Inflation, the issue of the moment, is grounded in the difficulty we have in trusting each other, and the intensity with which we all tend to defend our share of any spoils. As I detailed yesterday, making this point was enough to get Huw Pill, chief economist of the Bank of England, into a lot of trouble. But he was right. I’ve had a lot of feedback, so I’m returning to the topic. In another way to illustrate it, Paul Krugman in the New York Times earlier this year quoted Olivier Blanchard, former chief economist of the International Monetary Fund and a hugely influential figure, as follows:
Inflation is fundamentally the outcome of the distributional conflict between firms, workers and taxpayers. It stops only when the various players are forced to accept the outcome.
For a straightforward rendering in game theory, Krugman also quoted William Nordhaus, another giant of the economics profession. In the 1970s, he compared inflation to what happens in a football stadium when the action on the field was especially exciting: “Everyone stands up to get a better view, but this is collectively self-defeating.”
Applied to inflation, this means that corporate executives want to keep profits up, which is what their shareholders pay them to do, while union leaders want to maintain standards of living for their members. Again, this is their job. The problem is that collectively, this will only push up prices. Both would be better served by thrashing out a compromise to share the pain, but that would require the kind of trust that is currently rare. Inflation can be viewed as the consequence of competition for the spoils.
Former colleague Matthew Klein, who runs the “Overshoot” newsletter, points out that other senior figures at the BOE have also made this argument. Klein’s interview with Jonathan Haskel, an external member of the bank’s monetary policy committee, revealed this judgment:
What we have suffered in the UK is a big negative terms of trade shock. The stuff we are buying has become more expensive and the stuff we are selling has not become more expensive. That means that on a level basis, and Olivier Blanchard has written about this on Twitter, there is a terrible distributional issue in terms of our consumption behavior. Somebody’s got to take that hit as long as we want to keep buying all this stuff from foreign producers.Returns to labor or returns to capital have got to go down. You are right, real wages have indeed gone down. That is an unfortunate byproduct of the horrible economic logic that somebody’s real returns have got to fall.
Back in the 1970s, the remedy of choice was a wage policy in which unions and employers thrashed out an agreed maximum increase. Such policies generally didn’t work for long, although they had some initial success. These days, the lack of trust makes the problem look intractable. The fund manager Bruno Momont offered the following thought:
It didn’t work in the 1970s. And considering the increased political polarization, any collaborative framework for management of inflation would need even stronger safeguards for inappropriate political interference. Still, I’d prefer policymakers are not too wedded to whatever the current paradigm is and keep an open mind in their analysis.
Win-Win of Change
That leads to another massive collective action problem, which is the environment. There may be disagreements about the seriousness of climate change, but there’s no question that it has a massive free-rider problem. If everyone else is limiting emissions, you have nothing to lose and much to gain by cheating and continuing to burn fossil fuel.
The environmental, social and governance (ESG) approach was to treat this as a “win-win” issue, or in Boris Johnson parlance, to apply “cakeism.” The idea was that by investing in environmentally healthy companies, there was also more money to be made. It was a victory for everyone. That argument did work quite nicely for a while. Now, it’s in difficulties.
A piece in the latest “Ruffer Review” by Duncan Austin suggests that such hopes are now “gone with the win-win.” He submits that ESG as a concept was almost an attempt to deny that there was a problem of collective action, but instead that it could be treated as usual by profit-seeking capitalism. (Many would argue that ESG tried to smuggle in socialism under a different guise, but Austin’s version also makes sense.) Before ESG, efforts to deal with climate change in Europe revolved around a “precautionary principle,” which regulators were required to apply before giving the go-ahead to projects. Originally developed in West Germany in the 1970s, it tells regulators that they cannot wait for scientific proof before mandating environmental measures. As enunciated in the Rio Declaration of 1992, it holds that “where there are threats of serious or irreversible damage, lack of full scientific certainty shall not be used as a reason for postponing cost-effective measures to prevent environmental degradation.”
The precautionary principle is still around, and it generated controversy in 2021 when regulators invoked it in being extremely cautious over the rollout of the AstraZeneca vaccine against Covid. But Austin suggests that ESG arrived about 20 years ago in large part to exempt regulators from needing to interfere in a precautionary way with businesses. There is no way of conducting a controlled experiment on global warming, so more or less any action has to be taken without scientific certainty. As he puts it:
When you cannot step out of an experimental frame and there is some risk the experiment will fail, it is best to proceed very cautiously. This is why sustainability researchers formulated a precautionary principle in the 1980s. Despite rising ecological challenges, usage of the term precautionary principle peaked in 2002 and has declined markedly since – quite possibly a casualty of the appealing and reassuring win-win narrative that emerged at the time.
As this chart shows, mentions of the principle have declined steadily for two decades, with the one brief blip upward probably attributable to the vaccine rollout:
Austin’s suggestion is that there is an analogy between the inflation problem and the climate problem. If everyone acts in their straightforwardly defined self-interest, we get an intractable collective action conflict and disaster. The answer, he implies, may be to admit that the market cannot save everything, and to treat the issues as moral challenges rather than economic or profit-maximizing ones.
He uses what is likely to be a contentious metaphor:
We are discovering that Adam Smith’s invisible hand is connected to an unmentionable foot. The hand represents the market’s autonomous allocative and innovative dynamics, which are real and remarkable and have been much celebrated. But the foot represents the real costs generated by market activity which are not recognized and land on other people and other places, sometimes with a lag.
Unfortunately, the hand and the foot are engaged in a dynamic struggle. A market system’s overall benefit for human well-being depends on the relative strength of the hand’s (internal and recorded) value creation and the foot’s (external, largely unrecorded) cost-shifting. To believe that economic growth can solve all social and environmental problems is to trust that the invisible hand can always repair what the unmentionable foot damages – and do so before irreversible or intolerable harms occur.
The implication is that someone needs to decide when and how to override the market. That, presumably, will need to be a democratically chosen and trusted political institution. And we don’t have many of those at present. Giving up on using the market to help us solve environmental problems raises as many questions as it answers. But it’s worthy of discussion. And some more open minds would be good.
People Will Always Pay for Toothpaste
Tech companies are exciting, as most everyone would agree. But in terms of their finances, it’s the most boring staples companies that have been making hay during this earnings season. Over the last 12 months, as rolling forward earnings expectations for the S&P 500 as a whole have fallen, so estimates for the S&P 500 Consumer Staples sector have risen. The following figures are rebased to 100 as of 12 months ago:
Demand for these companies’ products has not increased over the last 12 months. The whole point of staple goods is that demand for them is constant. The reason profit estimates are rising is that staples providers are demonstrating that they have pricing power. And that’s another example of the difficulties in dealing with inflation. Steve Sosnick of Interactive Brokers expressed this as follows:
Today’s big gainer, even more than Microsoft, is Chipotle Mexican Grill (CMG). It is up about 14% this morning, setting a new all-time high after beating estimates and offering positive guidance. The company’s CFO stated that lower-income customers are returning to the restaurants even as prices have risen by about 10%. In short, CMG has found that they can pass along price increases to their customers without penalty.
It would be one thing if a single company made comments like that, but we have heard something similar from Coca-Cola, Pepsi, McDonald’s and Procter & Gamble. All beat analyst consensus estimates and cited their ability to pass along price increases during their earnings calls. For better or worse, we’re willing to pay up for our favorite hamburgers, soda, potato chips, and burritos. Health ramifications aside, if the Federal Reserve’s goal is to combat inflation, this is a clear sign that their fight is far from over.
That is the reason for concern. It’s a tad depressing that companies that distribute fat and sugar are proving to have so much pricing power. It’s also not a great look for inflation. One of the critical insights that built Warren Buffett’s fortune was his understanding that companies with a “wide economic moat” (a euphemism for a huge inbuilt competitive advantage) were worth paying for. Big stakes in Coca-Cola Co. and Gillette (bought by P&G) anchored the Berkshire Hathaway portfolio for years. It’s natural and rational that capital flows to such companies. In the process, competition is starved of funding, and incumbents’ pricing power grows (or as Buffett would put it, their moats widen).
The relative performance of staples and consumer discretionary companies has traditionally been considered a recession indicator. If people are excited to buy into the certainty of toothpaste, fizzy drinks, or toilet paper, it suggests they’re not positive. On this measure, sentiment was as bad at the turn of this year as it was during the worst of the pandemic lockdown. After a revival by discretionary stocks in January, staples’ advantage has been inching back:
BloombergMeanwhile, if consumers continue to be prepared to pay whatever the staples companies ask, it’s difficult to see why the Fed would cut rates, barring a banking crisis that gets much more serious. Sosnick says it’s difficult to see the consumer sector “slamming on the brakes sufficiently” to allow the Federal Open Market Committee to relent. “If you like the idea of healthy consumers, it is hard to have it both ways.”
And that further implies that it’s probably a good idea to allocate money to staples at present. Collectively, that’s unhealthy. But for each individual, it makes a lot of sense.