Profit Margins and Wages (Email to a Friend)

A friend emailed last week, asking for updated figures on U.S. corporate profit margins and wages. This is an edited and modestly improved version of what I sent him:

With the caveat that I’m crunching numbers that other people who work regularly with these stats know more about than I do, my observation is that based on Dept. of Commerce data (NIPA table 1.14), corporate profits remain well above the long-term average, and employee comp is well below.

Specifically, in 2011, compared to the total gross value added by corporate businesses, total compensation to employees was 58.7%. This was well below the long-term average (1929 – 2011) of 64.2%.

The flip side of this is that corporate profits, as a percentage of gross value added, were 9.6% in 2011. This was well above the long-term (1929-2011) average of 7.1%.  (The profits are after interest payments and taxes, and include adjustments this series makes for inventory valuation and consumption of capital, i.e. depreciation.)

The cause of this higher profitability and lower comp to workers? Up for debate. Things I suspect are reduced bargaining power of workers (weaker unions, greater global competition); deficit governmental spending (spending must go down from here, or taxes up, or both); low interest rates; and less competition by businesses (weaker antitrust enforcement). These aren’t mutually exclusive. The last factor, less competition and weaker antitrust enforcement, might be hard to quantify. Also, are there governmental benefits that act as compensation to workers, but are not captured by these stats? I don’t know, but that’s a question it would be nice to have insight into.

Increasing financialization of the economy might also be a factor. You could think of that as a somewhat unproductive finance sector siphoning off profit, and I think that is true to a degree, or, less polemically and more accurately I think, the fact that more and more work is done by machines and the owners of those machines get paid something for their capital. However, labor's share dropped sharply over the past decade, and that is in part what makes me suspect that it may well head back up. Even in 2003, for example, the percentage was 64.5%, which was entirely in line with the multi-decade average, and well above the current 58.7% figure.

New Shiller Interview on Housing

There's a new interview with Yale economist Robert Shiller here. Worthwhile and thought-provoking, as always. Among other things, he is co-creator of the Case-Shiller housing price index. Is he too gloomy in this interview? I do not know. I appreciate the way he thinks, whether or not he is exactly right in his worries here.

Self-Proving Ideas

Since high school, I have found myself interested in ideas that illustrate or prove themselves.

An easy example of this is the word "subtle." It is self-illustrating because the letter "b" is barely there. You don't have to look outside the word itself to see something subtle.

I recently noticed that the Harold Arlen song, "It's Only a Paper Moon," does the same thing. Yes, the song says, it's only a canvas sky, hanging over a muslin tree, but it wouldn't be make-believe if you believed in me. The world is phony and meaningless until love transforms it. The song seems a bit corny and trite at first, just "a melody played in a penny arcade." Yet, if you give it the benefit of the doubt and listen for a while, it grows on you. The song has to come off as a little tawdry and cheap in order to make its point. Subtle.

Montier on Profit Margins

Corporate profit margins in the U.S. continue to be very high. Will they revert back to the mean? James Montier of GMO has a new piece out on this topic, titled "What Goes Up Must Come Down!" It is worth reading.

There is also a good Reuters piece on this that I linked to earlier this month.

In my experience, when serious, numerate, detail-oriented analysts find something that makes them say, "This doesn't make sense," but runs counter to what people want to hear, they are often ignored. (O.K., that sounds a little petulant, sorry.) I am only seeing a few people really wring their hands over high profit margins -- but they are the smart guys.

Perhaps there is something to the other side here. There may be some reason for corporate profit margins to remain above the long-term level in the medium term. For example, maybe global competition will continue to diminish the bargaining power of labor for the next decade or more. Because businesses are not perfectly competitive with each other, this would tend to raise profit margins, at the expense of compensation to employees.

But such semi-permanent effects seem relatively small; most of the increased margin seems to be from federal spending that is much in excess of tax revenues, as Montier lays out, and very low interest rates, which the Reuters piece mentions. These conditions will return to normal, over time, and cannot be considered permanent or semi-permanent.

The Cinderella Problem

How long will foreign central banks keep buying so much of our debt? James Kwak has a good piece on this, with a nice graphic showing how much more aggressive buying by foreign central banks has gotten over the past decade-plus.

In the past three years, the federal budget deficit has been more than $1 trillion annually. We can do this only with heavy borrowing. In that sense, we are like Cinderella at the ball. Our carriage will turn into a pumpkin at midnight, but as Warren Buffett once put it, there is no clock on the wall.

I am not predicting doom; we may have a lot more time. I think it is not smart to assume that we do, however. In just about all areas of life, borrowing power should generally be used as a back-up plan, not as a primary strategy. In other words, even assuming we do have a lot more time, we will be better off taking the attitude that we don't.

Bernanke, Inflation Hawk?

Roger Lowenstein has written a new profile of Fed Chairman Ben Bernanke for The Atlantic. It is deep and very much worth reading, even though, as Yves Smith has written, it is a bit hagiographic. The title, "The Villain," is tongue-in-cheek.

There is much to like here, but the following passage is the most interesting one. It suggests that, despite all the dovish moves Bernanke has led the Fed in making in recent years, he nevertheless has only a modest appetite for inflation.

...[A]fter talking with the chairman at length (he was generally not willing to be quoted on this issue), I think that, although Bernanke appreciates the intellectual argument in favor of raising inflation, he finds more compelling reasons for not doing so. First is the fear that inflation, once raised, could not be contained. The Fed creates inflation by adding reserves to the banking system (falling interest rates are the market’s way of registering the increasing plenitude of money). If so much money enters the system that wages and prices start ratcheting upward, the momentum can be self-perpetuating. “The notion that we can antiseptically raise the target and control it is highly questionable,” Bernanke told me. 

This is truly interesting, and important.

Of course, we need to be a little skeptical of the tendency Fed chairs have to proclaim what everyone wants to hear. The position almost requires it. Chairman Bernanke, in May of 2007, said as part of a speech at central banking conference, "All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."

Incidentally, I love the careful way Lowenstein refers to his off-the-record conversations with Bernanke. I do not agree with him on every point, but his work is always thoughtful and balanced. In the end, Lowenstein is a reporter who cares deeply about truth. A few months ago, I mentioned other work of his.

Profit Margins

I tend to worry more about the downside than the upside.

This may be genetic. Or, it might be a continuing after-effect of advice that a kind stranger once gave me at a bowling alley, when I was a boy: "Focus on getting spares, and the strikes will take care of themselves."

Here is a good piece from Reuters that lays out some of the downside risks to corporate profitability in the U.S. This is one of those pieces that I think is, at least, asking the right questions. Profit margins are very wide now, and if they revert to the long-term historical levels, the stock market should go down.

Is it crystal-clear that profit margins should revert to their historical levels? No, but that's the correct concern, and if they are not going to, there needs to be a reason.