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The real problem

Created:
27 June 2008
Written by:
Chris Dillow

Our inflation problem is only temporary. What looks like lasting longer is the price problem - the fact that high energy prices (oil, gas and electricity) imply a transfer of real resources from energy consumers to producers.

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The question is: which users will bear the brunt of this - households, in the form of lower real wages, or companies in the form of lower profits?

You might think shareholders are lucky here. High energy prices come at a time when workers' bargaining power is weaker than ever thanks to the mass increase in the labour supply caused by China and India's industrialisation. So perhaps wages, not profits, will bear the cost.

This is too simple. For one thing, lower wages (than would otherwise be the case) mean lower consumer spending. And simple maths tells us this means lower aggregate profits.*

Also, although workers lack economic power, they don't wholly lack political power. Which raises two dangers.

One - which is greater in the US than here - is that voters will demand protection from foreign competition; when living standards are under threat from any source, humans' natural instinct is to blame foreigners. And protectionism is bad for economic growth and for profits; Bush's steel tariff in 2002, for example, merely transferred profits away from steel consumers.

The second danger is that voters will demand tax cuts to raise their disposable incomes.

Good stuff, you might think. No. Tax cuts without spending cuts are not tax cuts at all, but merely deferred taxes.

And this means lower profits - either immediately, if people save in anticipation of higher future taxes, as Ricardian equivalence predicts, or later, when taxes actually rise.

So, higher energy prices are bad for profits, even if the mechanism is indirect.

The truth is, the market already knows this. The fact that dividend yields on non-resource shares are higher than on resource shares shows that investors expect profits to shift from the former to the latter over the long run.

What can't be known is whether the market is fully pricing in the transfer or not. But let's be clear. It is this that is the genuine economic problem posed by higher commodity and energy prices. Inflation is just a passing problem.

*A reminder of the arithmetic. GDP (Y), by definition, is the sum of household spending (C), investment (I), government consumption (G) and net exports (X-M):

Y = C + I + G + (X-M)

It's also the sum of profits (P), wages (W) and taxes (T):

Y = P + W + T.

Re-arranging gives us an identity for profits:

P = (C-W) + I + (G-T) + (X-M).

This tells us that if consumer spending falls as much as wages, then profits don't benefit from the wage cut.

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