Corporate America is in trouble. Latest figures from the Federal Reserve show that non-financial companies’ pre-tax profit rate in the first quarter fell to its lowest level since the financial crisis.
This isn’t merely due to the lockdown depressing demand. Even before the pandemic began the profit rate was trending down. In fact, there are two distinct downtrends. One is a short-term one: the profit rate fell between 2012 and 2019 despite an economic upturn. The other is a longer-term one: profits have recently been well below their average rate in the 1950s and 1960s.
You might thnk this grim picture is at odds with the S&P 500, which has more than doubled since 2012. But there isn’t really a contradiction. For one thing, the S&P 500 is dominated by a few huge companies: just five (Apple, Alphabet, Amazon, Facebook and Microsoft) account for over a fifth of its market capitalisation. And for another, the vast majority of US companies are not listed – and the unlisted ones tend to be smaller and less profitable. The stock market is not corporate America.
In theory, low profit rates could be a sign of a healthy economy – a sign that profits are being bid down by fierce competition.
Two facts, however, speak against this. One is that if this were the case we should see strong productivity growth as inefficient companies go to the wall to be replaced by more efficient ones. But, in fact, productivity growth has slowed in recent years. In the past 10 years output per worker hour has risen just 0.9 per cent per year compared with a 2.2 per cent average annual rise in the previous 50 years.
The other is that a dynamic economy should see high capital spending as new companies expand. But last year the share of corporate capital spending in GDP was actually lower than it was before the financial crisis, despite the fact that lower real interest rates should in theory encourage companies to invest.
These facts suggest that the low profit rate is a sign of a stagnant economy, not a dynamic one.
And not just a sign of it, but a cause. Lower profit rates reduce companies’ incentive to invest – a problem not confined to the US. As long ago as 2005, Ben Bernanke, then chairman of the Fed, said that western economies were suffering “increasingly limited investment opportunities”. The fall in profit rate since then both vindicates him, and shows that the problem has intensified.
Which is a big reason why real interest rates have fallen: to try to maintain incentives to invest in the face of lower profit rates, the cost of capital must fall. It’s no accident that a downtrend in real interest rates has occurred alongside a downtrend in profit rates.
Indeed, it was a lack of profitable opportunities caused by the falling profit rate that contributed to the 2008 crisis. Because there were insufficient productive investment projects the glut of savings from Asia flowed instead into the US housing market and (via falling bond yields) into credit derivatives. That fuelled bubbles that led to the banking crisis. As Ravi Jagannathan at Northwestern University has written, the crisis was "the symptom, not the disease”.
While profits remain low the danger remains of speculative bubbles and crises as these burst. As one 19th century economist said, low profits mean that money is instead “driven along the adventurous road of speculation, credit frauds, stock swindles and crises”.
The low profit rate is therefore a key cause of many of our current troubles. Yes, it is grossly under-reported. But the profit rate sets the climate even though everybody talks instead about the weather.
But there’s a reason for optimism here. As the lockdown is lifted we could see the unleashing of large pent-up demand. This has already begun: last week’s figures showed that US retail sales jumped by 17.7 per cent (although they are still well below pre-lockdown levels). And it’s likely that a wave of business failures will shrink the capital stock. The aggregate profit rate could therefore rise not just because of a rise in the numerator, but also a fall (or at least little growth) in the denominator.
Will this be enough? Cyclical upturns in the profit rate are common, but they haven’t yet been sufficient to reverse the long-term downtrend. It’s not obvious that the coming recovery will be any different.