The US economy has entered a period of what former US Treasury Secretary Larry Summers calls secular stagnation – sustained slow growth. We know this because there are fears of recession even though economic policy is super-loose, with real interest rates low and government borrowing high. Financial markets expect the malaise to continue. The yield on 10-year inflation-proofed Treasuries is just 0.1 per cent; if investors were optimistic about growth it would be much higher simply because they would be anticipating much higher interest rates.
A big reason for this is that productivity growth has slowed. It’s risen just 1.2 per cent a year in the past 10 years compared with 2.2 per cent a year in the 50 years before the financial crisis – despite the fact that recoveries from deep recessions should see big productivity gains.
But why has growth slowed? There are many explanations, which are not mutually exclusive. High inequality and an ageing population have raised desired savings and so reduced interest rates and growth. A slower pace of innovation and low animal spirits since the crisis have cut investment and productivity growth. Lower prices of capital goods mean companies invest less in nominal terms simply because their money goes further – something that reduces interest rates. And the fear of competition from future better technologies is deterring companies from investing today.
There is, however, another reason that is vitally important but underappreciated. It’s that non-financial companies have seen a long-term decline in their return on capital. And, obviously, lower profits make companies more reluctant to invest.
My chart shows this, using data from the Federal Reserve’s financial accounts: I define the profit rate as pre-tax profits expressed as a percentage of non-financial assets in the previous quarter, measured at historic cost. It’s clear that there was a trend decline in the profit rate from the early 1950s to late 1990s. A big reason for the slowdown in growth in the 1970s was precisely that profits had fallen so much.
This was reversed by capital scrapping and a growth spurt after the tech crash. But profit rates fell again in the 2008-09 recession and recovered only briefly. They are now back to the levels we saw in the early 1980s.
You might wonder how this is consistent with the rise in monopoly power documented by Jan De Loecker, Jan Eeckhout and Gabriel Unger. Simple. The rising mark-ups they describe are largely confined to a minority of superstar companies, and a few monopolies are consistent with the vast mass of companies struggling. What’s more, it costs a fortune to get a monopoly position: you must spend millions on building the brand. For this reason, several high-profile companies such as Uber or WeWork are still losing money. And even those that enjoy decent profit margins do so on the basis of a large capital stock and hence see low profit rates.
Now, this isn’t necessarily directly terrible for the stock market: most of the superstar monopolies such as Apple are listed, while many of the struggling companies are not. But it does matter enormously at one remove. Low profit rates are a good reason why companies are investing so little – because it doesn’t pay so well to do so. This depresses productivity and hence economic growth generally. And this is an environment in which quoted companies will struggle.
What’s going on here is something that 19th century economists such as David Ricardo and Karl Marx anticipated. They thought that additional capital would earn successively lower profits – that’s the law of diminishing returns – until the motive to invest was extinguished. The secular stagnation of which Larry Summers speaks is a renaming of the stationary state that classical economists expected.
Of course, they were no fools. They knew there were counteracting influences to this trend, one of which was technical progress: one reason for the high profit rates of the 1950s was that companies exploited the backlog of innovations created by the war interrupting normal economic activity.
These counteracting influences, however, have faded away, leaving profits lower now than they were in the golden age of capitalism in the 1950s and 1960s.
Herein lies one reason why stock markets are so scared by the mere possibility of a recession. These usually cut profit rates simply because demand and profits fall faster than capital can be scrapped. And if profits fall from their already low levels the question arises: how might they recover? It would require not just a huge rebound in demand but also significant capital scrapping. And that entails business failures and mass unemployment, which imply not just losses for banks but also the social and political uncertainty that accompanies these.
Yes, the US economy is coping well with a low profit rate now, thanks in large part to huge support from fiscal and monetary policy. But it is a fragile sort of coping.
