MACRO PROFIT-KILLERS
By Kurt Richebächer
In our opinion, the breaking of the U.S. economy's last
boom had one main cause: a sudden slump in business fixed
investment. But then, what exactly triggered this slump?
The short answer is a corporate profit carnage that has
been lingering for many years, and that has worsened
dramatically in the last few years.
While Wall Street celebrated a profit miracle, the reality
was America's worst profit performance in the whole post-
war period. The present U.S. profit carnage started in
earnest as early as 1997 - that is, at the height of the
economy's boom. In the following four years to 2001,
producer prices for finished goods increased altogether by
6.8%, or 1.7% per year. Over the same period, recorded
productivity in the non-farm business sector increased by
10%, or 2.5% per year.
Under these excellent price and productivity conditions,
profits ought to have soared during these years. But even
though the economy boomed, nonfinancial profits dived from
6% to 3.3% of GDP, their lowest level in the whole post-war
period.
After close investigation, we find that structural, profit-
impinging influences began to develop in the early 1980s,
but that they went to extreme excess during the boom years
in the late 1990s. There is a common denominator to all
such influences: a gross neglect of capital formation. In
the United States, the spending excesses went totally into
overspending on consumption, leaving an economy that has
become extremely lopsided toward consumption to the
detriment of capital investment.
The obsession with shareholder value has given rise to
virtual anarchy in many fields of economics. One of them is
macroeconomics, meaning the study of the economy as a
whole. To understand the U.S. economy's deteriorating
profit performance during the past few years, one must
examine it from a macroeconomic perspective.
Applying this perspective boils down to posing and
examining one single and simple question to all corporate
activities: How do such activities impact business revenues
in the aggregate? The emphasis here is on the word
aggregate. Changes in spending, saving, investing and, most
important, taxing cause changes in profits through their
effects on certain flows.
From the perspective of a single firm, firing labor, for
example, seems a straightforward device to boost a firm's
profits as it reduces costs. But looking at the economy as
a whole, the lower wage costs mean an equal lowering of
consumer incomes which, in further sequence, reduces
consumer spending at the expense of other firms' revenue
and profits. For the economy as a whole, wage-cutting is
clearly self-defeating as a device to increase profits.
Keeping this macroeconomic perspective in mind, let us
examine the provenance of business revenues. Examined in
the aggregate, business revenues have one major source that
is generally crucial for profit creation: their own net
capital investment.
Net capital investment is typically the single most
important profit source because - looking at the business
sector as a whole - it creates business revenue without
generating expenses. The reason is that the investing firms
capitalize this spending in their balance sheets. But to
the manufacturer who produces and sells the machine, it
generates a sale and revenue. No expense is incurred until
the first deprecation charge is recorded. A very high
correlation between movements of net investment and profits
is historically notorious.
As noted earlier, Corporate America's profitability turned
ominously bad during the 1980s. As you will remember, the US
was famous for its supply-side Reaganomics. In actual fact,
there was no supply-side improvement in resource allocation.
Fueled by easy money and wealth effects in the stock market,
consumption increased its share of GDP growth over the decade
by seven percentage points to 70%. Net nonresidential
investment, on the other hand, increased modestly between
1980 and 1989 from $129.2 billion to $153.4 billion. As a
share of GDP, it fell from 4.8% to 2.9%.
What actually happened during this decade was an unusual,
sudden sharp divergence between gross and net investment,
reflecting a massive shift in Corporate America's fixed
investment stance towards short-lived investment, mainly
high-tech equipment. Gross investment rose by $252.5
billion over the decade, or 70%, but depreciation charges
soared by $228.3 billion, or close to 100%, leaving very
little net investment. Only net investment, however, adds
to profits, while depreciation charges add to expenses.
As earlier explained, net business investment is typically
the economy's largest profit source. But this profit source
literally dried up in the 1980s. In the early 1990s, net
business investment performed splendidly - and so did
profits. But while net investment didn't turn sharply down
again until the great bust - when it crumbled from $407
billion to $268 billion in one year - profits began to fall
abruptly beginning in 1997.
A major culprit behind this downturn was clearly the trade
deficit. Over the 1980s and violently toward the end of the
1990s, profits came under heavy attack from the emerging
and soaring trade deficit, as consumers began to spend an
increasing share of their income on imported goods. The
crucial point to keep in mind here is that in the
aggregate, all incomes in an economy derive ultimately from
business costs. The problem with a big trade deficit is
that it diverts domestic spending towards foreign
producers.
Conventional opinion holds that the soaring trade deficit
squeezes business profits through price effects. It says
that cheap foreign competition deprives domestic producers
of their pricing power, as reflected in the declining U.S.
inflation rates. No doubt, this contributes to the profit
squeeze, yet it is not the main cause. By far the greatest
part of the economy - services, retail and transportation,
apart from airlines - is sheltered against foreign
competition.
Nevertheless, we share the view that assigns a key role to
the soaring trade deficit in hammering U.S. corporate
profitability. But the devil is not in the price effects of
the higher dollar. Rather, it is in the massive loss of
revenue that American businesses incur due to the outflow
of domestic spending to foreign producers. The problem is
that much of the money spent on foreign goods comes from
the wage expenses of American companies. If it were not for
the trade deficit, all this money would return to these
companies as Americans purchased domestic products,
bolstering domestic revenues and profits. Instead, the
trade deficit slashes U.S. business revenues in relation to
expenses.
But didn't all the money that exited through the current
account promptly return through the capital account, as
foreigners bought American assets? Yes, but again, from a
macroeconomic perspective, these flows match only in the
balance of payments, not in the economy. Capital inflows do
not invalidate spending outflows. Foreign purchases of U.S.
assets may boost asset prices, but they add nothing to U.S.
domestic incomes.
The steep slide of profits since 1997, happening against
the backdrop of extreme monetary looseness, low interest
rates and a booming economy, is shocking and indeed,
portentous. Altogether, it allows no further doubt that the
U.S. economy's protracted profit stress is not cyclical,
but of deeper-seated, structural nature.
This is a point that we have been emphasizing for years,
pointing also to the two major macroeconomic causes - a low
rate of net investment and the exploding trade deficit. It
has been and still is strict macroeconomic considerations
that induced us years ago to flatly disavow the brouhaha
about a profit miracle in the United States. And the same
considerations suggest to us that there is worse to come for
profits and the economy.
Regards,
Kurt Richebächer
for the Daily Reckoning