The Disconnect Between Profits and Investment

Paul Krugman writes:

Another Economic Disconnect - New York Times: Edward Lazear... explained that what’s good for corporations is good for America. “Profits,” he declared, “provide the incentive for physical capital investment, and physical capital growth contributes to productivity growth. Thus profits are important not only for investors but also for the workers who benefit from the growth in productivity.”

In other words, ask not for whom the closing bell tolls; it tolls for thee.

Unfortunately... [i]n the Bush years high profits haven’t led to high investment, and rising productivity hasn’t led to rising wages. The second of those two disconnects has gotten a lot of attention.... Less attention... has been given to the first disconnect: the failure of high profits to produce an investment boom.... [W]ith corporate profits more than doubling since 2000... profits as a share of national income [in 2006] were at the highest level ever recorded. You might have expected this gusher... to produce a corresponding gusher of business investment. But the reality has been more of a trickle. Nonresidential investment — that is, investment other than housing construction — has grown very slowly by historical standards... remains far below its levels of the late 1990s, and it has been declining for the last two quarters.

Why aren’t corporations investing, and what does the lack of business investment mean for the economy?... Floyd Norris... [sees a] disturbing possibility. Instead of investing in physical capital, many companies are using profits to buy back their own stock. And cynics suggest that the purpose of these buybacks is to produce a temporary rise in stock prices that increases the value of executives’ stock options, even if it’s against the long-term interests of investors.... Researchers at the Federal Reserve have found evidence that company decisions about stock buybacks are strongly influenced by “agency conflicts,” a genteel term for self-dealing by corporate insiders....

Whatever the reasons, we now have an economy with incredibly high profits and surprisingly low investment. This raises some immediate, short-run concerns... optimistic projections for the economy depend on vigorous growth in business investment. And that doesn’t seem to be happening.

The bigger issue, however, may be longer term. Mr. Lazear was right... business investment plays an important role in raising productivity. High investment in equipment and software was one major reason for the productivity takeoff that began in the Clinton era, and continued in the early years of this decade. And low investment may be one reason productivity growth has slowed....

[N]ext time someone tells you... reduc[ing] corporate profits... will reduce business investment, bear in mind that today’s record profits aren’t being invested... [but] being used to enrich executives and a few lucky stock owners.

Comments

[RonK, Seattle]

Conceivably, we are operating in a franchise economy rather than an investment economy, and profits are being devoted to bidding up franchise rents.

Further conceivably, "profit" has shifted away from its role as an accounting device memorializing excess of production over consumption (representing factors available for physical investment), and shifted toward its alternate role as an accounting device memorializing franchise-driven redistribution of purchasing power.

[Doctor Jay]

I have the notion that capital investment was overbuilt in the 90's and that we've spent the last 6 years letting production catch up with capacity. This gives us productivity growth, since that capacity didn't require any investment.

Another way of looking at it is that we simply generated too much cash during the 90's, and that cash is now being used up bid up the value of investments. Consumer prices weren't affected much because the cash was concentrated in the hands of a few.

But those few didn't have enough investment opportunities, and so bid up the price of those opportunities that did exist. Distracted by the asset bubble, nobody thinks about capital investment.

We saw this happen in Silicon Valley. Companies took way too long to die, because they were sitting on a pile of cash that could sustain them a long time. This delayed the shakeout that must occur in new businesses. The losers have to close, which makes things easier for the winners. But they had too much cash, which made returns poor for everyone. Would you make capital investments in this climate?

But buying back your stock will enhance value of shareholders, which aren't just the corporate board. I accept the fact that corporate officers might have some bias toward buyback, but if there are obviously better opportunities for investing loose cash, they are going to be making them.

If you're really smart, you think that this is the time to be making some long-term bets, since interest rates are low. The trick is finding some, and keeping your job when the board complains that you're not keeping up with Brand X's stock price.

By the way, I don't think I'm smarter then Paul Krugman, I'd just like to know how these pieces fit together...

[Ian Whitchurch]

I'm pretty much rephrasing Dr Jay here, but ...

Profit maximising buisnesses dont invest because they have money - they do it because they think they can make money.

If they can convince other parties they can make money, then they can get the money to invest via borrowing it, issuing more shares or a joint venture ... and if they cant, then they probably are wrong thinking they can make money.

If they have money, and think they can't make money by investing, then they should give it back to the owners.

Therefore, the low rate of reinvestment of profits mean that American companies do not think they can make money investing.

Ian Whitchurch

[Ponzi Q. Globalization]

Businesses don't invest, people controlling the businesses do. If these people think they can enrich themselves more by not investing they will do so. Even if it hurts the profits of the business they control in the long run.

For many corporate executives, the corporations they control are not beloved institutions but tools they can use and discard.

[KY Choong]

Presumably the excess profits are temporary and will be competed away, in which case the productivity gains will flow to consumers (in the form of lower prices or higher quality) instead of investors (via buyback). However, if the excess profits persists, why?

[RonK, Seattle]

Businesses don't invest, economies do. They invest surpluses, if they have them. If they don't, no amount of prospective future profit will result in investment.