Monday, 17 October 2011

US Corporate Profits and Fiscal Deficits

Amidst the black-hole view on financial markets regarding Europe, Bloomberg reports that, "corporate profits are calming U.S. stocks more than any time in 19 years." John Farrall, director of derivatives strategy at PNC Wealth Management rightfully points out the obvious: "...corporate profits are supposed to be good." Others, some time ago, said that corporate profits were "freakishly high" and it was time to start buying equities again (with some caution). So what's going on? Why are corporate profits so high, during financial turmoil bested only by the Great Depression?

There is no great mystery where the corporate profits are coming from. Even though Obama may have missed his employment targets with the big spending, nobody can deny that he saved the corporate profits by putting, as Minsky called it, Big Government into play.

US corporate profits (08' - 11') and US Fiscal deficits (07' - 10') 
(1H profits 2011 are doubled to estimate full year 2011).
This isn't new. The same relationship was in place during the slowdown of early 1990s and 2000s. Corporate profits were lower back then because the government didn't support them as strongly as it's doing today. 

US corporate profits (90' - 93') and US Fiscal deficits (89' - 92')

US corporate profits (00' - 03') and US Fiscal deficits (99' - 02')

But what is Big Government? Minsky used this term. It is meant to demonstrate the power of the government - Big Government - to maintain aggregate cash flows in the economy during the times of economic problems. In an economy with Big Government, whenever business activity goes down, automatic stabiliser - unemployment benefits, public investment programs, etc. -  will kick in and governmental profit-maintenance be in place. The upside of this functionality is that serious deflationary depressions like the Great Depression are unlikely to happen. But the downside is an upside pressure on prices, i.e. inflation. 

What is important to remember is that this economic shield that Big Government provides can shatter. But it will take time.

If economic slowdown happens because of too much debt burden, the Big Government can't ensure that bad debts and assets will be cleared off corporate balance sheets. On the contrary, Ponzi financing (betting on asset prices to go up by higher percentage than the interest on the debt you're using to buy the asset in question) and clear speculation would actually show themselves to be profitable. Why? Because the government provides the cash flows needed to make such investments go on through. And blatantly, since politicians are inclined to be myopic, there is always a trend to "save the system" for the time being. 

Schumpeter's "creative destruction" is never allowed to do its job then. The fix is always only for the short term, every single time Big Government steps in. The bad debts and the hopeless investments, who started the slowdown in the first place, are bailed and never written off as they should be. Moral hazard increases, such as in the form of banks making speculation bets knowing that if they mess them up they will be bailed out by the State (Too Big To Fail) and the underlying problem, i.e. hopeless debt levels, is never fixed. This "kicking the can down the road" process continues until the problem gets so colossus in size that not even Big Government can't fix it. And then, a long lasting financial crisis takes place.

That financial crisis will continue until the debt burden, i.e. cash flows due to debts, has decreased in comparison to cash flows from sales (corporations) and work (labour). By then, private investors are again keen on investing and merry-go-round of cash in the economy becomes self sustainable without Big Government maintaining it with deficit spending. And employment goes up.

But this merry-go-around never started properly this time. The reason why Obama failed to get the employment going with all the billions of dollars that the federal state of US spent is that the private investors never got keen on investing again, until very late. The profits were there, provided by the State, but firms chose to use them to repay debt instead of investing. When they finally wanted to invest again, it was too late: Europe was crashing and businesses jumped back into the "let's be careful and see what happens" mindset. Investment decreased again. 

The best way to see how massive the debt repayment was, it's enough to check the Fed data on outstanding loans. Debt repayment was enormous and dwarfed the early 1990s and 2000s! Crucially, households repaid their debts as well, stopping the cash-flow round-about dead in its tracks. 

The overall result: stagnation, long-term useless and costly bailouts of banks who otherwise would have been forced to write off the bad debt that was causing the slowdown in the first place, and last but not least, 1.4 trillion dollar federal debt. 

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