Cost-of-Living Crisis Fuels Surge in Foreign Dividends

During a cost-of-living crisis, Australia has never paid more investment income to foreign residents. Since inflation broke out in June 2021, primary investment income outflows surged to an average of nearly $42 billion every three months, up 81% in seasonally adjusted terms from the pre-inflationary 10-year average.

This historic increase, which is the highest ever recorded, started as soon as high inflation began and peaked at nearly $52 billion in the June 2022 quarter, when interest rates began to rise.

The Australian Bureau of Statistics (ABS) attributes this to the largest growing component of this series – the mining sector - which has experienced a 153% increase in gross operating profits over the same reference periods, and is 86% foreign owned.

Profit-Price Spiral?

Much has been made of the recent report by the Organisation for Economic Co-operation and Development (OECD) which concluded that there was a significant profit factor in recent inflation. It follows a report by the Australia Institute which argued profits account for 63% of Australian inflation.

These reports, which challenge the traditional, wage-driven understanding of inflation, have prompted a national debate on the nature and cause of recent high inflation, as well as the appropriate policy response.

The Reserve Bank of Australia (RBA) has devoted space in its monthly statement on monetary policy of late to ‘debunk’ this theory, by claiming that “The distribution of net operating margins, which measure the extent to which firms’ revenues exceed their wages and other operating costs, has remained largely unchanged relative to 2019”.

Although it is true that aggregate (non-mining) profit to sales ratios have remained the same, they have substantially increased in the manufacturing (26%), wholesale trade (19%), and construction (10%) sectors (from the pre-inflationary 10 year average), offset by declines in other industries. There were increases in other sectors as well, however these particular industries are important because they have been some of the largest contributors to the CPI over the past two years.

The RBA got their data from Morningstar, an American investor analytics firm, which didn’t measure these industries separately. If they had used data from the ABS for their industry disaggregation, the increases would have been clear.

So who is to blame for inflation? Is it greedy workers or big business?

What is Inflation?

Firstly, it is important to understand that from a macroeconomic perspective, inflation is always either wage or profit driven, because there is no such thing as ‘non-labour costs’ when analysing an entire economy. This concept is confusing and unintuitive, because we can imagine many non-labour costs when we think from a microeconomic perspective about the cost of doing business, however, this is a widely understood concept in macroeconomics and is fundamental to the ‘circular flow of income’.

If you take the example of a retailer who is facing higher costs of non-labour inputs such as raw materials and electricity, that business’ increased costs become sales to the providers of those inputs. Those providers then distribute those sales to labour costs (salaries & wages) and profit (dividends, equity, etc.), as well as to their own suppliers (non-labour costs), who then do the same.

This process continues until we reach the primary production stage (mining, agriculture, etc.). This is because primary producers do not pay for their non-labour inputs (you wouldn’t pay the earth for iron ore). Of course, primary producers face other non-labour costs, but this same breakdown can be applied to those inputs as well.

We know this intuitively because money is only ever paid to people. It would not make sense to pay money to a material object.

Thus the proceeds of all sales of final goods are at some point along the various stages of production, distributed to people (either in wages or profits). If prices have increased, and real unit labour costs have fallen, then, by default, there must have been an increase in unit profits. However, this process is complicated by the role of international trade.

What the OECD report points out is not that Australia is domestically encumbered by a broad-based increase in price gouging and profit margin fattening, but that internationally, there has been an increase in unit profits.

In our modern, globalised economy, where countries focus on their comparative advantage and import what they don’t produce domestically, it does not make sense to analyse only domestic economic conditions. Doing so will necessarily exclude key components in the production process of the goods which are subject to inflation.

With the understanding that all price rises stem from increases in the compensation of either labour (wages) or capital (profits), we can conclude that, given the global profit share of factor income has increased, it is global wages which have been squeezed, generating global inflation.

Who’s to blame?

The initial outbreak of Australia’s inflation in June 2021, was primarily driven by transport costs which skyrocketed due to global oil prices. If you track the transport cost component of the CPI throughout this period, it follows closely the global price of crude oil. Oil prices skyrocketed (as well as coal and gas prices), because western countries such as Australia, refuse to trade with Russia (one of the largest global suppliers of oil and gas) after its illegal invasion of Ukraine in February 2021.

Oil makes up 36% of Australia’s total fuel consumption, and 88% of it is imported. This leaves Australia at the mercy of international prices, despite being a net energy exporter. It also changes the meaning of non-labour costs, because, although they still settle themselves into either wages or profits at some point along the global supply chain, this process occurs in foreign countries governed by different laws and politics which are not influenced by Australian economic conditions.

This creates a unique situation where, as the RBA pointed out, aggregate (non-mining) profit margins have remained the same in Australia whilst real unit labour costs have fallen.

The RBA simply ended the analysis there, claiming that the mining sector should be exempt from this discussion because “[mining sector] output prices reflect the balance of demand and supply in global markets”.

What is curious however, is that in January 2021, Russian oil composed just 1.9% of Australia’s import volumes, and following the invasion, total oil import volumes did not change. This means that, regardless of global market factors, supply in the domestic economy did not fall. Under these conditions, there is no reason that domestic suppliers should have charged Australians international prices, other than the fact that they were allowed to.

Similar patterns were occurring in the coal and gas markets, which have a much higher proportion of domestic production than the oil markets, prompting the federal government to implement coal and gas price caps on advice from the Australian Competition and Consumer Commission (ACCC), which warned that:

“Given production costs are not expected to have increased significantly, gas producers stand to make windfall gains from the all-time highs in international gas and LNG prices stemming from a decline in Russian gas supply leading up to and following the conflict in Ukraine. In a well-supplied and competitive domestic market these outcomes would not be possible.”

However, these price caps only apply to domestic contracts, and our mining companies were allowed to charge full price in their export customers. This is the source of their record profitability, driving dividend payments to foreign investors - primarily in the United States and Europe - as well as the increase in tax receipts which resulted in a budget surplus in the 2023 federal budget.

The problem is that on the one hand, we’re happy to allow Australian mining companies to increase their profit margins on exports by raising prices according to foreign market factors, but foreign companies will only do the same to us in oil contracts.

This is what has occurred over the last two years. Recent high inflation has resulted from global mining profit competition.

The United Kingdom are managing this by imposing a windfall profits levy on their mining industry so that their taxpayers get the benefit, however, for some strange reason, Australia likes to send its mining profits to offshore shareholders. We get all the costs with none of the benefits.

Are wages a factor at all?

RBA Governor Phillip Lowe has recently claimed that “wages growth is consistent with inflation returning to target provided that trend productivity growth picks up”.

Ordinarily, economists say that wage increases are contingent on productivity increases. This is because increasing labour costs without a proportionate increase in output (revenue), increases the costs which businesses face, leading to higher prices which erode real wages back to their original level.

The key here is that businesses face higher labour costs as a result of these wage increases.

The reason this argument is not applicable in today’s economy, is because although nominal wages are increasing, real unit labour costs (the inflation-adjusted cost of hiring workers per hour, accounting for changes in real productivity) have fallen 6% below the pre-inflationary 10-year average.

This means that nominal wage growth could have been higher over the past two years, without increasing the real cost of hiring workers.

What we have seen since inflation began in June 2021, is that real unit labour costs have fallen, whilst non-labour costs have increased, and aggregate profit margins (ratio of gross operating profits to the sum of labour and non-labour costs) have remained the same (excluding the mining sector).

This means that the cost of inputs to business (primarily from the cost of transport and energy intensive materials) have risen, and in order to maintain (non-mining) profits, labour costs have been squeezed.

This describes a situation where – domestically - the inflation battle is being fought, not between profits and wages, but between labour (wage) and non-labour (foreign profit and wage) costs. Domestic (non-mining) profits have been exempted from the conflict altogether.

Further evidence of this, is the spike in (non-mining) sales to wages ratios, which describe the proportion of total sales which have gone to profits and non-labour costs. An increase in this measure, means that wages as a portion of total sales have fallen. Since June 2021, the average ratio has increased 6% from the pre-inflationary 10-year average.

The largest increases were in Financial and insurance services (19%), Wholesale trade (13%), and Accommodation and food services (10%), however, all but three out of fourteen industry groups saw increases.

This suggests that broad-based non-labour input cost increases (foreign profits and wages) have cut into labour compensation rather than domestic profits.

What can we do about it?

Once the non-labour cost pressures have abated (and they have already begun to do so), they will leave in their wake, extra room in the income distribution which was previously (before mid-2021) occupied by labour costs.

If nominal wages do not rise such that real unit labour costs and sales to wages ratios return to their pre-inflationary levels, this space will be automatically filled by domestic profits. The argument that productivity increases will be needed to justify nominal wage growth under these conditions amounts to advocating for a structural increase in profit margins.

There are two possible scenarios from this point.

One option, is that the transition back to pre-inflationary real wages would be concurrent and commensurate to the fall in real non-labour costs. However, given wages have recently proven to be sticky and unresponsive to historically low unemployment, there would likely be lags during which (non-mining) profit margins will temporarily increase. This effect may be exacerbated by inflation expectations embedded in pricing arrangements.

Alternately, businesses could accept a temporary fall in profit margins as wages are allowed to overshoot the fall in non-labour costs until they abate completely. Much like how the union movement accepted real wage cuts during the ‘80s by signing the Prices and Incomes Accord, businesses could accept a portion of the pain which labour has been experiencing thus far in order to return inflation to the RBA’s target band and keep workers out of poverty. This would be a small price to pay for avoiding recession, and would be no different to the sacrifice that workers have made in the past, and are making today.

No doubt the counterargument to this will be that when demand outstrips supply, it is only natural for commodity prices to increase.

Our current monetary frameworks consider how when a resource such as labour is scarce (low unemployment), the price (wages) will increase, which will need to be passed on to consumers (inflation). The policy response to this is to target a level of unemployment high enough to prevent this from occurring.

What all of these data indicate is that these same conditions can apply in another circumstance.

When a resource such as fuel is scarce (supply is restricted for whatever reason), the price (profit) will increase, which will need to be passed on to consumers (inflation).

In order to argue that the NAIRU is an acceptable policy instrument, and that price flexibility must be used to control real unit labour costs, one must also argue that wage flexibility can be used to control profits.

At a time when the most powerful decision-maker in monetary policy is telling workers to “cutback spending” and “find additional hours of work” for the good of price stability, it is only reasonable for businesses to be expected to do the same.

For access to the quoted data, please contact mqueconomicssociety@gmail.com