that mean you think we're IN a recession, or that we will be soon?
and they'll come most forcefully in the place that can actually least resist it or afford it, the public sector. All but two or three of the states with fully unionized public employees are controlled by Democrats. They will not be able to resist public employee wage demands, even assuming they have any desire to, and can only pay for those demands through increased taxes, since the unions and the other D constituencies will not allow them to reduce services.
Last time around, we had much more of a heavy manufacturing economy than we do today and it was heavily unionized. As cost of living went up, the unions took wages up with them; all the way to the demise of some of those manufacturers or the manufacturing jobs in this Country. The public sector, especially in the Blue States is MUCH more unionized than the private sector ever was. The private sector outside the regulated industries had at least some incentive to resist wage demands, a Democrat government has none, and even a Republican government has only a limited ability to resist. Watch your tax bill!
In Vino Veritas