If aggregate demand is so low, why are profits so high?

That's not a facetious or sarcastic question, I am puzzled.  Here is one story from yesterday:

Major corporations are expected to report some of their strongest profits in years.

“It has been one of the strongest profits recoveries ever,” said David S. Bianco, chief United States equity strategist for Bank of America Merrill Lynch. “You have got to go back to the Depression to find a profits recovery that outpaces this one.”

What are the options?

1. It's earnings manipulation and real economic profits aren't high at all.  Or they may represent capital consumption.

2. It's an oligopoly model and mark-ups are countercylical (NB: this would eaier to maintain if the recovery in output had been weaker).

3. Aggregate demand is recovering but a) workers are unemployed because, at current margins, their labor simply isn't worth very much, and b) real interest rates are low because of cushions of corporate cash.

4. We're seeing a lot of cost-lowering positive supply shocks, but AD remains stagnant.

Each of these explanations has its problems.  What other hypotheses should I be considering?

Addendum: Arnold Kling comments.


Perhaps there were ways companies could have been this profitable all along, but internal politics prevented them from being implemented (until a world-wide crisis occurred).

It's like when companies get taken over. Often times the new owners find all sorts of ways to save money that the old owners could have implemented, but didn't.

5. The companies being considered don't reflect the market as a whole for one reason or another. Example: JPMorgan Chase recently acquired WaMu and we should expect its profits to climb year-on-year as they become better integrated.

6. Corporate profits are surging among companies with a large international presence because the downturn has reduced costs in the US while leaving much of the world unaffected, especially developing economies in Asia where demand continues to grow.

7. The companies in question all provide inelastic basic goods and have seen their costs fall faster than their sales.

The article doesn't provide good reasons to believe that these are economy-wide issues and many of the so-called "bellwethers" are multinationals involved mostly in basic goods and services. The article itself admits that there are only "bright spots" in the economy. Is it really so strange that we would find the occasional oasis in the desert?

take Apple as example and explain to me why in the middle of a depression (according to Krugman) people go crazy about buying iPads and iPhones.

Is it beyond comprehension to argue that the existing unemployed were simply not very productive to begin with? I work at a University that certainly could materially produce the same or similar product with 20% less staff, and no consumer would notice the difference. I include myself among the redundancies.

Several suggestions:

1) Sharp increase in earnings was driven by a few sectors, notably Financials, Metals & Mining, and Oil & Gas, which have seen remarkable recoveries. Strip out those 3 sectors and earnings look much more "middle of the road"

2) Companies with large foreign revenue streams are outperforming. USD weakness enhances margins further

I'd say their definition of "profits" is probably very misleading. Basically choice number 1.

Part of the strong rebound in S&P earnings reflects the massive write-offs
in the financial sector.

But overall strong productivity and a record decline in unit labor costs are
driving profits.

Labor compensation in current dollars as a share of current dollar output has fallen about five percentage points since the start of the recession.
This is about double the historic norm.

Business is essentially capturing all the record drop in labor cost
in profits.

How about incipient deflation? Companies are doing well because their costs are decreasing and demand is not (yet) dropping.

Consider the hypothesis that "aggregate demand" doesn't mean anything and never has. The current path of the economy is literally incomprehensible at the level of aggregates. You have to dig into sector-level shifts at the very least to make any sense.

From your list I like #3.

I think it's mostly #4 with a little of #3 sprinkled in. My firm owns a number of small manufacturing companies, and I can tell you from my limited experience that our companies were terrified by the decline in demand. As a result, they slashed spending in all categories. In almost every case the companies discovered new manufacturing efficiencies. Also, the companies found that some of the terminated employees had been contributing very little value. As demand rebounded modestly, the companies have employed their newly discovered efficiencies to increase production without rehiring many people, and they have only hired back the best members of the labor pool. In addition, many of the companies have made capital investments so that they can continue to increase production without adding labor.

Profit margins are at their highest levels ever for the relevant data time series. A large portion of this reflects the financial sector, whose profits comprise 36% of EBITD compared with a 50 year average of around 10%. (Source: Andrew Smithers). The high profitability of the financial sector reflects ZIRP, a direct transfer of wealth from savers to the banking and finance industry.

1. The decline in marginal demand resulted in the decline in the least productive inputs. In many cases, profit margins have increased, but profits still have declined from the peak. 2. Due to the high cost of eliminating inputs (including labor), most low productive inputs and/or business units are let go en masse and typically during recessions ("restructuring"). This often results technologically-driven productivity improvements that accumulate over several years. 3. Companies with access to capital (including cash cushions) are not constrained and can invest. 4. Large companies with scale economies can lower prices and drive volume and still raise profit margins, especially those with access to global markets where demand is growing.

Let's start with challenging the premise that "aggregate demand is so low." Because unemployment is up so much, many have the impression that GDP (aggregate demand) must have dropped accordingly. This is not so as the maximum decline in real GDP was less than 6%. And given three quarters of GDP growth, real GDP is down just a bit from pre-recession levels. (These decline would be slightly greater if reported on a per capita basis) In fact, real consumer spending in 2010 Q1 was actually higher than its pre-recession peak.

So, because labor compensation is down because of the high level of unemployment, profits (and productivity) can be up as real GDP returns to its former level.

The Marxist Anwar Shaikh points to profit net of interest. Interest costs continue to decline but that could go into reverse. So the boost to profitability (as well as debt driven spendingi) s temporary; the marginal efficiency of capital remains low because interest costs are expected to go up due to things the Fed will do and due to things the Fed cannot prevent.

Yes the capital consumption guess is a reasonable one. Moreover, businesses can't count on the fear-driven overwork of the employees they have retained for ever and that makes new net investment unappealing.

The dollar value of profits made abroad may have increased due to the strength of the dollar. But again this could easily go in reverse.

For there to be a real recovery of profitability there will have to be huge spike in business consolidations. This will cut costs and give firms power to make big cost cutting investments.

But it will come at the expense of tremendous unemployment.

There will be jobless and socially unjust recovery.

1.1. Managers are being incentivized to cut costs.
1.2. Competitors have gone out of business.

Wow, who would have expected you could borrow at 0% and loan it to the government at 2-4% and make a profit.

I vote for capital consumption on a scale you won't understand for another 5-10 years.

First of all, increased profits in the early stages of an economic recovery are usually a leading indicator of increased hiring soon to come. Why leave profits on the table when instead you can hire and capture that money?

Second, don't rule out the corporate version of Ricardian Equivalence. Corporations see or at least fear massive tax hikes, directly or indirectly, coming down the pike due to the current insane budget deficit (not to mention the Cap and Trade Tax and healthcare mandates). Thus the pretax profit margin needed for future projects, and hiring, to make sense is significantly higher than "normal", therefore corporations are only making new investments in projects that are abnormally profitable. Therefore corporations are making abnormally high profit margins.

Reminds me of the Great Depression, when regime uncertainty under FDR caused businesses to fear investing in new projects, leaving them with huge profit margins. For that matter it reminds me of Venezuela today. What business in that country would invest in future capacity knowing that Hugo Chavez is looking for ways to "eliminate their profits", to borrow a phrase that Obama's union buddies routinely use on picket lines and recruiting drives.

Personally speaking, we're trying to book higher profits this year, and lower profits in the future where taxes will likely be higher. There is also a decrease in investment, as riskier projects don't get funded. The disincentive to make a profit will be back soon.

Overall, AD is not low, nor is it a meaningful measure upon which to make decisions.

The real question I have is why we are obsessed with national statistics. Markets, even many labor markets, have gone global. Unemployment is directly explicable due to the excessive wages being paid in many industries, not just low skill industries, in the US. We still have lower unemployment than Europe as a whole, and should be more closely compared with Germany, whom we trail in worker skill level.

If housing prices are allowed to complete a natural adjustment downwards, we will lower cost of living enough to support more competitive wages.

I took a look at the John Hussman piece linked to above. He also writes:

"Think about this for a moment. Since the late 1990's, many employees have earned paychecks for producing capital goods that did not turn out to be worth what companies spent, and consumers have received loans for amounts which they are not actually able to repay. Both of these outcomes have been the economy's way of forcing a large but rather overlooked "correction" in the income distribution back from corporate profits (and by extension shareholders) and toward the average American worker."

He seems to be saying that since the 1990s, an increasing amount of workers' compensation has been in the form of loans, not wages. To the extent this is true, this is interesting. Why has their been a bias to hold wages for American workers steady, but to allow some of them to "recapture" the lost income by essentially taking out loans (and then defaulting!).

This may also tie into the tendency to pay unionized workforces in promises of (often unpayable) pensions, instead of wages.

Perhaps jdd is right, in tough economic times managers have huge incentives to get creative with the accounting - better numbers mean more job security, at least for some period.

1. It's earnings manipulation and real economic profits aren't high at all. Or they may represent capital consumption.

A) economic theory is wrong; the theory that profit bring in more competition which drives down prices which drives economic profit to zero is proved by the current economy to be false.


B) economic theory is correct; the market is over-saturated with capital/capacity through consolidation, so capital bought below value is being depreciated without offsetting capital spending.

I fear we are operating by the rules of decapitalism: consume capital in all forms with no plans to replace it:
- mine property you don't own - public land, or by destroying surface land to get to underground minerals - without suffering a price reduction on property
- shed experienced older workers and work middle workers harder without bringing in younger workers - lose oldest experience and stop building new experience.
- shed all knowledge creation and just live on past monopoly knowledge
- sell proprietary innovation to Asian firms and then rent it non-exclusively, reaping short term profits and long term lower profits

I think this part of economic theory is correct, and the US economy is driven by decapitalism while China is driven by capitalism.

Kalecki profits equation.

"In this model total profits (net taxes this time) are the sum of capitalist consumption, investment, public deficit, net external surplus (exports minus imports) minus workers savings. "

Those who forget the past are doomed to try and reinvent it.

Another possibility, from this toy model:


... so while AD drives the mean economic growth, wealth distributions are made more unequal by a larger variance (economic uncertainty) through a rich get richer mechanism. So anyone (or anycompany) with money will be more profitable as the wealth distribution skews.

It's obvious.
AD is still low, even while recent few YOY changes in SOME corporation profits looks good because:

(i) negative wealth effect on US and European households still holds sway, esp resi R.E. @ Spain, Ireland, US;

(ii) US and some Euro financial sector not in too much better shape, and there has continued to be opacity in both reporting and addressing this, either at the firm level or in public policy (extend & pretend, valuation of Level III assets, etc.);

(iii) the adjustment process of financial leverage --- both absolute amount of leverage, and more importantly, leverage relative to new, lower expected growth rates --- takes a lot of time, and is still underway at the household and finance corporate level, while it's going sideways obviously at the government level
(clarification of III: ex-ante or pre-crisis leverage may have been fine given assumptions @ global growth, asset values, and firm revenue/income growth. But because of new information, largely regarding global resource constraints, growth rate expectations got revised, and then asset values followed, such that ex-post leverage is too high)

And now the easy part:
lots of corporate profits have relatively little to do with these sectors....esp true of much of the international earnings of tech companies.

I also believe that constrained financing markets, risk aversion, and a smaller population of entreprenurial investors (some were simply 'taken out') has resulted in less competitive markets, such that some market structures have changed.

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