Is There Really a Profits-Investment Disconnect?: (Late) Friday Focus for October 24, 2014
I think Paul Krugman gets one wrong–or, at least, I need more convincing before I think he gets this one right, in spite of the extraordinary empirical success of my rules (1) and (2):
…so why are companies concluding that they should return cash to stockholders rather than use it to expand their businesses? After all, we normally think of high profits as a signal: a profitable business is one people should be trying to get into. But right now we see a combination of high profits and sluggish investment. What’s going on? One possibility, I guess, is that business are holding back because Obama is looking at them funny. But more seriously, this kind of divergence — in which high profits don’t signal high returns to investment — is what you’d expect if a lot of those profits reflect monopoly power rather than returns on capital. More on this in a while.
So far there are no signs anywhere that the gap between today and the pre-2007 trend in levels will be made up. So far there are no signs anywhere that the gap between today and the pre-2007 trend in growth rates will be made up.
That means that, come 2024 a decade hence, we can now expect a U.S. economy to be 19.5% smaller than the economy we confidently projected as of 2007 we would have.
And, with a capital-output ratio of roughly 3, that means that between 2007 and 2024 cumulative net investment will be lower than projected back in 2007 by 58.5%-point years of GDP–and cumulative gross investment considerably lower.
Given this extraordinary shift in our long-run growth trajectory and in the investment requirements consistent with that trajectory, is it really surprising that investment in this “recovery” is not matching previous patterns?
Paul Krugman says that because profits are high, the marginal return on capital is high, and that means that firms ought to be eager to add to their capital stocks via investment in order to achieve high returns and further boost their profits. This seems to me to rely on an identification of average-Q with marginal-Q that I have always found suspect. Remember: Profits are not high now because demand is high, throughput is high, and capacity is being fully used. Profits are high now because the labor share is unusually low. Firms almost surely, given the collapse in the labor share over the past fifteen years, operating with too much capital and too little labor along the isoquant to be profit maximizing. Why shouldn’t we presume that–just as after 1973 and 1979 they shifted to more energy-intensive mixes, and productivity growth was thus lower than previous experience would have predicted–firms are now shifting to more labor- and information-intensive mixes, and that investment (in everything except real investments in information technology) is lower than previous experience would have predicted?
I do see a puzzle needing explanation in the extraordinary shortfall in housing investment–in the now 8 million people who ought to be out on their own in apartments and houses but who are instead living in their sisters’ or other relatives’ basements.
I still have to be convinced that there is any shortfall or puzzle needing explanation in non-housing investment…
UPDATE: Now Paul could respond that my point is really his: that you do not get a wedge between marginal-Q and average-Q in any competitive marketplace with constant-returns-to-scale firms and labor and capital as the factors of production. You need an additional factor of market position or some such that it is difficult to invest in and then profit from for any of a number of reasons. Too that I would say “touché…”, but then I would add that I think saying that there are the two and only the two boxes of “return on invested capital” and “monopoly power” is much too simple to be of much use…