March 28, 2002 (Porfits Byte)

Overall corporate profits fell sharply in 2001, dropping 12.5 percent from their 2000 level. Domestic profits fell even more sharply, falling 16.5 percent. This decline in profits is surprisingly sharp given the relative mildness of the recession. By comparison, total profits fell by12.9 percent from 1969 to 1970, by 12.1 percent from 1979 to 1980, and actually rose by 3.3 percent from 1989 to 1990. Since there was higher inflation in these earlier periods, the direct comparisons are slightly misleading, but even adjusting for inflation, the drop in profits would be consistent with a much more severe recession.

The decline in profits in the non-financial corporate sector was especially large, with profits in the sector falling by 18.1 percent. In spite of this drop in profits, firms in the non-financial sector actually increased their pidend payments by 15.1 percent in 2001. As a result, retained earnings plummeted to a negative $80.0 billion. The only other year in the post-war period when this sector had negative retained earnings was 1986, when firms paid out $1.6 billion more in pidends than they took in as after-tax profits.

The fact that non-financial firms have negative retained earnings could be a bad sign for investment in the year ahead. The vast majority of investment is financed through retained earnings. With non-financial firms feeling the need to pay out pidends in excess of their profits, many may find it difficult to obtain the cash to finance additional investment. In this respect, it is worth noting that the size of this negative flow grew larger over the year, with pidend payments exceeding earnings by $167.1 billion in the fourth quarter.

The biggest falloffs in profit came in the manufacturing and transportation sectors. Profits in manufacturing fell by 48.8 percent, from $155.2 billion in 2000 to 79.5 billion in 2001. The drop in profits in transportation, driven by both the recession and September 11th, was even larger in percentage terms, falling 95.6 percent from $13.7 billion to just $0.6 billion.

The drop in profits corresponded to a large fall in the capital share (profits plus net interest) of income. In the non-financial sector, the capital share fell from 17.0 percent in 2000 to 14.3 percent in 2001. The biggest drag on profits in this sector has not been a surge in wages, but rather the growing portion of output that goes to replace worn out equipment. Since 1999, depreciation has risen by 20.6 percent, going from 11.6 percent of output in 1999 to12.6 percent of output in 2001. This rise is attributable to the growing portion of investment in very short-lived items such as computers and software. If businesses continue to upgrade their equipment and software at the same pace in the future as in the past, they may find it difficult to obtain the financing. 

It is worth noting that the increase in net foreign profits, which went from $136.8 billion in 2000 to $149.3 billion in 2001, was entirely attributable to a drop in the earnings of foreign corporations in the United States. The foreign earnings of U.S. corporations fell from $204.9 billion in 2000 to $190.8 billion last year. But the drop in U.S. generated earnings of foreign corporations was considerably steeper, going from $68.1 billion in 2000 to $41.5 billion in 2001-a decline of almost 40 percent. This indicates that foreign corporations buying assets in the United States may have made some bad investment decisions.

The sharp drop-off in profits shown in this report does raise questions about the prospects for investment this year. These concerns are intensified by the fact that the 4th quarter was by far the worst, with profits of domestic industries down 28.1 percent from their year-ago levels. If weak profits restrain investment, then the recovery will remain almost entirely dependent on the strength of consumer spending.