Corporate Profits: Reward, Incentive and That Standard of Living

By autumn, something appeared amiss. While the equity markets soared, there was talk of rising interest rates and questions about the visibility, as well as the momentum of corporate profits going forward. There was an increased willingness to overlook traditional metrics and certainly the existence of a credit/profit cycle. But of course, that was 1999 and investors had learned their lesson. Or have they?

Our perspective is that there is a critical role of profits in economic growth in any economy and there is a clear cycle in corporate profits over time. When those principles are ignored, trouble usually follows. Now under way is our review of the historical patterns of profits over the business cycle. In this report, we examine the role of profits in our society and the many links profits have throughout our economy, including providing future income for retirees or other investors whatever their goals. To anticipate, there is a clear pattern of profits over the business cycle, and, contrary to some comments, profits are an essential partner in the success of the overall economy. 

“For the Engine that drives enterprise is not thrift, but profit.”

Profits are frequently disparaged in our society by some commentators. However, profits, in many forms, drive most of the economic activity. We often find that a political candidate “profits” from another candidate’s mistakes. This fall many college football athletes will profit from hard work and a bit of luck with a draft and opportunity to play in the NFL. A writer profits from her efforts and imagination by writing a best seller. Hollywood writers, producers and actors profit from their efforts and imagination. Yet, when profits accrue to a “corporation” through the efforts of its employees and the insight of its investors, those profits are often disparaged. Moreover, the profits of the corporation do not accrue to the “corporation” but instead benefit its employees and investors—often in the form of pension plans for households at all income levels and charitable contributions to their communities. 

Profitable companies find many ways to contribute to their communities. Bankrupt firms do not. Profitable firms pay taxes. Bankrupt firms do not. The failure to appreciate the role of profits as reward, incentive and as a fundamental building block for the standard of living for savers and investors for their many goals—including retirement—is a sad commentary on today’s public rhetoric.

The Role of Profits in the Economic Cycle and Economic Actions

When viewed from the context of the business cycle, profits are a residual, or a buffer to fluctuations in the economy. Relative to real factors such as economic growth or employment, as well as inflation, wages or interest rates, profits are far more variable, as illustrated in Figure 1.

What accounts for this variability? Profits reflect the effects of cyclical and exogenous forces. Since the timing of these forces is random, profit volatility is a natural outcome. Five factors dominate the pattern of profits. First, profits tend to follow the gap between actual output and potential output in the economy. The key issue here is fixed costs and idle capacity. When the economy is strong, actual output is close to capacity and firms are using their full complement of capital and fixed resources, so the fixed cost per unit of output is low and thereby the firm is making efficient use of its land, equipment and labor (Figure 2). However, when the economy is weak, per-unit fixed costs are higher due to more under- or unutilized physical capital. In addition, there will be less work for an existing workforce, and this is associated with lower productivity and/or lower employment. 

Second, there is the cyclical pattern between output prices and input costs for many firms, which is shown in the comparison between output prices (as measured by the GDP deflator) and input prices (Figure 3). 4 These series also tend to move with the business cycle. A weak economy tends to be associated with weak aggregate demand and weaker output prices relative to trend; thereby profit growth is weaker when compared to its values in a stronger economy. In Figure 3, the rise in output prices, the GDP deflator, tends to be faster than the unit labor costs in the early years of the economic recovery (1983-1984, 1992-1995, 2002-2006, and 2009-2010) and thereby tends to boost profits in the early recovery period. However, as the economic expansion ages, unit labor costs catch up (1986-1988, 1997-1998, 2007 and 2012-2014) such that profit growth tends to slow. 

Third, interest rates tend to fluctuate over the business cycle such that interest expense tends to be low in the early phase of an economic recovery as the Federal Reserve keeps rates low due to slow growth, while during boom periods the Fed will tend to raise rates. In addition, during boom periods, the financial markets will reinforce the upward trend on interest rates to compensate for higher inflation and rising credit demand in a search for financing that usually accompanies the latter phases of the economic cycle.