March 27, 2003 (Profits Byte)
Domestic corporate profits rose by 12.0 percent in 2002 from their recession levels the prior year, but still remained far below the peaks of the late nineties. Adjusted for inflation, domestic corporate profits were 16 percent below the peak reached in 1997. Measured as a share of net output the falloff was even sharper, with the profit share falling from 18.3 percent at its peak in 1997 to just 13.4 percent in 2002.
Part of the drop in the profit share of output was attributable to a rise in the share of net output going to meet interest payments, due to a buildup of corporate debt in the late nineties. The interest share of output rose from 3.3 percent in 1997 to 5.2 percent in 2002. This increasing interest burden is especially noteworthy given the sharp drop in interest rates since 2001. If interest rates rise even modestly, then interest payments could seriously restrict investment plans for many important sectors.
The impact of falling profits and rising interest burdens is even more striking if the financial sector is excluded. Profits in the non-financial sector were up 11.0 percent over their 2001 level, but were still 25 percent below their 1997 peak, adjusted for inflation. Measured as a share of net output, profits declined from 15.8 percent in 1997 to 10.5 percent in 2002, with the interest share rising from 3.4 percent to 4.5 percent over the same period.
The falloff in profits in this recession is striking given that at the profit peak of the nineties cycle, profit shares had reached levels not seen since the late sixties. The profit shares of 2001 and 2002 are only slightly above the troughs hit in the 1980-82 and 1990-91 recessions for the corporate sector as a whole, and actually lower than these prior troughs for the non-financial sector.
The decline in the profitability of the non-financial sector relative to the financial sector is undoubtedly exaggerated somewhat by outsourcing of some tasks (e.g. customer credit or accounting) over the last three decades, nonetheless the deterioration in the profitability of the non-financial sector is real. For the first time since the depression, the non-financial sector had two consecutive years in which it had negative retained earnings (meaning that borrowing exceeded the growth in assets). The only other post-depression year in which it had negative retained earnings was in 1986.
An obvious factor depressing profits in the non-financial sector is the strong dollar, which has made it difficult for manufacturing to compete in the world market. Adjusted for inflation, profits in manufacturing are down 53 percent from their peak in 1997. The transportation and communication sectors have both been very hard hit in the downturn as well. The transportation sector showed a profit of just $0.3 billion, while the communication sector lost $11.7 billion in 2002, more than twice the loss shown for each of the prior two years.
The profit picture in 2002 makes it unlikely that an investment boom will lead to a strong recovery any time soon. Weak current profitability, coupled with relatively high debt burdens and large amounts of excess capacity are all acting to dampen investment. In addition, given high current debt levels, even a small uptick in interest rates will substantially increase debt service burdens. The uncertainty over the outcome of the war is a further dampening factor, but plenty of problems will persist even if the war ends quickly.
The best hope for a resurgence of investment would come from a drop in the dollar, which would make U.S. manufacturing more competitive. However, such a decline (which has already begun) would inevitably lead to some rise in the inflation rate. Higher inflation is likely to lead to higher long-term interest rates, especially if the Fed raises short-term rates in response. In short, there is no easy path forward from the economy's current situation.