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The profits paradox

The profits paradox

If UK companies are doing so well, why aren't they investing? This is the question posed by official figures.

On the one hand, these show that non-oil, non-financial companies' profit rates are now close to their highest levels since the late 1990s. But, on the other hand, companies are not investing: figures next week are likely to show that the volume of business investment is lower now than it was in 2015. This is a paradox: high profits should incentivise companies to invest more. So why aren't they doing so?

One possibility is that profits are not, in fact, as high as the ONS says. It calculates them according to the replacement cost of capital. Because capital goods prices have fallen in recent years - especially for IT - this means that they in effect devalue the capital stock, which inflates the return on capital.

This is questionable. Andrew Kliman at Pace University in New York says it's a "bogus" way of calculating profits. If a company paid £1m for a computer system a few years ago, it's not obvious that it is doing well because that system would now cost £700,000. It still has to cover the cost of the £1m.

Many of you won't like Kliman's argument: it's a defence of Marx's theory that profit rates would tend to fall. So you need another explanation of the profits paradox.

Luckily, there is one. It's that averages conceal considerable dispersion of returns across companies. Jason Furman and Peter Orszag show that "there has been a trend of increased dispersion of returns to capital across firms" in the US. This is consistent with work by Hendrick Bessembinder at Arizona State University, who shows that most shares underperform cash and that the great long-run performance of the stock market is due to good returns on a small minority of firms.

The same is true in the UK. On the one hand, we have 'zombie companies' who are lingering on thanks to low interest rates and creditors' forbearance. But, on the other, we have a few stellar companies. In a recent speech, the Bank of England's Andy Haldane said there's a "long tail" of inefficient companies, while better companies are "pulling ever-further away from the lower tail".

This matters. Think of profits and genuine investment opportunities as being distributed unevenly across companies. What's the relationship between the two distributions? If high-profit companies are also the ones with good opportunities, we'll get an investment boom. But if the opportunities lie with the long tail of less successful companies, capital spending will stagnate as those firms lack capital or management expertise to expand. (It's always been the case that capital spending is financed very much by internal funds rather than external sources such as banks, equity or bond markets).

And this is quite possible. Future profit opportunities are not the same as past ones. Many companies are doing well simply by having a strong position in a niche market. It doesn't follow that they can expand profitably.

Secular stagnation, therefore, might be the result (in part) of a mismatch between the distribution of past profits and the distribution of future opportunities.

That's a theory. Perhaps my main point, though, is that there aren't just zombie companies. There are also zombie ideas. Traditional textbook theories assume that there's a tendency for competition to equalise profits across companies, while macroeconomics thinks of the economy as comprising a "representative" agent company producing one good with a smoothly differentiable production function. If we want to understand the paradox of high reported profit rates coexisting with low capital spending, however, we need to ditch these old ideas and think more about corporate heterogeneity.

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By Chris Dillow,
17 May 2017

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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