OPINION 

The profit squeeze

Chris Dillow

Chris Dillow

Accountants EY this week reported that profit warnings have hit a three year high. This reminds us that falling real wages do not necessarily mean rising profits.

Everyone knows that real wages are lower now than they were at the end of 2007. What’s not so well known is that the real profits of non-financial firms are also lower. How can this be, given that we were told last week that GDP – which is mostly the sum of wages and profits – is now above its pre-recession peak?

Simple. We are now producing the same GDP with more workers. Although GDP is 0.4 per cent above the pre-recession peak reached in 2007Q4, hours worked have risen four per cent since then. The same output is thus spread among more workers. And this must mean a smaller slice of the pie for everyone – workers and business owners.

Workers’ real wages haven’t fallen because they are being more exploited by bosses. They’ve fallen because productivity has fallen. This same drop in productivity has hurt profits.

We can see this by looking at the own product real wage. This is simply wages divided by the product of productivity and prices. The idea here is that workers will get a bigger slice of the pie if real wages rise faster than productivity – that is, if we get pay rises that aren’t offset by increased production. In fact, the own product real wage has been stable for years. Yes, it’s fallen a little since the end of 2012 – consistent with profit margins rising slightly – but it is only 1.6 per cent higher than it was in 2007Q4. This corroborates national accounts data showing that the share of non-financial profits in GDP hasn’t changed much since the mid-00s.

In one sense, this is very weird. Usually recoveries from recessions see big rises in the share of profits in GDP; this happened in the early 80s and early 90s recoveries. This is because rising output causes previously under-utilized members of staff to work more, with the result that productivity rises, whilst mass unemployment continues to hold down wage growth. Although we’ve seen the latter this time, we haven’t had the pro-cyclical rise in productivity that boosts profit margins; whilst GDP has risen 7.9 per cent since its trough, hours worked have risen 7.4 per cent, giving us no significant productivity gain. The upshot has been almost no rise in margins or profit share.

In this sense, companies have in aggregate missed the bus. They’ve missed the easiest way to raise profit margins – that procyclical rise in productivity. Granted, there are other methods of doing so – to hold down real wages or to get staff to be more productive. But if firms lacked the wit or power to do that when (official) unemployment was over 2.6 million, they’ll lack it when unemployment is half a million lower.

The message here is that equity investors should have modest expectations. We should assume that, in aggregate, domestically generated profits won’t rise much faster than GDP – which implies roughly five per cent growth per year. Expectations much above this are likely to lead to even more profits warnings.

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