[OPE-L] profits

From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Thu Feb 10 2005 - 21:49:11 EST

About sponsorship
Corporate profits
Breaking records
Feb 10th 2005
From The Economist print edition
Capitalists are grabbing a rising share of national income at the
expense of workers

WOODY ALLEN once quipped "If my films don't show a profit, I know I'm
doing something right." For most other people, in most other
circumstances, profit is a mark of success, and in most countries
corporate profits are currently booming. Last year, America's
after-tax profits rose to their highest as a proportion of GDP for 75
years; the shares of profit in the euro area and Japan are also close
to their highest for at least 25 years. UBS, a Swiss bank, estimates
that in the G7 economies as a whole, the share of profits in national
income has never been higher. The flip side is that labour's share of
the cake has never been lower. So are current profit margins (and
hence equity values) sustainable? Are they fair?

Corporate profits may be inflated in various ways. If firms made full
provision for the future cost of pensions, their earnings would be
smaller. And especially in America, the share of profits in national
income has been bolstered by the surging profits of the financial
sector which have benefited hugely from falling interest rates. Even
so, the impressive efforts of American firms to boost productivity
and cut costs are genuine (see article). Firms elsewhere, notably in
Japan and Germany, are also restructuring aggressively. The share of
profit in GDP always rises sharply after a downturn, but in the
United States a bigger slice of the increase in national income this
time has gone to profits than in any previous post-war recovery. Over
the past three years American corporate profits have risen by 60%,
wage income by only 10%.

If the share of wages in GDP continues to slide, there could be a
backlash from workers who feel short-changed. Yet the chances of this
are lower than before. The old divide between "them" and "us" is
becoming blurred: many workers also own shares directly or through
pension funds, which sooner or later will give them a slice of
profits. In any case, there are good reasons to believe that profits
growth will soon slow sharply and that workers will make up some of
their lost ground.
An economic fallacy

The usual explanation for why profits are booming is that
productivity growth has increased thanks to the computer revolution
and tougher management. Thus, goes the argument, increased
productivity and hence lower production costs mean fatter profit
margins. History suggests otherwise. It is normal for the share of
profits in national income to rise during the early stages of a
technological revolution, but then those extra profits tend to be
competed away. Higher profits tempt firms to cut prices to steal
market share; they also increase the incentive for new firms to enter
the market. The benefits of the productivity gains from railways,
electricity or the car eventually went not to producers but to
consumers and workers, as competition forced firms to pass cost
savings on as lower prices and higher real wages. There is even
greater reason for thinking that the benefits of computing technology
will flow the same way, for it also increases competition in many
industries by lowering barriers to entry and making it easier for
consumers to compare prices on the internet.

However, there is another factor that might have raised the return on
capital relative to labour in a lasting way, namely the integration
of China and India into the world economy, along with their vast
supply of cheap labour. To the extent that this increases the global
ratio of labour to capital, it will lift the relative return to
capital. Outsourcing may not have destroyed many jobs in developed
economies, but the threat that firms could produce offshore helps to
keep a lid on wages. As a result, the share of profits in national
income could stay relatively high for a period. Labour's share would
remain low, though workers may still be better off if the cake itself
is growing faster. But this is not a reason to expect profits to
continue to grow faster than GDP; indeed, in a competitive market
profit margins will eventually narrow. Even if outsourcing reduces
costs, competition will eventually force firms to reduce prices,
distributing the benefits back to consumers and workers.

Stockmarket investors seem to think otherwise: current share
valuations appear to assume that profits will continue to outpace GDP
growth. Most analysts still expect American profits to grow by an
annual 10% over the next couple of years. With nominal GDP growth of
around 5%, that implies the proportion of GDP going to profits
growing still larger. But this looks unlikely, and if so, share
prices are overvalued. Both economic theory and historical experience
argue that, in the long run, profits grow at the same pace as GDP.
Such long-standing rules deserve more respect.

Copyright  2005 The Economist Newspaper and The Economist Group. All
rights reserved.


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