One curious fact about this recession is that corporate profits have held up quite well. Today’s figures (pdf) show that, in Q2, non-oil, non-financial firms’ net return on capital was 10.8%. Though down from the peak of 13.7% recorded as long ago as Q4 2006, this is comparable to end-2002’s rate, and far above the profit rates we saw in the 1991-92 recession, even though that was milder for output.
So, why have profits held up? Two possibilities can be disregarded:
1. Firms have cut costs. True. But, in aggregate, this cannot increase profits simply because one firm’s costs are another revenues. If a firm sacks a worker, other firms see reduced consumer demand. If it cuts inventories, others see reduced orders.
2. Sterling’s fall has sheltered firms from overseas competition. Surprisingly, though, it is the service sector - which tends to be more sheltered from international competition - where profits have held up best. The profit rate in services is higher now than at the end of 2007, whereas manufacturers’ profit rate has fallen from 13.1% to 6.7%.
This leaves us with another answer - profits have held up because government borrowing has risen.
To see how, let’s play with the national accounts identities.
The basic expenditure identity is:
Y = C + I + G + X - M.
GDP is also equal to wages, profits, taxes and other incomes such as rent:
Y = W + P + T + O.
We can rearrange these to get an identity for profits:
P = (C - W) + I + (G -T) + (X - M) - O.
Tables C1 and D of the national accounts (pdf) give us these numbers. They show that the £3bn fall in profits (including oil and financial firms) between Q2 2008 and Q2 2009 can be decomposed as follows*:
C - W = - £5.4bn
I = -£14.6bn
X - M = +£0.9bn
G - T = +£10.4bn
O = +£5.5bn.
The numbers show that private sector decisions - cuts in capital spending and inventories, and cuts in consumer spending relative to wages - have been major forces depressing profits. But these have been offset by higher government spending and lower taxes.
In fact, my numbers probably understate the benefits to profits of fiscal policy. This is because the T in the national accounts refer only to taxes on production. But in fact, lower taxes elsewhere have helped boost profits. I suspect that, had income tax receipts not fallen, households would have cut spending by even more than they did in order to raise their savings. That would have hit profits too.
The message here is simple - the budget deficit is helping to protect capitalism from itself, by underpinning profits.
This is awkward for both left and right. For the right, it suggests that attempts to cut the deficit quickly could hurt profits. For the left, it means arguments in favour of “Keynesian” fiscal policy are, in effect, arguments for bailing out capitalism.
* The numbers don’t add up exactly because of the pesky statistical discrepancy.
So, why have profits held up? Two possibilities can be disregarded:
1. Firms have cut costs. True. But, in aggregate, this cannot increase profits simply because one firm’s costs are another revenues. If a firm sacks a worker, other firms see reduced consumer demand. If it cuts inventories, others see reduced orders.
2. Sterling’s fall has sheltered firms from overseas competition. Surprisingly, though, it is the service sector - which tends to be more sheltered from international competition - where profits have held up best. The profit rate in services is higher now than at the end of 2007, whereas manufacturers’ profit rate has fallen from 13.1% to 6.7%.
This leaves us with another answer - profits have held up because government borrowing has risen.
To see how, let’s play with the national accounts identities.
The basic expenditure identity is:
Y = C + I + G + X - M.
GDP is also equal to wages, profits, taxes and other incomes such as rent:
Y = W + P + T + O.
We can rearrange these to get an identity for profits:
P = (C - W) + I + (G -T) + (X - M) - O.
Tables C1 and D of the national accounts (pdf) give us these numbers. They show that the £3bn fall in profits (including oil and financial firms) between Q2 2008 and Q2 2009 can be decomposed as follows*:
C - W = - £5.4bn
I = -£14.6bn
X - M = +£0.9bn
G - T = +£10.4bn
O = +£5.5bn.
The numbers show that private sector decisions - cuts in capital spending and inventories, and cuts in consumer spending relative to wages - have been major forces depressing profits. But these have been offset by higher government spending and lower taxes.
In fact, my numbers probably understate the benefits to profits of fiscal policy. This is because the T in the national accounts refer only to taxes on production. But in fact, lower taxes elsewhere have helped boost profits. I suspect that, had income tax receipts not fallen, households would have cut spending by even more than they did in order to raise their savings. That would have hit profits too.
The message here is simple - the budget deficit is helping to protect capitalism from itself, by underpinning profits.
This is awkward for both left and right. For the right, it suggests that attempts to cut the deficit quickly could hurt profits. For the left, it means arguments in favour of “Keynesian” fiscal policy are, in effect, arguments for bailing out capitalism.
* The numbers don’t add up exactly because of the pesky statistical discrepancy.
I totally agree - and this is of course what Keynesian fiscal policy is meant to do.
The other point worth noting is that the overall 10 - 13% net return on capital is considerably less than the 20-25% target that was being used as the norm by many in the financial sector. And of course what was the consequence of pursuing such impossible returns - other than a ramping up of risk. I am still not sure that the financial sector/regulators have yet done enough to address the consequences of this pursuit of the unachievable.
Posted by: tory boys never grow up | October 07, 2009 at 01:35 PM
"arguments in favour of “Keynesian” fiscal policy are, in effect, arguments for bailing out capitalism": as the last poster noted, that is of course the point. This is why the radical left aren't Keynesians.
Posted by: RobG | October 07, 2009 at 02:19 PM
Presumably we could live in a world where firms made thinner margins and carried more workers in times like these, what do you think we'd have to change for that to happen?
Legislation to increase the cost of firing workers? Fiscal stimulus via tax instruments targeting job creation?
This is presuming a lower return on capital would be desirable, from a left-wing p.o.v., why might that be wrong? Consequences for investment, perhaps?
Posted by: Luis Enrique | October 07, 2009 at 02:20 PM
on second thoughts, I'm not at all clear what would constitute "not bailing out capitalism"
Posted by: Luis Enrique | October 07, 2009 at 03:56 PM
Chris
Could you explain something to me? People often criticise the likes of Eugene Fama for using accounting identities to make statements of causality
e.g.
http://economistsview.typepad.com/economistsview/2009/01/a-dark-age-of-macroeconomics.html
in order to disprove Keynesian insights. Fama is obviously nuts on this one. But are you not doing something similar here?
Your equation
P = (C - W) + I + (G -T) + (X - M) + O.
Could be balanced in a number of ways: if G-T fell, could not I rise, or X-M rise, or O rise, for example - all depending on matters that are invisible to that equation?
I don't doubt that you are right: higher G-T saved a whole lot of things. But does this really prove it?
best
Giles
Posted by: Giles | October 07, 2009 at 10:05 PM
@ Giles - I'm not making the Fama error. I'm merely using the identity as it should be used - as a motivation for a calculation.
Underpinning the numbers is a simple story that everyone would agree upon. Cuts in private sector spending have incipiently reduced profits (and GDP), and the budget deficit has expanded to partially offset this, partly by fiscal stabilizers and partly by policy actions. All my identity does is help quantify that.
Of course, the identity is consistent with a story in which G - T rose, which crowded out investment (more than one-for-one) and so hurt profits. But that story just isn't what happened.
In your example, a fall in G - T might lead to higher I, through crowding in. But the identity tell us nothing about whether this will happen or not.
@ Luis - a world in which capitalists accepted thinner margins but continued to invest was what we saw in the late 60s. That, though, required that capitalists had huge confidence that aggregate demand would stay high - so high sales volumes would offset low margins. Such optimism eventually proved misplaced.
Posted by: chris | October 08, 2009 at 09:01 AM
This paradox is because of persistant biases in perception on left and right. The right insists on seeing the economy as a whole as being like the economy of a household or an individual firm which is a fallacy of composition. The left insists on thinking simple actions have only simple consequences. Both are basically fallacious.
Posted by: reason | October 08, 2009 at 02:33 PM