Low US inflation is essential.

Andrew Smithers
Financial News, a Dow Jones Company, 19th April 2010

Profits are very important, not only for shareholders but also for the economy. When profits collapse, the economy dives. Investment and employment both drop sharply and the economy is often so badly hit that monetary policy cannot stabilise demand on its own and the economy has to be supported by large fiscal deficits, which mean that the public sector has large negative net savings. If the public, private and foreign sectors are taken together, the sum of their net savings must always be zero. As there is no foreign sector for the world as a whole, a rise in public sector deficits must boost the surpluses of the private sector, through some combination of higher profits and higher household savings. It follows that when fiscal deficits are large enough they should boost profits and this has indeed been the case recently. Although profits usually fall in recessions, they have been remarkably buoyant in the current one, with the profit share of US corporate output rising to its highest ever recorded level in the fourth quarter of 2009.

It is highly probable that profits will fall back as the budget deficit comes down and the support it has provided for them is withdrawn. As profits are currently so high, this should not be an insuperable problem, but past experience shows that economies seldom adjust easily to falling profits. It is easier to adjust to expected events than to surprises and we are heavily biased towards expecting profits to rise, as it is easier to make a living by forecasting good profits than by good forecasting.

Falling profits are likely both because the budget
deficit needs to fall and because profit margins are high. Profit margins rotate around their average – they are strongly mean reverting, so the fact that they are so high makes it likely that they will fall. They are likely to come down as the budget deficit falls, since this must be offset by a fall in the private sector’s surplus. The problem is a large one because the budget deficit is huge and needs to fall a long way. For the US in isolation, a hit to profits would be modified by a fall in household savings, a rise in investment, or an improvement in the external current account deficit.

Household savings, however, seem unlikely to fall. Even after some recovery, US household savings are running at only about 3% of disposable incomes, which is very low indeed. A rise is made all the more likely because household debts are huge and are beginning to come down. They have grown from 24% of GDP in the 1950s to 94% today and, although credit is tight and likely to remain so, they have only come down so far by two percentage points from their peak. Household savings are thus more likely to rise than fall.

A sharp fall in US profits will probably have a nasty knock-on impact on the economy, so it is important that rising investment and an improvement in the external current account make a large contribution to offset the improvement in the budget deficit. From the stock market’s viewpoint, rising investment is far and away the less satisfactory of the two, as companies will have to raise more capital and we know from the Flow of Funds Accounts, which are published by the Federal Reserve, that US non-financial companies have record high levels of debt. It is common to find different views on corporate leverage in the publications of investment banks, but I prefer to rely on the Fed’s data and, if they are correct, companies will need to raise a lot of new equity if there is strong recovery in investment. In recent years companies have been net buyers of shares and if they switch to being net issuers, while at the same time having falling profits, the stock market is likely to suffer and, as US stocks are currently rather over-valued, the suffering could be intense.

The stock market matters for the economy. The belief that it didn’t by the Federal Reserve under Alan Greenspan and Ben Bernanke was a major cause of the recent severe recession. It is always very important that it doesn’t crash. It is particularly so today, when the abilities of central banks and governments to support demand by cutting interest rates or taxes are so limited. Economic policy should therefore aim to avoid putting too much pressure being put on the stock market and at the same time to allow the fiscal deficit to improve substantially. It is improbable that this combination can be achieved without a large improvement in the US current account.

But a large improvement in the US trade balance requires an equal deterioration in other countries’ balances. The issue of the Chinese trade balance and its undervalued exchange rate is thus becoming a steadily more troublesome problem. Within the Eurozone there is a similar problem with Germany, but it is one that cannot readily be solved by an exchange rate adjustment. The difficulty of achieving a satisfactory recovery for either the US or the Eurozone without changes in Chinese and German economic policy has become increasing clear. The pressure for change is therefore mounting on “Chermany”, as Martin Wolf of the Financial Times has dubbed the offending nations.

The past successes of China and Germany are seen as an argument against change and there is a tendency to think that virtue is on their side, as savings are to be preferred to spending. These make accommodation difficult. Hopes are rising for some revaluation of the renmimbi, but its scope is likely to be limited. The problem is made worse because China grows much more rapidly than the US. This means that it naturally has a rising real exchange rate. Either China must constantly revalue its nominal exchange rate, or its inflation must be significantly higher than that of the US. As high inflation is dangerously unstable, it is very important that inflation in America is kept down to as near zero as possible.

This article first appeared in Financial News.