Marginal improvement

Corporate profit margins are extremely high. Can they be sustained?

Mar 31st 2012

THE past four years have been bad for workers and savers but good for the corporate sector. Profit margins in America are higher than at any time in the past 65 years. That helps explain why the equity market has rebounded so strongly despite a lacklustre economy.

Margins have been boosted by firms’ tight control of labour costs and by a reduction in interest expenses caused by the policies of central banks throughout the rich world. Whether such margins can be sustained is important for equities.
Most stockmarket bulls build their case on the trailing price-earnings ratio for the S&P 500, which stands at 16. But there is a warning sign in the cyclically-adjusted p/e (which averages profits over ten years). At 22, this ratio is well above the historic mean, making the market look a lot less attractive.

Theory would suggest that profit margins will revert to the mean over time. If profits are very low then companies will go out of business, improving the competitive position (and thus the margins) of those businesses that survive. Similarly, if profits are high then more capital will be attracted into the industry (and existing businesses will be tempted to expand) and the resulting competition will cause margins to fall.


However, the current high level of profits is not leading to a surge in investment. As a proportion of GDP, American business investment is close to 30-year lows. This shortfall has been blamed on many things, from over-regulation in America to uncertainty about the outlook for demand when real incomes are being squeezed by higher fuel prices and the lack of wage growth.

Peter Oppenheimer of Goldman Sachs points out that the high profit share of GDP is simply a corollary of the low share taken by labour. “With high unemployment and further substitution of technology for labour, it is unlikely that this will change dramatically any time soon,” he says.

So the cash is going on other things. Robert Buckland of Citigroup says both American and European companies are choosing to spend their cash on mergers and share buy-backs rather than capital expenditure. As a consequence “while profits remain sensitive to the economic cycle, those waiting for the structural mean reversion in margins will continue to be disappointed,” he says.

Andrew Smithers of Smithers & Co, a consultancy, believes that executives are given incentives to boost margins in the short term at the expense of long-term value for shareholders. Pushing up prices boosts profits quickly, for example, but at the risk of losing market share over time. Similarly, executives might not begin a programme of investment that is vital for a company’s long-term health because of the effect on earnings per share. Woe betide any company that misses its quarterly earnings target.

If Mr Smithers is right, investors may be overpaying for current profits. The earnings forecasts of American equity analysts imply an increase in margins from current elevated levels, since they show earnings growing much faster than nominal GDP. Of course, to the extent that companies sell goods to the emerging markets, the profits of quoted companies can grow faster than domestic GDP. But that requires investment to keep the corporate sector competitive, and capital expenditure has not been happening on a sufficient scale.

Governments would like companies to start spending their cash piles. But as James Montier of GMO, a fund-management group, points out, that depends on their own behaviour. In terms of national accounts, massive government deficits are a counterpart to the surge in corporate profits. The surpluses and deficits of the various sectors of the economy (government, households, foreign and corporate) must balance, so a huge surplus in one sector must be balanced by deficits elsewhere. Governments spend money on goods and services (that are bought from the corporate sector) or borrow money to finance social benefits, which are then also spent on goods and services from the corporate sector.

This is not to suggest that chief executives should wish for permanent government deficits. But it does suggest that, as those deficits fall, profits might come under pressure. There is a “goodway that this could happen, as companies recruit more staff and pay higher wages, boosting tax revenues. But there is also a “badway for it to happen, if austerity programmes cause a slump in demand. Pray for the first outcome.

March 30, 2012 7:29 pm

Europe warned crisis not over yet

Euro coin pworld

European finance ministers were warned on Friday that the underlying causes of the continent’s debt and banking crisis had yet to be resolved, as Spain, struggling to rein in its fiscal deficit, published its most austere budget since democracy returned after the Franco era.

Two confidential analyses prepared by European Union officials and distributed to ministers meeting in Copenhagen said €1tn in cheap loans to banks provided since December by the European Central Bank had provided a reprieve, but sovereigns and financial institutions needed to use the relative calm to shore up finances and balance sheets.

Click here to enlarge

Contagion may ... re-emerge at very short notice, as demonstrated only a few days ago, and re-launch the potentially perverse triangle between sovereign, bank funding risk and growth,” one of the analyses, prepared by the EU’s economic and finance committee and seen by the Financial Times, said. The existence of the documents was first reported by the Italian daily La Stampa.

The reference was a clear allusion to the recent sharp rise in Spanish borrowing costs, which have hovered near 5.5 per cent for more than a week. Eurozone and Spanish officials have launched a two-front offensive in an attempt to prevent the country becoming the next crisis victim.

In Copenhagen, ministers agreed to increase the ceiling of their two bailout funds to €700bn, an attempt to erect a firewall big enough to convince markets the EU can protect Spain. In Madrid, the government announced €27bn in benefit cuts and tax increases as part of the toughest budget since the death of General Francisco Franco in 1975.

As part of what Cristóbal Montoro, the budget minister, referred to the “the biggest fiscal consolidation of the democracy”, €12.3bn will be raised in new taxes, with €5.3bn coming from corporate taxes, and €2.5bn projected to come from a temporary amnesty on tax evasion.

Other savings will come from cutting ministry budgets by almost 17 per cent to €65.8bn this year. The foreign affairs ministry is hardest hit, losing 54 per cent of its funding. Industry and agriculture both lost just over 31 per cent each.

“We are convinced that Spain will no longer be a problem, especially for the Spanish, but also for the European Union,” Luis de Guindos, finance minister, said.

The warning on the fragility of the European recovery undercuts optimistic rhetoric by government leaders. Nicolas Sarkozy, French president, this month said the eurozone had “turned the page”, and Mario Monti, his Italian counterpart, this week said the “financial aspect” of the crisis had ended.

However, senior officials at EU institutions – particularly the ECB and the European Commission, the EU’s executive branch – have been more sanguine, warning the ECB’s long-term refinancing operation has bought time but cannot replace reforms in national economies and the financial sector.

The second document, which was prepared by the Commission, warned bluntly: “The euro crisis is not over. Many of the underlying imbalances and weaknesses of the economies, banking sectors or sovereign borrowers remain to be addressed.”

The paper argued the elements of the recent restoration of confidencefinalising a second Greek bailout, increasing the eurozone’s rescue fund, EU-wide bank recapitalisation, new eurozone fiscal discipline rules, and efforts to pass policies to encourage growth must be fully implemented or leaders risk losing their last chance to act.

“If this window of opportunity is not most effectively used we might have missed the last chance for a considerable amount of time,” the analysis said.

Copyright The Financial Times Limited 2012.

The optimal speed of fiscal adjustment

March 30, 2012 12:28 pm

by Gavyn Davies

How rapidly should governments correct their fiscal deficits, which in the long run are unsustainable in the US, UK, Japan and many countries in the eurozone?


That is a question which continues to dominate the policy debate among economists. Rapid correction undoubtedly damages near term economic growth, but is intended to reduce the risk of a sovereign debt crisis coming suddenly out of the blue. Slow correction does the opposite. There is no theoreticallycorrectpolicy on this. The result depends on how the near term loss of output should be weighed against the risk and consequences of a fiscal crisis, which is an empirical matter. (See this earlier blog: Assessing the risk of a financial crisis, which attempts to measure the risk of fiscal crisis.)

It is possible for reasonable economists to disagree about this, and for the “right policy to be different in different countries. However, occasionally a piece of research comes along which changes the “dial” on the debate, and I believe that applies to the important Brookings Paper published last week by Brad DeLong and Larry Summers. This paper, which is well summarised here and here, essentially implies that the trade-off between near-term GDP growth and the probability of fiscal crisis can be irrelevant, because temporary fiscal expansions, at a time when interest rates are at the zero bound, are eventually self-financing.

The intuition behind this result is reasonably straightforward. It depends first on a belief that the “multiplier”, which measures the relationship between a fiscal injection and the resulting rise in GDP, is unusually high at present, so that fiscal easing would have a large beneficial effect of GDP in the near term.

And it also depends on a belief that the current recession will have permanent effects on the long run future path for output in the economy. This results in a “hysteresiscoefficient, which is defined as the relationship between a near term shortfall of GDP relative to trend, and the permanent loss in trend GDP which this causes.

If either the multiplier or the hysteresis coefficient is equal to zero, then there is no possibility that temporary fiscal expansions will be self-financing, and the DeLong/Summers result becomes irrelevant. However, if both of the coefficients are positive, then it is possible that fiscal expansion can be self-financing in the long term, and that fiscal contraction can actually make public debt ratios worse.

Basically, a fiscal expansion today raises GDP today; higher GDP today permanently raises the path for GDP; and a permanently higher path for GDP results in permanently higher tax receipts. Eventually, these higher tax receipts might fully finance the original cost of today’s budgetary injection.

All of this has been in the public debate for quite a while (see Paul Krugman for example), but the important additional contribution of DeLong and Summers is that we can now quantify the parameters involved. Their methodology, which was apparently unchallenged at the Brookings meeting last week, enables us to plug in estimates for the multiplier and the hysteresis coefficient, and then calculate whether a fiscal injection will be self- financing.

The authors, for example, suggest a case in which the multiplier is 1, and the hysteresis parameter is 0.05. Their equation then suggests that a temporary fiscal expansion will be self-financing unless the real yield on treasuries exceeds the long-term growth of GDP by more than 2.5 per cent per annum, which has hardly ever happened in recent US history.


How robust should we take this result to be?

A fiscal multiplier of around 1 in present circumstances seems reasonable. In normal times, the Fed might well tighten monetary policy in the face of fiscal expansion, eliminating most or all of the boost to GDP, in order to keep inflation on their pre-determined target. If so, the multiplier would be zero, and a budget stimulus would not be self-financing.

But these are not normal times for the Fed. To judge from what Ben Bernanke has been saying recently, the Fed would actually welcome some easing in fiscal policy in the immediate future, provided that this is accompanied by credible measures to reduce public debt in the long term. In that event, the Fed would be unlikely to raise short rates (though it might do less QE), and the resulting fiscal multiplier could be unusually high. Many independent studies suggest it might be in the range of 0.8-1.5.

Much less is known about the hysteresis coefficient. In the US, GDP has in the past shown an encouraging tendency to return eventually to its long-term trend, even after very major shocks like the 1930s depression. In that case, the hysteresis coefficient would be zero, and the DeLong/Summers result would collapse. But that was certainly not the case in Europe in the 1980s or Japan in the 1990s.

It seems optimistic to suggest that the current deep recession will leave no mark whatsoever on either the capital stock or the active labour force in the US, and the suggestion that the coefficient might be around 0.05 or more seems somewhat conservative.

So the DeLong/Summers results deserve to be taken seriously in present economic conditions. But I would pose one more question to Brad and Larry, concerning policy credibility. They take this seriously, but make the assumption that a temporary easing in fiscal policy would have no effect on the risk premium which the market expects on US treasuries, either now or in the future. They no doubt justify this by pointing to the large demand for low risk investments in the present climate of excess savings. And they would argue that it is not rational for investors to expect a higher risk premium if a temporary fiscal injection is actually likely to be self-financing.

These are valid points, but investors are not always rational, and they would be sceptical about any government which takes the “make me chaste, but not yetapproach to policy. Easier fiscal policy today might well be taken as a signal that the political will to tighten policy tomorrow simply will never exist. Rational or not, that remains a serious problem.

March 29, 2012

Broccoli and Bad Faith


Nobody knows what the Supreme Court will decide with regard to the Affordable Care Act. But, after this week’s hearings, it seems quite possible that the court will strike down the “mandate” — the requirement that individuals purchase health insurance — and maybe the whole law. Removing the mandate would make the law much less workable, while striking down the whole thing would mean denying health coverage to 30 million or more Americans.

Given the stakes, one might have expected all the court’s members to be very careful in speaking about both health care realities and legal precedents. In reality, however, the second day of hearings suggested that the justices most hostile to the law don’t understand, or choose not to understand, how insurance works. And the third day was, in a way, even worse, as antireform justices appeared to embrace any argument, no matter how flimsy, that they could use to kill reform.

Let’s start with the already famous exchange in which Justice Antonin Scalia compared the purchase of health insurance to the purchase of broccoli, with the implication that if the government can compel you to do the former, it can also compel you to do the latter. That comparison horrified health care experts all across America because health insurance is nothing like broccoli.

Why? When people choose not to buy broccoli, they don’t make broccoli unavailable to those who want it. But when people don’t buy health insurance until they get sickwhich is what happens in the absence of a mandate — the resulting worsening of the risk pool makes insurance more expensive, and often unaffordable, for those who remain. As a result, unregulated health insurance basically doesn’t work, and never has.

There are at least two ways to address this reality — which is, by the way, very much an issue involving interstate commerce, and hence a valid federal concern. One is to tax everyonehealthy and sick alike — and use the money raised to provide health coverage. That’s what Medicare and Medicaid do. The other is to require that everyone buy insurance, while aiding those for whom this is a financial hardship.

Are these fundamentally different approaches? Is requiring that people pay a tax that finances health coverage O.K., while requiring that they purchase insurance is unconstitutional?

It’s hard to see why — and it’s not just those of us without legal training who find the distinction strange. Here’s what Charles Fried — who was Ronald Reagan’s solicitor general — said in a recent interview with The Washington Post: “I’ve never understood why regulating by making people go buy something is somehow more intrusive than regulating by making them pay taxes and then giving it to them.”

Indeed, conservatives used to like the idea of required purchases as an alternative to taxes, which is why the idea for the mandate originally came not from liberals but from the ultra-conservative Heritage Foundation. (By the way, another pet conservative projectprivate accounts to replace Social Securityrelies on, yes, mandatory contributions from individuals.)

So has there been a real change in legal thinking here? Mr. Fried thinks that it’s just politics — and other discussions in the hearings strongly support that perception.

I was struck, in particular, by the argument over whether requiring that state governments participate in an expansion of Medicaid — an expansion, by the way, for which they would foot only a small fraction of the billconstituted unacceptablecoercion.” One would have thought that this claim was self-evidently absurd. After all, states are free to opt out of Medicaid if they choose; Medicaid’scoercivepower comes only from the fact that the federal government provides aid to states that are willing to follow the program’s guidelines. If you offer to give me a lot of money, but only if I perform certain tasks, is that servitude?

Yet several of the conservative justices seemed to defend the proposition that a federally funded expansion of a program in which states choose to participate because they receive federal aid represents an abuse of power, merely because states have become dependent on that aid. Justice Sonia Sotomayor seemed boggled by this claim: “We’re going to say to the federal government, the bigger the problem, the less your powers are. Because once you give that much money, you can’t structure the program the way you want.” And she was right: It’s a claim that makes no sensenot unless your goal is to kill health reform using any argument at hand.

As I said, we don’t know how this will go. But it’s hard not to feel a sense of foreboding — and to worry that the nation’s already badly damaged faith in the Supreme Court’s ability to stand above politics is about to take another severe hit.