Deflating the Inflation Myth

The Absurdist Myth That Inflation Drives Growth

By GENE EPSTEIN

Contrary to recent assertions, rising prices don't help profits or encourage people to spend quickly.

Desperate times can breed ideas born of desperation. The sluggish rate of economic growth is getting blamed on a new scapegoat, the tame rate of price inflation. The consumer price index ran just 1.2% higher in September than the same month a year ago, the Bureau of Labor Statistics reported last week, a rate of increase that falls noticeably short of the 2% target set by the Federal Reserve. And according to simplistic logic, economic growth would get a shot of adrenaline if only prices would rise a lot faster.

"Rising prices help companies increase profits; rising wages help borrowers repay debts," opined the New York Times last week ("In Fed and Out, Many Now Think Inflation Helps," Oct. 26). "Inflation also encourages people and business to borrow money and spend it more quickly."

Somehow that prescription didn't work out so well in recession year 1974, when the CPI jumped 12.3%, while the economy shrank. And as the chart on this page shows, despite the claim that profits benefit from rising prices, actual profit rates were much lower in 1974 than they have been over the recent expansion.

To focus on prices as the driver of profits is reminiscent of the old joke about selling at a loss and making it up on volume. Business activity is motivated by profit, not prices. The price of the output matters for profits, but the cost of the inputs -- principally, labor -- matters just as much. What really matters for profits, then, is the spread between the cost of the inputs and the prices of the outputs. Before we decide that the slow rise in prices is significantly impairing business activity, we should find out if profitability is suffering.

The chart tracks rates of profit, or profit margins, beginning in 1950 for the domestic output of nonfinancial corporations. Profits are taken as a percentage of "gross value added," the economist's measure of the contribution this sector makes to gross domestic product. We exclude corporate profits from overseas operations and from the financial sector, both of which have grown since 1950 and would have made the recent period look even higher in historic terms.

The chart does show that even for domestic nonfinancial corporations, the rate of profit has been higher than usual, even higher than during the late-1990s, when GDP growth ran an enviable 4% per year. The chart also indicates that profit rates over the decades have been unrelated to rates of inflation: highest in the relatively low-inflation decades of the 1950s and 1960s, and then moving lower in the high-inflation 1970s and 1980s; moderate in the low-inflation period of the 1990s, and then moving higher after 2000.

The recent pattern of relatively high profitability is consistent with record earnings per share in the third quarter of this year in Standard & Poor's 500 stocks. It is also confirmed by the cost of the key input, labor. Labor costs incurred by business are best measured by labor compensation adjusted for labor productivity, called "unit labor costs." And since labor productivity has been increasing almost as fast as labor compensation, unit labor costs in the nonfarm business sector through the first half of the year have run less than 1% higher than in 2008. By contrast, over the same period since 2008, the increase in the CPI has run more than 10%.

As for the notion that "rising wages help borrowers repay debts," that tendency can be undermined by rising prices. If the cost of living leaps ahead faster than the rise in wages, that could mean less left over to repay debts. And as for whether inflation encourages businesses to "borrow money and spend it more quickly," that mainly depends on business profitability—which, as we have seen, has been healthy over the recent expansion, and is unrelated to rates of inflation.

THE SIMPLE INSIGHT that business focuses on the spread between the cost of the inputs and the price of the outputs helps explain how business activity can flourish even when prices are falling -- normally called "deflation," which happened in the U.S. in the late 19th century. A study published by the mainstream American Economic Review called "Deflation and Depression: Is There an Empirical Link?" concludes, "A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation."

So even the idea that deflation is to be feared is at least open to question. It's a lot more interesting than the hoary notion that inflation is somehow our newfound friend.