The public discourse on inflation, led by both mainstream Republican and Democratic economists, has been wholly inadequate. President Biden’s recent decision, one week before the midterm elections, to threaten an excess profits tax on oil and gas companies, is late in coming. It is a necessary supplement to the singular focus on raising interest rates.
Biden’s policy choices are not the main cause of the surge in inflation, despite the dominating opinion that excess demand for goods and services—largely due to fiscal rescue packages—is the primary driver. Republicans in particular have been serving up the idea that the Biden fiscal rescue is the driving cause, pure and simple—but they offer no anti-inflation plan of their own. This singular focus on excess demand as the driver of inflation has left raising interest rates the only policy tool to combat rising prices, with recession and higher unemployment the painful consequences.
This excess-demand tunnel vision has also made Democrats fearful of boasting about legislative achievements, because they involve government spending. Given the sharp rises in the prices of gas, bread, milk, eggs, and mortgage rates, and many other products, inflation—according to almost all opinion surveys—is the main political and social concern of Americans. And Americans usually blame the party in power for what they perceive as their most serious concerns.
But there are many reasons to question whether a Biden-induced increase in demand is the main reason for America’s high inflation. For one thing, America is not an outlier. In fact, inflation is now lower in the United States than in Europe and the United Kingdom. The latter’s inflation rate is now above 10 percent, for example, as is the rate across much of Europe. America’s latest consumer price index is up by a little more than 8 percent.
Europe’s inflation is strongly stoked by high energy prices, including natural gas prices, due to the repercussions of Putin’s war in Ukraine. By contrast, many Democratic economists and almost all Republican economists argue that inflation is being fueled more in the United States by excess consumption than it is in Europe. The Federal Reserve has received bipartisan plaudits for raising its key target rate, the federal funds rate, by more than three percentage points this year to hold back consumer spending. But inflation has not been dampened. In the meantime, thanks to this rate increase, mortgage rates have about doubled in this period, causing a housing recession.
The evidence is strong that demand is not the driving force of inflation that is claimed. For example, the best measure of consumption—personal consumption expenditures adjusted for inflation—are only now rising at their former rates of growth. Inflation started to take off well before these measures of demand started to rise. Representative Katie Porter recently presented an analysis by the Economic Policy Institute to Congress with data that reinforced doubts about demand as the driving factor. Representative Jamaal Bowman (D-NY) introduced the Emergency Price Stabilization Act, which envisions the creation of authority to rein in price shocks. Nobelists Joe Stiglitz and Paul Krugman are both skeptical that the demand is the main driver of inflation.
Few seem to acknowledge that this consensus among economists is based on a free market neoliberal ideology à la Milton Friedman, one adopted by Chairman Jay Powell of the Federal Reserve, which has authority over short-term interest rates, and leading centrist Democrats, most conspicuously former Clinton Treasury Secretary Lawrence Summers. For them, austerity is the order of the day. As interest rates rise, demand for goods and services will slow or outright fall, and wages will fall as well, putting less pressure on businesses to raise prices, goes the theory. Most economists are thus asking workers to pay the price for inflation by reducing the number of jobs they hold.
There is ample evidence, however, that supply-side bottlenecks are driving inflation in America significantly more than demand, from manufacturing shortages to transportation blockages to explosively excessive profits due to corporate power to raise prices unjustifiably and to buy back stocks with the proceeds rather than invest. Excess profits are especially obvious in oil and gas, due to the cuts in supply by energy producers, including notably Russia, and lately the Arab oil nations.
There is ample evidence, however, that supply-side bottlenecks are driving inflation in America significantly more than demand, from manufacturing shortages to transportation blockages to explosively excessive profits due to corporate power.
But can these supply-side blockages be readily identified and targeted by government policy? Isabella Weber, an economist at the University of Massachusetts, Amherst, is among the fresh voices doing leading research on the supply-side drivers of inflation in the United States. While some insist the rapid European inflation, being driven by oil and gas price surges due to the Ukrainian war, make it different from America’s inflation, Weber and her colleagues show that the oil and gas price and profit explosion has been a major input to American inflation and, further, unequal distribution of income.
Weber’s research is mostly based on a long-standing tool called input–output analysis developed before World War II and expanded much further by economist Wassily Leontief after the war, which won him one of the earliest Nobel Prizes in Economics. The two largest oil companies in America, ExxonMobil and Chevron, earned by far the highest profits in their history in the second calendar quarter of 2022, some $23 billion and $15.6 billion respectively. Recent reports from other oil companies also show a profit explosion. Though fossil fuel prices soared, due to the cuts in production in Russia and elsewhere, profits went up far faster as these companies suppressed investment. Many wells and refineries were closed down during the COVID-19 pandemic and they have not been brought back up to old production levels. Chevron’s CEO boasted that in two years, its capital expenditures were cut in half while prices were raised sharply. Profit margins soared in company after company.
The two largest oil companies in America, ExxonMobil and Chevron, earned by far the highest profits in their history in the second calendar quarter of 2022, some $23 billion and $15.6 billion respectively.
The input–output analysis enables Weber to determine an estimate of how the excessive price hikes spread to other industries that are customers of these fossil fuel companies. Weber reported in important testimony before Congress in September, “that oil and coal producers have had the largest impact on consumer price inflation compared to all other sectors of the US economy by a very wide margin.” She went on: “This is the case because of the high price volatility in fossil fuels, their ubiquity in production processes across a wide-range of sectors and their weight in consumer baskets.” As the price explosion spreads, it affects a wide swath of American business from small to large companies, from defense to transportation, to government budgets, and beyond.
Aside from fossil fuels, other industries that affect inflation widely include farming, housing, food and beverage, chemical products, and a few notable others. Price increase in these industries, as with fossil fuel, spread across American business, leading to further price increases.
While many economists who place priority on demand acknowledge the influence of price hikes on other industries, Weber and her colleagues show how excessive they really are. Often they are a result of industry concentration, giving undue companies power to set higher prices. Weber, much like John Kenneth Galbraith—a key administrator of the highly successful price controls office during World War II—argues that price controls could temporarily keep things in check until the causes of these price explosions can be corrected. Such policies might involve increases in subsidies for the manufacturer of some goods, for example. Another possible option is to cap the rising prices, not commonly discussed in the U.S. regarding the fossil fuel companies. Excess profit taxes are also widely considered, as President Biden now illustrates. Many mainstream economists find such interference with free-market forces dangerous. Weber and others think in this environment the market is just not working efficiently.
European nations are indeed capping energy prices these days, and Weber was on a committee in Berlin that recommended price caps on natural gas—now disrupted by Russian supply reductions—on up to 80 to 90 percent of earlier purchases by households and businesses. The remainder of the household purchases can be left to the discretion of the consumer. Thus the market price plays some small part, at least—a concession to those who demand that free market price signals must be maintained.
Joe Stiglitz makes similar recommendations in a recent column for Project Syndicate. He argues that it would make sense to cap prices in appropriate markets at roughly 90 percent of past average usage and allow users to buy up to 110 percent of former expenditures at 150 percent of the previous year’s price. Both Stiglitz and Weber argue that excess profits taxes are also sensible options to mitigate price hikes.
They also agree, similar to Galbraith’s World War II point, that the foundational causes of the price explosion should then be addressed. This might require more manufacturing subsidies, like Biden’s chip manufacturing legislation. Subsidies for farming and housing, now undersupplied, are likely an appropriate target. In short, significant government intervention is necessary, not just central bank policy.
Also neglected in the discussion is how the supply-side issues have affected the distribution of income. While most Americans suffer losses due to the explosion in prices, the current set of shocks, Weber finds, seriously benefit high wealth individuals who can buy fossil fuel stocks. The losers are generally poorer Americans and in particular people of color.
It is encouraging that policymakers are increasingly showing concern for the very high profits made in oil and gas, and other industries, which lead to undue profits. Governor Gavin Newsom of California, for example, has justly criticized oil company Valero for holding gas prices high at the pump.
In sum, the way to get America back on track is to focus on the supply-side drivers of inflation, not simply raise interest rates to cause unemployment. The latter might have made Milton Friedman happy, but it won’t solve America’s economic problems rapidly or without causing a lot of pain. The discussion needs to be broadened. The Biden administration should have pursued such supply-side interventions sooner. Raising interest rates so that supply-side obstacles will eventually be subdued in the marketplace is not a cure-all, as it will require significant sacrifice on the part of most Americans in lost jobs and sharply reduce buying power of wages—and it will take a long painful time.