The other day I listened to a podcast with Larry Summers, former Treasury Secretary and "Just Asking Questions About The Biological Basis Of Female Intelligence" President of Harvard discussing his pessimistic view of the inflationary landscape. Since I'm an inflation skeptic I went into the episode expecting to disagree with him, and I did, but not for the reasons I expected. Rather than lampooning him, I want to summarize a "steelman" version of his argument to explain precisely why his crippling fear of inflation is ideological, rather than empirical.
Take a hypothetical world not unlike our own (except the numbers are rounder), where a barrel of oil is sucked up out of the desert in Saudi Arabia (at a cost of "about" $9 in 2016 depending on how you calculate), sold for $100 at a port in Galveston, Texas, piped to a refinery in West Texas, then shipped to gas stations around the country where it is sold as unleaded gasoline for $6.66 a gallon. At all of these prices, Saudi Arabia makes a profit, the port operator makes a profit, the refinery makes a profit, and the Texaco station around the corner makes a profit.
Now consider what might happen if a major oil producer on the other side of the world began a war of aggression and was hit with crippling sanctions, including on its fossil fuel sector. Saudi Arabia, spotting an opportunity, calls up the Galveston port operator and says the same barrel is going to cost $125 now, a 25% increase. Note that the Kingdom's costs haven't changed at all: the additional $25 per barrel is a pure windfall profit.
Now the Galveston port operator has a decision to make: how much should it charge the Texas refinery for the same barrel of oil that used to cost $100 and now costs $125? The port's situation is different from Saudi's: Galveston's costs have actually increased, so if it charges Texas the same price as before, say, $110, its profits will definitely fall — the cost increase will turn a tidy profit into a crushing loss. One natural answer would be to pass along the $25 price increase to Texas, maintaining the same quantity of profit as before the war. But just as the CEO is about to pick up the phone and call Texas to pass along the bad news, his Chief Financial Officer bursts into the room to remind him: although the quantity of profit will remain the same, Galveston's rate of profit will fall: if revenue increases only by as much as costs, profit as a percentage of costs will mechanically be lower than before. This is true regardless of how much the profit was before: $10 in profit represented a 10% profit on a $100 barrel but only an 8% profit on a $125 barrel. The CEO sagely decides to charge Texas not $135 per barrel, but $137.50 per barrel, maintaining not $10 in profit but a 10% rate of profit.
This process repeats itself at every step of the chain. The refinery, paying $27.50 more per barrel, has to decide whether to maintain its former profit of $11 per barrel it converts into gasoline, or maintain its former rate of profit of 10%. Naturally, the CEO decides to maintain the former rate of profit, and calls the Texaco station to let them know it'll be charging not $6.05 per gallon of gasoline (apparently you get about 19 gallons of gas from a barrel of oil but 20 makes the math easier), but $7.56. The station operator solemnly updates the sign outside. But what price does he put up? He's paying $1.51 more per gallon, so he might charge $8.17, maintaining his prior quantity of profit. But, having taken a few business classes at the community college, he realizes what really matters is his rate of profit, so gets up on his ladder and decides to charge $8.32 instead.
Eagle-eyed readers will notice that this story leaves two pieces out of the traditional economic story: demand and competition.
On the demand side, Galveston may tell Saudi Arabia, "I have a $10 million budget for crude, so instead of 100,000 barrels send me 80,000." Texas may tell Galveston, "I have an $11 million budget for crude, so send me 80,000." Texaco may tell Texas, "I have a $12.1 million budget for gasoline, so send me 80,000." And you might say, "I have a $133.20 budget for gas, so just give me 16 gallons instead of 20."
On the competition side, if Galveston has other sources of oil than Saudi Arabia, they may tell Galveston to get lost and call Norway. If Texas has other sources of oil than Galveston, they may tell Galveston to get lost and call North Dakota. If Texaco has other sources of gasoline than Texas, they may tell Texas to get lost and call Louisiana. And if you have other sources of gasoline than Texaco, you may tell Texaco to get lost and head down to Chevron.
But setting aside those considerations allows us to isolate the core issue: just as Saudi Arabia's $25 price increase was a pure windfall, since its costs did not change at all, the extra 25% profit received by every company in the supply chain is also a windfall profit: it does not reflect an effort to maintain the same quantity of profit, it's an attempt to maintain the same rate of profit.
And this, at last, brings us to Larry Summers.
Larry Summers believes supply and the rate of profit are fixed
I'll pull out the relevant quotes right away:
"LARRY SUMMERS: I think that’s right in part, but I think it restates what I think is a bit of a popular confusion in the following sense — supply is what it is. Monetary policy can’t change it. Fiscal policy can’t change it, except in the long-run. And so given what supply is, it’s the task of demand to balance supply. And if demand is greater than supply, then you’re going to have excess inflation and you’re going to have the problems of financial excess."
...
"EZRA KLEIN: Let me give you then another question where you’ll like the underlying assumptions even less. So one of the arguments being made on the left is that part of what is driving inflation right now is that corporations are using this moment almost as cover to make pretty significant pricing increases. So if you look back to say 2019, nonfinancial corporations had roughly a trillion dollars in profits. That had been more or less stable for a while. By 2021, they were a lot closer to $2 trillion.LARRY SUMMERS: Maybe an alternative way of understanding this is I’m a furniture store, and at my furniture store there used to only be a few customers. And if I raised my prices, I’d have even fewer customers and my inventory would sit. And now I’m having difficulty keeping my inventory stocked because there’s so many people in my store demanding new furniture.And so in order to keep supply and demand balanced, I raise prices more than I used to. And so I’m able to raise prices now because there’s so much demand. So I think that the way to understand a business person who says they have pricing power is not that somehow they now feel they can be greedy where before they couldn’t be greedy. It’s that economic conditions mean that the supply-demand balance has tilted in their favor."
This is, fundamentally, a confusing statement, but which part of it you find confusing is the part that matters. Summers is suggesting a furniture store works something like a bazaar or souk. When the Mattress Store is crowded it's hard to get a salesperson's attention, and the manager notices the crowds waiting in line to try out each mattress, so he radios down to the floor to raise prices 10%. When only one or two customers trickle in each day he tells them to put the "25% off everything in store" sign up.
In other words, because supply is fixed, the only determinant of prices is demand, and the Mattress Federal Reserve's job is to throttle demand so that prices rise at a positive-but-moderate rate, given the Mattress Store's fixed rate of profit.
At another point in the interview Summers describes this as "the most basic introductory economics model of an industry." And he's right, although it helpfully illustrates the banality of that expression: most economics departments have additional courses after the introductory level.
No one forces businesses to balance supply and demand through prices
Summers's story may sound familiar, because it's one we've been told for a long time about the inflation of the 1970's: the unionized workforce demanded cost-of-living adjustments to their pay, which were "passed along" to customers in higher prices, triggering additional COLA's and every-higher wages and prices.
But of course in the real world, businesses don't have any obligation to "keep supply and demand balanced" and the rate of profit isn't fixed. Here I like to use the example of landlords, since the supply chain is much shorter than in the case of furniture stores, who really do have to deal with constantly fluctuating prices for different materials, designs, finishings, etc.
A landlord who buys a condo unit with a 30-year fixed-rate mortgage locks in her payments for 30 years. Solemnly accounting for vacancies, repairs, taxes, insurance, and the other expenses of renting, suppose she decides to charge her first tenant a rent 25% higher than her monthly mortgage payment.
In 5 years, the tenant decides to move. After torturing the law and withholding as much of the tenant's security deposit as possible, the unit is empty for 2 months while the landlord uses her saved cushion to paint and clean before putting it back on the market. After doing a little market research, she discovers similar units are renting for 50% more than she charged her first tenant. What should she do?
If you're a landlord, the answer is obvious: hike the rent for the next tenant. Accounting for the same expenses, the landlord will now receive closer to twice her mortgage payments while budgeting for the same 25% expense cushion.
But in fact, there's nothing obvious about this. The landlord's costs haven't changed; she is in the role of Saudi Arabia here. Any increase in rent is a pure windfall profit. Just as in the case of the Mattress Store, if she lists the unit at its old price, she'll be inundated with tenants. But just like the Mattress Store only has so many mattresses, the landlord only has one unit to rent. When it's leased, it's leased. She has no obligation to balance supply and demand.
The capital share of profit is an ideological question
I am not saying that Summers picked his argument's priors because they would lead to his desired conclusion. On the contrary, I think he came by his priors honestly as an economist coming up in the 70's and 80's. Back then, it looked like the economy was quite unionized, it looked like workers were receiving annual pay increases to keep up with inflation, and it looked like prices were rising at an accelerating rate, so he concluded that supply was fixed, the rate of profit was fixed, and that the only way to raise wages without causing runaway inflation was to make long-term changes to increase supply.
Again, in complete fairness to Summers, he's a Democrat, so his preferred methods of increasing supply are banal Democratic stuff: increased immigration, investment in technology, etc.
But Summers's ideological, as opposed to empirical, prior is that the capital share of profit is fixed, so any increase in wages is invariably passed along as higher prices in order to maintain that share, precisely as every increase in the price of Saudi crude is passed along not dollar-for-dollar, but percent-for-percent. In fact, of course, the organized labor movement does not exist in order to increase prices, it exists to collect for workers a higher share of the profit they themselves are responsible for creating.
Summers, solemnly intoning what he thinks are eternal truths, is in fact just carrying on the legacy of the long-dead economists who trained him.
