Business success, as defined by growth in revenues and profits and not by financial engineering, is crucial to the economy. But for nearly a quarter of a century, corporate profits have been rising at a faster rate than GDP and they’re now “dangerously elevated by all reasonable measures,” writes Chris Brightman, Managing Director and Head of Investment Management at Research Affiliates, in his excellent report.
S&P 500 Index real earnings per share are far above their long-term historical trend. Industry profit margins are at or near all-time highs. Corporate profits, both as a percentage of GDP and relative to labor income, are at or near record levels. The dramatic rise in income inequality is a direct consequence of this spectacular reallocation of income to capital and away from labor.
Equilibrium real growth in earnings per share cannot exceed real growth in per capita GDP, real growth in wages, and real productivity growth, on a long-term basis, without violating our sense of social fairness: More rapid growth in profits than GDP means a rising share of income to capital. Capital’s share cannot rise in perpetuity; social and political forces, if not economic developments, will cause it – sooner or later – to revert to a more usual level.
The current “profit bubble,” as he calls it, is an outgrowth of a tectonic shift. From World War II until the 90s, the US, Europe, Australia, Japan, Korea, Taiwan, and some other countries – about one billion people – formed the developed economy. Technologies and populations grew at similar rates. And income, with exception of some cyclical variations, was divided up between capital and labor along long-term averages that created the phenomenal growth of the middle class – the bedrock of economic health.
But in the 1990s, with onset of globalization, China, India, Russia, Eastern Europe, South America, and Southeast Asia joined the club, adding three billion people to the one billion. But their wages, technological development, and accumulated capital lagged far behind the developed economies. What happened next?
Imitation and appropriation is far easier than innovation and invention, so catching up has been rapid for those nations willing to make even modest concessions to the aspirations of their citizenry. For the past quarter century, the capital, and technology accumulated by the old equilibrium advanced global economy has been suddenly shared across a labor force and populace that quadrupled.
Hence years of job destruction in manufacturing as entire industries migrated to China, India, Mexico, and other countries that led to real wage declines in the US, Japan, Germany, and other globalized parts of the developed economies. Those were the losers.
But there were also winners: the three billion people who joined the club in the 1990s and saw their incomes and economic opportunities surge; global poverty rates which plunged; and corporate profits.
This inflation of corporate profits has been “facilitated in part by a corporate capture of government policy, inhibiting competition, depressing investment, and promoting rent seeking. Rent seeking may be more extreme within our very own financial industry than in any other. TARP and QE are just the most recent and largest examples of government intervention to benefit corporate interests.”
The link between Wall Street and Washington has produced economic policies that favor “politically savvy corporations and too-big-to-fail megabanks.” Alas, policymakers “have too often mistaken what is in the best interest of their elite peer group (and, surely by sheer coincidence, some of their largest campaign contributors)” with what is in the best interest of society as a whole. The results? “Decades of stagnation in wages, high taxes on labor income, subsidies for debt and consumption, underinvestment, and soaring corporate profits.”
The post-World War II average ratio of profits to wages is 19.8%. By 2013, after the sizzling run since the financial crisis, when companies dumped millions of workers and slashed their labor costs, the ratio (green-to-red line below) hit 29.9%, an all-time high by a big margin. Even when benefits and entitlements are thrown into the mix (blue line), the ratio is “darned close to unprecedented records.”
The profit bubble since the financial crisis was preceded by the profit bubble of 2007, which, in real EPS terms, was 79% above long-term trend – by far the widest margin than any prior profit bubble, except the one in 1916. And look what happened: profits crashed. They didn’t stop crashing until 1921, then stayed mostly below trend line until 1951.
OK, two World Wars and the Great Depression occurred during that time, so it’s not quite the same thing, but he warned, it would be “unwise to lightly brush aside the aftermath of the 1916 crest.”
Many of today’s investors uncritically assume that the conditions they have known over the course of their professional careers must be normal. The idea that we may soon experience a multi-decade period of zero or negative growth in real earnings per share, taking the level of profits down to a lower share of national income, seems preposterous. Yet economic history has seen many examples of such a turn, including the 1880–1890s, the World Wars, the 1930s, and the 1970–1980s. In fact, almost every decade except the 1990s and 2000s saw a protracted profits slump. Some declines in profitability lasted most of a decade; others, longer!
“Fueling popular unrest.”
This tectonic shift of income from labor to capital – and thus the growth of corporate profits at the expense of wages – is a “political choice,” Brightman writes. “The present share of income going to capital seems increasingly intolerable. Populism is rising throughout the developed world and will likely lead to political change.”
So pressures are rising. Big banks are under constant – and well-earned – rhetorical attack. Forces are coming together to advocate for higher minimum wages, both locally and nationally. There will be pressures to redistribute corporate profits through taxes. And interest expenses are likely to rise. While no knows when – this will ultimately prick the profit bubble. A process that could extend “over the next couple of decades.”
The 85 richest folks own as much as the poorest 3.5 billion, but where the heck are they staying when they come to town for dinner? We already know where the poorest 3.5 billion are staying: in shacks, hovels, and moldy apartment blocks. Read…. ‘Wealth Effect’: Spiffy Hotel Rooms For The 85 Richest Folks Who Own As Much As Poorest Half Of Humanity