Commentary

Profit Paucity

This article was published in the Washington Times, October 20, 2002.
With elections looming, politicians have begun making vague promises or threats to “do something” about the economy. Democrats hope to subsidize longer spells of unemployment, and the White House hopes to subsidize risks of terrorism. Before we start writing lists of irrelevant proposals, however, it would be wise to first identify the problem.

Politicians cannot possibly talk seriously about troubles in the economy without talking about troubles in corporate profits. Yet no politician wants to been seen expressing sympathy for “giant corporations,” much less doing anything to improve the business climate. On the contrary, they hope to been seen as being “tough” on big business. Unfortunately, reality is tough enough.

Profits in manufacturing fell from $176.1 billion in the second quarter of 2000 (when stocks peaked) to $50.9 billion in the last quarter of 2001, before recovering to $91.9 billion in this year’s second quarter. After that recovery, however, profits were still down 48 percent from the previous peak. Little wonder stocks are down, too.

Profits are the spark that gets the economy’s engine started and the fuel that keeps it moving. If it is not profitable to produce more of something, then less will be produced. If it is not profitable to employ someone, that person will not be employed.

To understand the economy and stock market, we have to look at two measures of profits — one for the stock market and another for the economy. That is because the Standard & Poor’s 500 stock index includes only 500 companies, while the government’s profit numbers cover more than 5 million.

Profits of the S&P 500 companies fell from $120.2 billion in the third quarter of 2000 to $63.3 billion in the second quarter of this year, or 47 percent. The S&P 500 index likewise fell from a peak of nearly 1,500 to 868 by this September, or about 42 percent. That profits fell by even more than stocks should make you properly skeptical of the bipartisan political explanation — that the market high in 2000 was entirely due to a bubble and the subsequent drop was entirely due to a loss of confidence.

The real problem is that costs have been rising faster than prices. Prices are expressed per unit, such as the price per ton of steel, and the costs of doing business can likewise be measured per unit. From 1992 to 1997, unit labor costs in all nonfarm business rose 1.1 percent a year, while business prices rose 2 percent a year. From 1998 to 2001, however, unit labor costs rose 2.6 percent a year, and prices by 1.5 percent. That is no way to make money.

Taking financial profits out of the picture makes it look even worse. In 2000, unit labor costs among nonfinancial corporations rose 4.4 percent, while prices rose 1.8 percent. That put a nasty squeeze on profit margins. In fact, from 1997 to 2001, unit labor costs gradually expanded from 64 centsto 66.7 cents out of every nonfinancial corporate dollar and interest costs rose from 2.7 cents to 3.7 cents. The result was that after-tax profit margins fell from 8.9 to 5.9 percent.

The averages conceal many outright losses. Companies had no choice but to bring unit labor costs down by laying off workers and to become more frugal about rising compensation and debt. This appears to be working, but not without some discomfort. Unit labor costs actually fell from the third quarter of 2001 through the first quarter of 2002, though prices also fell slightly at times.

The point of rudely introducing facts into this political dispute is to identify what went wrong, not to identify an easy cure. Government could probably help most by not doing things that increase business costs, such as mandated employee benefits, cumbersome regulations and, of course, taxes. One panacea to be studiously avoided, however, is the idea that faster inflation means faster growth of profits.

The Economist, for example, argued that “low inflation will mean profits grow more slowly.” That dangerous notion reflects two common confusions. Inflated prices do not improve the profit on each item sold because inflation means rising costs of labor and credit, not just rising selling prices. Inflation may create the illusion that sales are rising, but the reality is that fewer goods may just be selling at higher prices. What matters for real growth of profits is real growth of sales volume. That is, the number of widgets and gadgets sold depends on growth of real GDP, not inflated prices.

Pollsters tell us that people believe Republicans are mostly interested in corporations, while Democrats are interested in the average guy. This distinction is quite unhelpful, because it is impossible to have a healthy economy full of sickly corporations. The average guy is extremely dependent on the success (profits) of corporate America for products, services, jobs and pensions. If we are ever going to talk seriously about the economy and stock market, a few bold politicians may need to muster the courage to mention the dreaded “P” word — profits.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.