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.
Soaring Trade Deficit: The Aggregate
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.
Soaring Trade Deficit: Supply-Side Reaganomics
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.
Soaring Trade Deficit: Sheltered Against Foreign Competition
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.
for the Daily Reckoning
April 8, 2003
War! War! War!
Here in London, as in America, newspaper and TV stations talk of little else. Gone from the public eye are the naughty vicars and corroded town councilmen.
Instead, the old generals and the young reporters enjoy their moments of glory. The newshounds give us the latest events from the Tigris and Euphrates…the old warhorses tell us what they are supposed to mean.
Cynicism and irony seem to have been taken out – perhaps by a very smart bomb – in the first minutes of the war. Caught up the spirit of it all, who doubts that the whole thing is noble and just…rather than sordid and absurd?
And amid all the noise of war, who notices that unemployment continues to drop…that consumers become even less able to spend…and that debts continue to build?
“More Job Searchers Just Stop Looking,” says USA Today of the employment situation.
And consumers say they are more likely to save this year’s tax refund than they were last year. And fewer say they’ll borrow this month.
For a huge economy such as ours, says Milton Friedman, the costs of war in Iraq are negligible. And yet, the $75 billion set aside for the effort so far just covers the first 6 months. The total price is unknown, but the costs will stretch far into the future…including the cost of rebuilding Iraq and pursuing America’s new, activist foreign policy. Look for total deficits of $1 trillion over the next 10 years, says the Congressional Budget Office, the same savants who previously projected a $5.6 trillion surplus for the same period. More like $2 trillion in deficits, say other analysts. And then along comes Goldman Sachs with a deficit estimate of $4.2 trillion!
Wow…between the CBO’s former estimate and Goldman’s current estimate is a chasm as wide as the entire national GDP. Which just goes to show, when it comes to the future…nobody knows anything.
But the war is a great distraction…for the humble and the great. What national leader wouldn’t want to be found ahead of his troops…rather than behind some scheme to defraud the taxpayers…and what vicar wouldn’t rather be seen with a colonel in full dress uniform than with the choir mistress stark naked?
And now over to Eric Fry, with more news from Wall Street:
Eric Fry, checking in from New York…
– Aggressive and persistent sorties into the stock market by bullish investors yesterday morning pounded short- sellers like so many Republican Guard troops. But the “shorts” held fast and repelled the onslaught, reducing the Dow’s early 240-point advance to less than 30 points by the closing bell.
– The shorts also repelled the Nasdaq’s incursion into bullish territory, reducing the tech index’s advance from more than 3% to less than 1%. The Dow finished the day ahead 23 points to 8,300, while the Nasdaq Composite was better by 6 points to 1,389. The dollar also picked up some ground for the fifth straight day, ending the New York session at $1.067 per euro.
– Collateral victims of the bullish advance on Wall Street yesterday included bonds, oil and gold. These defensive assets are providing very little defense – acting less like safe havens than financial death traps. June gold fell $3.80 to $322.20 an ounce after losing as much as $6 an ounce; crude for May delivery fell 66 cents to $27.96 a barrel; and the benchmark 10-year Treasury note fell half a point, pushing its yield to 4.02% from 3.95% last Friday.
– We suspect that the final epic battle has not yet been waged between richly valued stocks and lowly valued commodities. A powerful counter-offensive from the commodity corps would not be completely surprising.
– Bonds, on the other hand, are a riddle wrapped inside of an enigma. Is it not an enigma, for example, that a titanic global borrower like the United States pays less than 4% per year to borrow money for a decade? And is it not a riddle that bond yields have been falling, even while the US government is running up large war debts and large fiscal deficits?
– The answer to the riddle may be that investors – individual and professional alike – have been so bloodied by stock market losses that they’ve been piling into bond funds. The bond fund managers, with the cash inflows burning a hole in their pockets, robotically buy bonds without worrying too much about the miniscule yields on offer.
– Give a bond fund manager some cash and he will buy bonds, just as assuredly as a wife with a platinum American Express card will buy a pair of Pradas or Manolo Blahniks. The purchase itself is a foregone conclusion. The only unknown is the particular “size and style” of the purchase.
– To be sure, we agree with the simple wisdom of legendary bond fund manager Bill Gross, when he remarked, “I still prefer an overvalued Treasury to an overvalued stock.” That said, we would prefer a 1% CD to either of the two choices Gross suggests. Buying an overvalued bond or overvalued stock or overvalued anything else is like buying a raffle ticket to win a litter of Siamese cats…winning is losing.
– Why then does the bond bull market keep chuggin’ along? Might the reason be that investors are afraid to buy stocks? The lumpeninvestoriat, after taking their lumps for three years in the stock market, have been cashing in their stock funds to buy bond funds. There’s nothing quite like an excruciating 3-year bear market in stocks to goad investors into bonds and money market funds.
– Individual investors have yanked about $59 billion out of equity funds and put nearly three times that amount into bond funds over the past 12 months. And so far this year, bond funds pulled in $10.5 billion, a record for any quarter, according to AMG Data Services.
– “In spite of their puny rates of return, money market funds have surged in popularity,” the Financial Times reports. “The relationship of funds in money markets to the Wilshire 5000 index, which includes all domestic U.S. common stocks, is up to 28 per cent. That is remarkably high considering that, for most of the years between 1991 to 2000, the amount of cash in money market funds as a percentage of the Wilshire never rose above 15 percent.” Just maybe, investors have purchased one bond too many.
– “Is the bond market another bubble that’s about to burst?” wonders Andrew Caffrey of the Boston Globe. “Bond mutual funds are still pumping out profits in the three- year bear market, and investors are continuing to chase performance, throwing billions into funds that buy government and corporate debt. It’s a scenario that looks a lot like that other bubble, the one in the late 1990s when the herd stampeded into stocks on the promise of ever- higher returns, and equity mutual funds were awash with money.
– Amazingly, Caffrey notes, many investors in bonds and bond mutual funds don’t even know the risks they’re taking. According to a Vanguard survey conducted last year, nearly 70 percent of respondents did not understand that when rates rise, bond prices fall. This widespread ignorance also suggests that most investors are unaware of the potential for losing money in a bond fund.
– “Ignorance is bliss” may apply to marital affairs, but not to financial affairs.
Bill Bonner, back in London:
*** The price of gold fell again yesterday…dipping down to $322. Gold buyers are getting discouraged, which is what happens in the early days of a bull market. Two years ago, an ounce of gold sold for only $255. Even at today’s price, gold is still up nearly 30% from its low 2 years ago. Is the bull market in gold already over? We cannot say. But never in the history of the world has a paper currency outlived gold. Maybe this is a New Era…but not likely.
*** America’s late, degenerate collectivized capitalism is hardly the paradise investors recently thought it was. More and more, businesses are run not for the benefit of capitalists, but for the benefit of workers, voters, lawyers, politicians and any hack who can find a way to put his hand in the till.
We say this after reading about the latest multi-billion judgment against Philip Morris. Big Mo’s big crime was that it sold cigarettes to people who wanted to buy them. Now, it finds itself attacked by every shyster in the country. So many parasites have attached themselves to the tobacco company’s hide that the firm is in danger of turning a whiter shade of pale. Recognizing the risk to their blood supply, the vermin are now battling among themselves in order to find a way to keep the blood flowing.