Is a lack of profits holding back the UK economy? There’s certainly a curious coincidence. On the one hand, official figures show that the non-oil, non-financial profit rate, at 9.2 per cent, is at its lowest level since 1993, whilst the share of those profits in GDP is close to its lowest since present records began in 1987. And on the other hand, the share of business investment in GDP fell below eight per cent last year, its lowest level since records began in 1966*. It’s natural to suspect, then, that low profits might be the cause of low investment.
Natural, but not necessarily correct.
For one thing, low profits are certainly not starving firms of finance. In the last two years, non-financial companies’ retained profits – that is, profits after tax and dividends – have exceeded capital spending by £106.3bn,or 3.6 per cent of GDP. For companies in aggregate, profits are more than sufficient to finance their investment.
But profits don’t just influence investment by providing the means of spending. They also provide the motive to do so; firms only invest (in theory!) to make a profit.
However, two things suggest that low profits are not a major cause of weak investment.
One is what companies are telling us. Last month’s survey of manufacturers by the CBI found that 42 per cent of firms said that an inadequate net return was limiting capital spending. That’s less than the number (46 per cent) citing uncertainty about demand. It implies that almost three-fifths of manufacturers’ are not constrained by weak profits. This is significant, because profits are much lower in manufacturing than elsewhere; according to official figures manufacturers’ net return on capital last year was 5.4 per cent, compared to 15.9 per cent for the services sector. If profits aren’t a massive constraint on investment in manufacturing, they’ll be much less of a constraint in the economy generally.
Secondly, the decline in the share of investment in GDP pre-dates the fall in profit rates. Non-oil, non-financial returns on capital rose strongly between 2001 and 2007, but the share of investment in GDP fell. This suggests that something other than profits has held back investment.
What’s going on here is, I suspect, a combination of two things. One is a long-term problem, a dearth of investment opportunities thanks to a mix of a slower rate of monetizable innovations and the migration of low-skill industry to Asia. Overlaid upon this is a cyclical problem of weak aggregate demand. If or when the latter picks up, so too will profits and probably capital spending. Whether the latter will do so sufficiently to give a big lift to the economy is, however, doubtful. Low profits, I suspect, are a symptom of our malaise rather than a significant cause of it.
* It’s not clear how worrying this in fact is. A lot of the decline reflects not so much a decline in the volume of investment so much as the fact that capital goods prices have fallen relative to other prices. But this merely poses the question; why have firms not responded to cheap prices by spending more?
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Chris blogs at http://stumblingandmumbling.typepad.com