For those following me on Twitter, you might know that I’m a bit fixated with inflation, its underlying causes, and how best to arrest it.

Here’s what we know after one year’s worth of controversy: (1) inflation is largely coming from two sectors of the economy, housing and electricity; (2) inflation does not seem to be slowing from interest rate increases, with core inflation of 6.6 percent hitting a 40-year high in September; and (3) neoliberal economists cannot fathom a theory of inflation that doesn’t blame workers.

I will be writing plenty on alternative remedies to arresting inflation, including de-concentration efforts, temporary industry-specific price controls, and FTC enforcement of invitations to collude. But in this piece, I wanted to stick a fork into the traditional view that inflation is best tempered with interest rate hikes.

The theory behind this view is that the labor market serves as a barometer to how hot the economy is running. As unemployment declines, the story goes, workers demand higher wages due to their newfound bargaining power. Profit-maximizing firms raise the price of their products in response to rising labor costs, yielding an inverse relationship between unemployment and inflation, as predicted by the Phillips Curve. Higher interest rates make investment projects less attractive by raising the cost of capital. Slow the labor market by making investments less attractive, demand for workers needed to staff new projects will decline, wages will fall, demand for goods and services by those underemployed workers will decline, and the rest of the economy will naturally cool down.

This theory is badly antiquated. There may have been a time when output and labor markets were competitive, prices were set at marginal costs, and wages were set at a worker’s marginal revenue product. But that time, if it ever existed, has come and gone.

In many industries, particularly concentrated ones with high fixed costs—or industries dominated by what some economists have dubbed “superstar” firms—prices are untethered to labor costs. A pharmaceutical company doesn’t set its drug price based on the salaries of researchers. A gas station doesn’t set its price based on the attendant’s hourly wage. A hotel doesn’t set its nightly rate based on the wages of the cleaning crew. A car rental company doesn’t set its price on the wages of the worker sitting near the checkout booth. A university doesn’t set tuition based on the wages of its adjunct professors. I could go on.

Given the fixed-cost nature of these industries, many prices in the economy are set to maximize revenue, which is purely a function of the demand elasticity facing the firm. Wages don’t enter the pricing calculus, as they too are perceived (at least in part) as a fixed cost.

Now I will grant that in certain labor-intensive industries, such as coffee shops and diners, prices will be tethered to labor costs. But these industries are not the drivers of inflation. Inflation is coming from concentrated industries such as food production, energy, and rent (more on that in my future work).

Even in some labor-intensive industries, such as sports, the price for pay-per-view does not rise with player payouts. Prices again are set based on consumers’ willingness to pay for the product. The players and owners divide a fixed pie, and an increase in the players’ share does not cause prices to rise.

Another reason why wages and prices have become untethered, aside from the evolution of our economy to high fixed cost industries, is growing monopsony power and the accompanying erosion of worker bargaining power. Employers with buying power drive a wedge between their workers’ marginal revenue product and wages, based on the (low) elasticity of supply they face. This markdown below marginal revenue product is the same phenomenon as we see when monopolists mark up prices above marginal costs in inverse proportion to the elasticity of demand they face.

When productivity increases, an automatic increase in wages no longer follows, as monopsony power now disturbs the the mapping from productivity into wages. Put differently, monopsony power has weakened, if not entirely severed, the linkage between prices and wages. Employers with buying power don’t need to acquiesce to wage demands: companies like Amazon and Starbucks have fought desperately against offering even the most meager concessions to workers. And even if they do, they already enjoy a sufficiently comfortable profit cushion that they don’t need to automatically revisit prices. Hence, an increase in wages won’t necessarily lead to an increase in prices.

But don’t take my word for it. A recent paper by two economists, David Ratner and Jae Sim of the Federal Reserve Board, shows that labor market policies that have eroded worker bargaining power are the source of the demise of the Phillips curve, which predicts that inflation rises as unemployment falls. As unemployment fell from 6.5 percent in 2009 to 3.5 percent in 2019, however, inflation showed no signs of increasing, or what is called “the missing inflation” puzzle. Ratner and Sim conclude that the “collapse of workers’ bargaining power” flattened the Phillips curve. The authors point out that, using their models in which workers bargain to keep the price-cost markup as low as possible so that wages and the labor share would be larger, the decline in worker bargaining power can explain the secular decline of the labor share, the secular rise of the profit share observed since the 1980s, and the stock market capitalization ratio.

Take the case of Starbucks, which is fighting off an attempt at unionization. Given the lack of bargaining power among its workers, when Starbucks raises the price of a latte, most of the price hike falls to the bottom line. If the workers were to unionize and demand a greater share of the pie, Starbucks might be less inclined to raise its prices, knowing that some of those gains would now be shared with workers. Continuing this union hypothetical, if workers were to become scare due to a decrease in unemployment, the union could extract higher wages, which likely would be passed on to consumers in the form of higher latte prices—revealing a steeper Phillips curve.

A flattened Phillips curve means that a decrease in unemployment that should, in theory, give workers greater bargaining power, doesn’t have any affect on prices (even if wages modestly rise) and thus inflation. Why? Because the power imbalance is so skewed in favor of employers that the small increase in the scarcity of workers doesn’t materially move the price needle (let alone the wage needle). In the post-Covid era, wage inflation peaked in March 2022 at just 6.8 percent, but for the reasons explained above, that change likely didn’t contribute to inflation, which outpaced wage growth in the same month. As explained by ESI’s Josh Bivens, “If the only change in the economy over the past year had been the acceleration of nominal wage growth relative to the recent past, then inflation would be roughly 2.5–4.5% today, instead of the 8.6% pace it ran through March.”

A flattened Phillips curve also implies severe labor market dislocations would be required to arrest inflation via rate hikes. As explained by Seccareccia and Romero in an INET blog, “the flatness of the relation [between unemployment and inflation] implies an immensely high sacrifice ratio if pursuing a Volcker-style strategy … since it would require excessively high unemployment to get the inflation rate down by even a very small increment.” Former Treasury Secretary Lawrence Summers claims that we now need five years of six percent unemployment to curb inflation.

Despite these horrific tradeoffs, the church of neoliberalism led by Summers, preaches that monetary policy that reduces worker power (by creating unemployment) will eventually albeit painfully lead to lower prices and slowing inflation. Ironically, Summers co-authored a Brookings research paper in 2000, before inflation took hold, in which he argued that to arrest the decline in labor share, “institutional changes that enhance workers’ countervailing power—such as strengthening labor unions or promoting corporate governance arrangements that increase worker power—may be necessary (but would need to be carefully considered in light of the possible risks of increasing unemployment).” It is not clear whether Summers would continue to advocate for worker power in an inflationary environment.

In sum, managing inflation via interest rate hikes is an outmoded school of thought that may have worked when labor markets were more competitive and the power balance between workers and employers was evenly split. Given the severing of the nexus between wages and prices, it is time that we abandon the old tools and explore alternatives that arrest the source of price hikes at their source. This will be the subject of future pieces.

The Democrats are in trouble. With the midterms less than two weeks away, a New York Times/Siena College poll is the latest to show Republicans gain as voters get increasingly anxious about the economy and high inflation. While the Times poll has received a lot of media attention, its findings are hardly surprising. In fact, it has been clear for quite some time that when it comes to the issue that voters are most concerned about — soaring prices — Dems lack a coherent message.

Not that there is a shortage of things to say about inflation that will connect with voters. By now, for example, we know that while inflation is driven by many factors — Russia’s invasion of Ukraine, the breakdown of global supply chains, and the devastating effects of climate change-related droughts on American farmers — one of the primary drivers of US price hikes is monopoly power. Earlier this year, a paper by Boston Fed economists Falk Bräuning, José L. Fillat, and Gustavo Joaquim showed the link between inflation and the increase in concentration over the past two decades. And a Roosevelt Institute paper by Mike Konczal and Niko Lusiani showed that markups increased dramatically in 2021 as companies with market power exploited the pandemic to raise prices above costs. With profit margins at a 70-year high, the Groundwork Collaborative has assembled dozens of examples of CEOs boasting about their ability to jack up prices and pin the blame on inflation during earning calls. Going after corporate price-gougers at a time of surging prices seems like a no-brainer.

It’s not that voters are particularly skeptical of this explanation, either. In fact, despite the best efforts of neoliberal economists to deny any connection between market power and inflation, polls show that a majority of Americans believe that profit-maximization is driving price increases. So why has it been so difficult to rally voters around cracking down on corporate profiteering? Perhaps, as Barry Lynn recently wrote, the problem is a lack of an overarching narrative. Or, as The Lever’s Andrew Perez and David Sirota note, it is a simple matter of Democrats not trying all that much. But it could also be a lack of opportunity: perhaps what has been missing is a story so egregious that it serves as a vivid illustration of how corporate greed exacerbates inflation. After all, every good story requires an attention-grabbing villain.

Enter the Kroger-Albertsons merger. If allowed to go through, the $25 billion deal would combine two of America’s largest grocery store chains into a corporate behemoth that would own Ralphs, Dillions, Safeway, Vons, and many others. It is, of course, a terrible idea that seems about as illegal as a merger can get. For one, the supermarket sector is already highly concentrated: the National Grocers Association estimates that over 60 percent of US grocery sales go to the country’s top five retailers. Moreover, merging the second-largest and fourth-largest grocery store chains would leave consumers in many markets with little to no options beyond Kroger-Albertsons and Walmart.

As Forbes’ Errol Schweizer writes in his fantastic analysis of this merger, the deal would potentially be highly lucrative for investors and company executives. But it would be extremely damaging for workers and for consumers, and especially for suppliers:

“A 5,000 store chain in over 48 states could more easily set payment terms, negotiate shelf space and assortment, and extract better costs and greater trade allowances for promotions, couponing, ad placement and slotting fees.”

Not to mention that proposing such a merger as food prices are increasing 13% year over year is a scandal unto itself. To justify this merger, the companies claim that the merged company would have the economies of scale necessary to reduce prices. But as Matt Stoller and others have pointed out, this is a weak argument. Moreover, it’s the exact same argument Albertsons made when it bought Safeway in 2015.

It would be easier to take these claims seriously if the merged company’s prospective CEO did not brag about how they can get away with raising prices by using inflation as a cover. Last year, Kroger CEO Rodney McMullen boasted that “a little bit of inflation is always good in our business” and added that as long as inflation is around 3%-4%, the company could cite it to justify price hikes since “customers don’t overly react to that.” Weeks later, Kroger raised prices, citing inflation as the reason.

Given its peculiar timing, it is no surprise that the merger has already sparked political backlash. Several Democratic Senators, including Elizabeth Warren, Bernie Sanders, and Amy Klobuchar, have come out strongly against the deal. Klobuchar and Republican Senator Mike Lee, the ranking members on the Senate Judiciary’s antitrust subcommittee, plan to hold a hearing on the deal in November.

In other words, it is a merger only a judge could love. While the FTC will almost certainly try to block this deal, Kroger and Albertsons are clearly counting on merger-friendly federal judges to reject these attempts, as they have done several times this year. Anticipating the regulatory backlash, the companies have offered to spin off up to 375 stores to alleviate antitrust concerns. It is easy to see why they would try to appease enforcers this way: it worked for Albertsons when it convinced the FTC to approve the Safeway merger in exchange for selling 168 stores to local chain Haggen. But as David Dayen and Ron Knox point out, that arrangement failed miserably, and Albertsons soon ended up buying many of the stores it sold at a nice discount.

In any case, FTC Chair Lina Khan is unlikely to take the bait. Khan has criticized similar divestitures in the past and has already set her sights on “the anticompetitive practices of large supermarket chains.” Given the judiciary’s long-standing pro-monopoly bias, the companies may be right that the merger could go through. But this merger may just be so preposterous that even the courts would have a hard time waiving it through.

This deal, in other words, is the antitrust equivalent of Liz Truss’s mini-budget: it is deeply unpopular, would be a complete disaster, and can only really appeal to ideological zealots or those paid to advocate for it. So why even attempt it? Stoller theorizes that the whole thing might be an attempt at financial engineering by Albertsons’ private equity investors, Cerberus and Apollo, to squeeze $4 billion from the company as a “special dividend” before the merger is inevitably shot down. 

But whether or not the Kroger-Albertsons deal actually goes through, it represents a rare political opportunity. What better way to encapsulate the connection between market power and high food prices than a merger that promises to increase prices and offers no benefit to anyone but private equity investors and executives? Whether Democrats capitalize on this opportunity or not remains to be seen. But if there was ever a merger that could tie it all together, this is it.

Much of economics is based loosely upon principles of physics. Social sciences, seeking street cred as a science, looked toward the hard sciences to improve their standing. Out of all the social sciences, economics perhaps did the best job of conveying the notion that it is a hard science and that its beliefs are actual scientific principles.

In Physics, Efficiency is measured in a CLOSED system

Efficiency in physics measures how much energy is preserved by a system. The greater the preservation of energy, the greater the efficiency of the system. However, most physical processes cannot be reversed, especially those that involve things such as electrical generation or heat. Most energy processes are not fully efficient: In electrical generation, for example, the efficiency of a unit can be measured by its heat rate.

According to Philip Mirowski, the law of conservation of energy prohibits the notion that energy is lost in a system. That is true if the system we are examining is a closed system. The laws of thermodynamics, upon which much of economics is based, assumes a closed system. For example, the first law of Thermodynamics states that energy cannot be created nor destroyed, only transferred in form. That transfer is unidirectional when discussing matters such as combustion. Compare with the notion of Pareto Optimality, in which no situation leads to any improvement without a transfer.

In antitrust, the analysis of conduct is quite distinct from that of physics, as it tends to ignore any losses outside the system.

Antitrust does not examine the entire effect of a merger. Instead, what is examined is the change to a “relevant market,” which is scrutinized to determine injury to consumers within that market. Thus, the merger creates changes in the relevant market only, and only those changes that remain in the market are considered positive or negative. Every other negative change is beyond the scope of examination. As an example, an efficiency to a merger in a relevant market might be massive layoffs. The effect of those layoffs are beyond the scope of antitrust, but may well count as positive for purpose of antitrust analysis.

This notion is not new to economics. Greg Mankiw had a parable related to a heroin addict. He wrote: “In some circumstances, policymakers might choose not to care about consumer surplus because they do not respect the preferences that drive buyer behavior. For example, drug addicts are willing to pay a high price for heroin. Yet we would not say that addicts get a large benefit from being able to buy heroin at a low price (even though addicts might say they do). From the standpoint of society, willingness to pay in this instance is not a good measure of the buyers’ benefit, and consumer surplus is not a good measure of economic well-being, because addicts are not looking after their own best interests.”

Mankiw’s point might be dismissed as a concern about a rationality failure in one particular market (the market for heroin). However, we could instill a different hypothetical here and reach the same result. Assume a single-product economy that produces widgets. Every worker is employed in producing widgets. A merger takes place, and two of the companies become more efficient by laying off workers. Fewer consumers of widgets means less demand, which in turn begets more mergers, laying off more workers. In such a situation, what is occurring is a wealth transfer.

However, because it is all internalized into one market, it should be a wealth transfer that antitrust cares about. It does not. Agencies would consider the layoffs efficient, no matter that the ultimate result would be collapse of the economy, because it only looks at one merger at a time without regard to follow-on mergers. The hypothetical here would be an approximation of a “closed system,” one in which there is no change in energy. Even here, however, there is loss in the sense of the workers who are lost to the system. It is possible that antitrust enforcers might start to care at around a “3 to 2” merger, but by that point it is far too late.

To those who might suggest my example ignores the perils of buyer power, again, antitrust would likely only care when the market moved from 3 to 2. Moreover, it would bring Section 1 wrath about any labor cartel, absent unionization. One might imagine one of the “efficiencies” here would be destruction of the labor movement.

The losses outside of the system of reference (in antitrust the “relevant market)” is something only occasionally analyzed by antitrust, but only for the benefit of merging parties.

One such example is “out of market efficiencies.” As the Commentary to the Guidelines states:

Inextricably linked out-of-market efficiencies, however, can cause the Agencies, in their discretion, not to challenge mergers that would be challenged absent the efficiencies. This circumstance may arise, for example, if a merger presents large procompetitive benefits in a large market and a small anticompetitive problem in another, smaller market.

In other words, even if there is an anticompetitive issue in the relevant market, large enough positive transfers accumulating into another market may trump those anticompetitive effects. Perhaps the best example of this is in the airline industry: A merger that creates monopoly in 13 smaller (rural) routes might not be challenged if it allows the merged airlines to vigorously compete with foreign carriers on international (business) routes.

To some degree, what the Guidelines is endorsing is akin to a wealth transfer that it typically believes to be beyond the scope of its analysis.

A final example of out of system losses are efficiencies in general. As the merger guidelines commentary notes:

Merger-specific, cognizable efficiencies are most likely to make a difference in the Agencies’ enforcement decisions when the efficiencies can be expected to result in direct, short-term, procompetitive price effects. Economic analysis teaches that price reductions are expected when efficiencies reduce the merged firm’s marginal costs, i.e., costs associated with producing one additional unit of each of its products. By contrast, reductions in fixed costs—costs that do not change in the short-run with changes in output rates—typically are not expected to lead to immediate price effects and hence to benefit consumers in the short term. Instead, the immediate benefits of lower fixed costs (e.g., most reductions in overhead, management, or administrative costs) usually accrue to firm profits.

These costs are typically labor costs. As such, the job losses create drags on local economies.

In Physics, transfers are often unidirectional and cannot be undone.

The second law of Thermodynamics states that the entropy of any isolated system (the unavailability of a system’s thermal energy for conversion into mechanical work) always increases. In terms of unidirectional movement, this means that “a system can only be oriented in one direction in time precisely because it cannot go back the way it came, if its path involved the dissipation of heat.” In other words, most system decisions are not reversible.

For antitrust, this would mean the processes of concentration cannot be undone in the way that neoclassical economics envisions. As Mirowski points out, this is a serious issue for economics.

Moreover, serious consideration of the notion of irreversibility would clash with the dictum that the market can effectively undo whatever man has wrought. Finally, and most pertinently from the vantage point of a discipline seeking to emulate physics, the concept of energy in thermodynamics is thoroughly unpalatable when cooked down into the parallel concept of utility in neoclassical economic theory. For example, the parallel would dictate that utility/value should grow more diffuse or inaccessible over time, a figure of speech possessing no plausible allure for the neoclassical research program.

This would suggest that allowing a market to concentrate would be incredibly difficult to undo. In other words, Type II errors are very serious because they are not undoable. This comes as no surprise to antitrust enforcers, who are always concerned about post-merger remedies. It is impossible to unscramble the eggs.

Physicists know what they are seeking to measure

I pause here only to recognize that there is a problem of WHAT is to be measured in markets. Much work has been done on the measurement problem in social sciences. Such a discussion would be the basis of its own post. Measurement problems abound not only because of the inability to make interpersonal comparisons of the utility consumers receive from consumption but also in terms of productive efficiency. As Mirowski states:

The metrics of the efficiency of inputs in a production process are rarely identical with the units in which the commodities are bought and sold. Oil is sold by the barrel, but its efficiency as an input depends on its BTU rating, or perhaps its sulfur content in milligrams per liter, or its Reynolds number, and so on. Further, this metric will vary from process to process, even if one is looking at the same barrel of oil….Such distinctions are critical for any serious representation of a production field, because they raise the possibility that, as long as the axes of the field formalism are confined to commodity space, the field cannot be analytically defined….We hasten to add that this entire discussion is a disquisition on the problems of neoclassical economic theorists, and not the practical actors in the actual economy. They do not separate their world into airtight divisions of substitution versus innovation; nor do they keep tabs on marginal products (unless they have been to business school); nor do they have difficulty keeping track of the boundaries of their economic activities. Instead, they actively constitute the identity of their economic roles and artifacts as they go along.

The problem is exacerbated in antitrust if Professor Herb Hovenkamp is correct and consumer welfare means more than one thing.

Incomplete Measurement Favors Concentration and Externalization of Economic Injuries

Thus, that to which antitrust enforcement agencies apply the notion, the “relevant market,” is not a closed system. A firm claims efficiencies, typically expressed by an economist making over $1000 an hour, it typically means job loss, layoffs, and the foisting of costs outside the system of examination. This is what Professor E.K. Hunt called the “invisible foot:”

The “invisible foot” ensures us that in a free-market . . . economy each person pursuing only his own good will automatically, and most efficiently, do his part in maximizing the general public misery. . . . To paraphrase a well-known precursor of this theory: Every individual necessarily labors to render the annual external costs of the society as great as he can. He generally, indeed, neither intends to promote the public misery nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible foot to promote an end which was no part of his intention. Nor is it any better for society that it was no part of it. By pursuing his own interest he frequently promotes social misery more effectually than when he really intends to promote it.

In other words, market transactions promote pervasive negative externalities. In examining only the relevant market and consumer welfare, the Antitrust Enforcement agencies are assuring they ignore effects foisted upon the remainder of the economy, the externalization of costs associated with the merged firms’ transaction. Those negative externalities are also considered efficiencies within the relevant market, and their exportation outside of the market is considered a value-less transaction. It could be the case that the positive effects inside the system are outweighed by the negative effects outside the system as those effects are externalized. It could be the case as well that the positive effects are overestimated, as might be the case in a merger claiming efficiencies of system integration that take 4 times longer than projected.

Consumer Welfare Theory isn’t Science—It’s A Policy (an Ethical Consideration)

If one changes the lens back to physics, the framework of analysis would be considered wrong because there cannot be loss of energy to the system. Thus, the focal point of the analysis is always a singular framework that tends to benefit the merging parties except in the most extreme cases. Thus, the “science of antitrust economics” is incomplete, because it disclaims losses to the system without further analysis. By focusing on consumer welfare in one relevant market, it assures a most narrow antitrust goal that in effect assures a large externalization of costs. Indeed, it solicits it. As an example, the consideration of out-of-market efficiencies without any consideration of out-of-market costs is indefensible outside of some ethical argument in favor of consolidation.

Efficiency in physics is a valueless concept, the purpose of which is to describe as the work performed per quantity of energy. It is the maximization of something to be measured, output, subject to the amount of input available. It is examined on a system basis. It is not a position of advocacy. Nor is it identical to the view economists have of the term.