A stimulus will work if and when it serves to increase profits, because profits are at the core of a free market system. The economy will recover if and when profits recover.
Wages and salaries rose by 3%, while corporate profits fell by 9%, from the third quarter of 2007 through the third quarter of 2008, according to Commerce Department data. Fourth-quarter figures, which will be available in late February, are expected to show weakening in both types of income, with wages and salaries showing almost no increase, and profits falling by more than 15% relative to last year’s fourth quarter.
The economy is in trouble today because of, pardon the pun, false profits. The financial sector reported as much as 40% of all profits in recent years. However, the reported profits on instruments such as mortgage-backed securities and the sale of credit default swaps did not reflect the long-term risks of those instruments. That is, the return on capital in the financial sector was artificially high because the amount of capital used to protect against risk was artificially low. Losses at many financial firms are inevitable. It is the market’s way of telling the bloated industry to contract, releasing capital and talent for use elsewhere in the economy.
The challenge for government is to walk a fine line by allowing individual firms to fail without impairing the payment system or impeding the ability of businesses and consumers to obtain banking services. So far, the government appears to be erring on the side of propping up insolvent institutions far more than is necessary. In fact, TARP, the Troubled Assets Relief Program, and other rescue plans have fostered “zombie banks,” which may impair the health of other banks and the entire financial system.
The financial sector is too absorbed in de-leveraging itself to play an active role in the economic recovery. The rest of the non-financial sector of the economy is going to have to survive in a less forgiving financial environment. In order to finance expansion, businesses will be even more dependent than usual on profits. In that sense, this is a Minsky moment, as many economists suddenly rediscover the late Hyman Minsky’s insight that financial structure is cyclical. As the economy grows stronger, firms are increasingly willing to engage in risky forms of finance and expand using borrowed money. When the economy weakens, firms fall back on organic growth financed by earnings.
Unfortunately, the pending stimulus package is not aimed at boosting profits. It is merely a massive transfer of power from the private sector to the government, disguised as a rescue plan for the economy. The decentralized process of markets with the discipline of the profit and loss system will no longer guide investment in the U.S. Instead, technocrats and central planners will control it.
A study by the Congressional Budget Office recently pointed out that the infrastructure projects and other spending programs at the heart of the so-called stimulus package will take years to implement. Moreover, this spending will create only discrete projects, not ongoing businesses that generate jobs and profits.
A genuine recovery needs the creation of new businesses earning profits. One excellent idea for stimulating profits, suggested by my colleague Bryan Caplan, a George Mason University economics professor, would be to cut the employer contribution to the payroll tax.
At full employment, a cut in the employer contribution to the payroll tax would soon be passed on to workers, as competition drives up wages.
However, in a recession, this competitive pressure is muted, and wages are unlikely to rise. In today’s environment, reducing the employer contribution to the payroll tax would cause an increase in profits and demand for labor. However, if the payroll tax cut is only a temporary holiday it is unlikely to affect business’ perception of the marginal cost of labor. It would be better to make the tax cut permanent. As the economy returns to full employment, the tax can either be restored or replaced by other taxes, if necessary.
A payroll tax cut could take effect tomorrow, and it would start working immediately. The increase in the budget deficit could be much smaller and more easily reversed than is the case with President Obama’s stimulus package.
When it comes to economic recovery, the bottom line is the bottom line. Restoring profitability to the nonfinancial sector is the key to long-term growth. If the government wants to help, it has to stimulate profits. An easy way to do that would be by cutting the employer contribution to the payroll tax.