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OPINION

Profits defy recession

Profits defy recession
January 11, 2013
Profits defy recession

One reason why the profit rate has held up relatively well is that capital spending has been low for years. This has raised the profit rate partly by trivial maths - it has held down the denominator, the capital stock - and partly because less capacity means that companies have not had to cut prices as much.

A second reason has been that increased government borrowing has underpinned aggregate demand, and the benefits of this have flowed in large part into corporate coffers**.

This raises two issues for investors.

One is: if profit rates are so high, why is investment so low: the volume of business investment in the third quarter was 11.6 per cent below its 2007 fourth-quarter level. One possibility is that, because of a lack of technical progress and difficulty in monetising new projects, the expected return on new investments is much lower than that on existing ones. If so, capital spending will remain low. A more pleasant possibility is that capital spending has been held back by a lack of finance for small companies and uncertainty, for example about the euro area's debt crisis, and that as these restraints weaken, spending will recover.

The second is: if profits have been supported by government borrowing, will they fall as borrowing falls? Insofar as borrowing falls for 'cyclical' reasons - a pick-up in private sector spending - the answer is: no. If, however, austerity continues to depress growth, the answer is: yes. In this sense, the outlook for profits depends on the macroeconomic issue of how far fiscal tightness damages the wider economy.

What we can be more sure of is that the net return on capital is much higher in the service sector than in manufacturing - 16.9 per cent against 4.7 per cent. While this remains the case, there's little chance of the 'rebalancing' of the economy towards industry that the government has targeted.

*It's probably well above the rate companies made in the 1980s and 1990s recession, although fully comparable data are not available.

**This is true as an accounting identity. Remember that national income (Y) is equal to the sum of consumer spending (C), investment (I), government spending (G) and net trade (NT):

Y = C + I + G + NT

It's also equal to the sum of profits, wages and taxes (and other incomes such as rent and self-employment incomes, but I'll keep things simple and ignore these:

Y = P + W + T

We can rearrange these two identities to get one for profits:

P = (C - W) + I + (G - T) + NT

Now, we know that (C - W) hasn't increased much, as consumer spending has been weak and the savings ratio has risen. And I has fallen, as has net exports. This means the big positive for profits in recent years has been the rise in G - T, government borrowing.