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US companies have increased their share of the economic pie at a faster rate over the past five years than at any time since the second world war.

Recent government figures show that profits from current production as a share of national income have risen from 7 per cent in mid-2001 to 12.2 per cent at the start of this year. This rate of growth is unprecedented since collection of these figures began in 1947.

Profits have climbed by 123 per cent over the same period, soaring from $714.5bn (€552.57bn, £378.89bn) to $1,595.4bn – also the fastest increase since records began. Other official data have shown that profit growth by manufacturing companies, often seen as one of the weakest sectors, has outstripped the rest of the economy. The figures suggest corporate America is enjoying one of its best periods despite more competition from low-cost countries and tougher corporate governance and disclosure rules.

[...]

As profits have increased as a share of national income, the return going to workers has been in decline, falling from 58.6 per cent in the middle of 2001 to 56.2 per cent in the first quarter of 2006. Paul Donovan, a global economist at UBS, believes the negotiating position of US workers may have been weakened by globalisation, giving companies the upper hand.

“The US labour market may be tightening, but there is still an ample supply of workers worldwide, and this may be capping what domestic workers can demand,” he said.

Over the past year, unit labour costs rose just 0.3 per cent – a downward revision from the first estimate. Since labour costs represent about 70 per cent of corporate ex-penses, the slow real growth in compensation, coupled with greater efficiency, has more than offset the impact of rising raw material prices for companies.

David Rosenberg, north American economist at Merrill Lynch, said competitive pressure had forced companies to slash healthcare and pension benefits for workers.

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When Ben Bernanke, the chairman of the US Federal Reserve, points out that the American economy is "in transition", that is Fed-speak for "there is no shame in being a little confused". Much of the market's puzzlement is focused on the reappearance of higher core inflation at precisely the point where the US economy shows signs of slowing down.

But whether or not Mr Bernanke raises rates again later this month, the probability is that the lagged effect of the Fed's previous 16 increases will start to show up in lower US inflation as the third quarter gets under way.

In contrast, it is harder to be confident about the trajectory of an equally significant but less commented-on puzzle - the historically unprecedented share of profits as a proportion of US gross domestic product. The rise and rise of America's corporate profits - from 7 per cent of GDP at the start of this cycle in mid-2001 to 12.2 per cent at the start of this year - has been good for equity investors. In contrast to the previous cycle in the 1990s, which was driven by stratospheric price-earnings ratios and (in retrospect) a tidal wave of illusory profits, this time corporate earnings seem to be real. But for how much longer?

[...]

ome of the sluggishness derives from the labour-saving effects of new technology and the waning clout of trade unions. The continued disinflationary impact of China and India on the global economy is also a factor. Whatever the principal cause, high US employment is not matched by strong feelings of security among employees.

There is an additional paradox to consider - the skewing of most income gains to the top 10 per cent of labour. In fact, as the economist Robert Gordon has pointed out, a large chunk of the gains in the past few years have gone to the top 1 per cent of workers, partly because of the "superstar" system, in which new technology and cross-border markets have magnified the earnings of the very rich. Yet the median US household income is 3 per cent lower in 2006 than in 2000, according to the US census bureau.

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Originally posted by Stephen Gordon:
'Course, part of this process is the improvement in the welfare of poor country workers.

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And I think that's what they want, from Jalalabad to Mogadishu to Port Au Prince to Buffalo Lake and Kashechewan. People the worldover want social democracy, and they want an opportunity to participate in society.

Let Them Eat Pie from last October

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Beginning over 200 years ago with Adam Smith, economists have claimed that the benefits of economic growth are spread throughout society. (To be more precise, mainstream economic logic contends that everyone is rewarded in proportion to how much they contribute to producing economic growth.) Economic growth is not supposed to benefit only the wealthy elite—that’s why Smith called his book The Wealth of Nations and not The Wealth of the King and a Few Other Rich Guys.

The promise that economic growth helps everyone is the central justification for our economic system. This belief is so sacred that it is almost above discussion: the consequences of disputing it are just too radical. For if economic growth benefits only the privileged few, we might be tempted to consider alternative economic arrangements that do not put such overwhelming emphasis on growth.

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Originally posted by Stephen Gordon:
Here are the data for full-time employment (CANSIM series v2461140, thousands of persons):

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1976 8529.7
1977 8626.5
1978 8871.5
1979 9201.8
1980 9415.3
1981 9631.3
1982 9202.7
1983 9173.1
1984 9410.2
1985 9641.6
1986 9956.2
1987 10281.4
1988 10573.9
1989 10835.0 (FTA)
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******2305.3

1990 10867.6
1991 10525.7
1992 10370.8
1993 10336.6
1994 10586.1 (NAFTA)
1995 10798.5
1996 10861.4
1997 11089.3
1998 11403.4
1999 11759.5
2000 12093.6
2001 12242.5
2002 12439.3
2003 12705.3
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******1837.7

Ok, Hurtig does mention 1.5 million FTP jobs created in 14 years after FTA, and 2.3 million FTP jobs before. Still, it's a significant drop in full-time payroll job creation in Canada since FTA.

[ 11 June 2006: Message edited by: Fidel ]

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Even if valuations do not completely revert to the mean, can one be sure that profits will not? Abdullah Nauphal, chief investment officer at Insight Investment, says that investors have a terrible tendency to extrapolate developments such as believing that profits can keep rising faster than GDP. History suggests this does not happen.

In short, one might believe that "it's different this time" for one variable; valuations. But believing it for a second, profits, as well, is too much of a stretch.

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There is a bit of a financial storm coming together. We don't know how the growth vs. inflation story will unfold, what the US Fed will decide on rates, and so on. But some imbalances are starting to unwind. For example, the US housing market is cooling and this has really sustained consumer behaviour in the US, with a lot of implications for the US current account, Chinese demand for US paper, and the US banking sector as well if defaults start rising.

Meanwhile, new asset classes especially in the derivatives world, have given the financial sector a sense that risk is very diversified, robust, and distributed now. But, as Philip Coggan points out in another column, all this apparent distribution of risk can collapse in a crisis as it is revealed that people were basically making the same underlying bet, for example, on continued growth. Recent market turmoil has shown signs of correlated bets in the hedge fund business as positions have had to be unwound in response to volatility.

There are lots of warning signs of myopia, excess, and wishful thinking in the financial sphere. Gillian Tett points to one of these in particular in her column on casualties of leveraged finance.

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Why can borrowers get away with this? In short because there is extraordinarily high investor demand for paper in the global leverage loan market, particularly in Europe. That partly reflects some industry-specific factors, such as a recent explosion in the number of London-based credit funds. But it is also stems from a more fundamental point: namely that recent years of loose monetary policy have left a flood of money swirling round the global financial system looking for a home. Indeed, the only reason why nobody is screaming the word "bubble" in relation to leveraged loans is because the sector is so opaque that the only people tracking it are financiers. Spotting bubbles in house prices - or telecom stocks - is far easier

Nevertheless, with or without a hullaboo, evidence of extreme behaviour in leveraged finance abounds. A few years years ago, investors would get nervous if a company's debt was more than four times core earnings; this year the average debt load is almost six times earnings, and eight is not unheard of. However, the price of loans has dropped (even before any flexes). Meanwhile, the legal clauses that used to protect investors in cases of corporate distress are being removed from deals. That is one reason why Europe has seen so few listed bankruptcies: with covenants this loose, it is harder than ever for lenders to declare default.

Eventually, this will inevitably produce some tears. After all - and as one rating agency privately admits - few companies raising leveraged loans these days even pretend they will repay this debt through earnings; instead, the assumption is that current debt will simply be refinanced. That means that if interest rates ever rise sharply in the coming years, a number of these deals could blow up.

But right now that grisly scenario is certainly not derailing the party. On the contrary, the recent falls in equity prices have left the private equity world eager to chase a new swathe of targets. More important still, there is no sign yet of a meaningful rise in the cost of raising leveraged loans. Indeed, as the bankers keep testing investors' masochism, some are even considering trying a triple "downward flex". Be warned: sooner or later, this leveraged finance game will produce casualties; after all, the craziest time of any bubble is invariably when it is close to its peak.

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[ 11 June 2006: Message edited by: rasmus raven ]

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Originally posted by Stephen Gordon:
Doesn't mean that the US govt doesn't have a responsibility to help the people hurt by this transition, of course.

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Ever since the Republicans took over in one form or another since the 1980s the US government has de facto if not by now de jure abdicated this responsibility.

I find it quite instructive that the US minimum wage roughly kept its purchasing power until 1981, when good ol' Raygun got in.

Also, please note that the minimum wage has been frozen for the last decade, and now buys $4 worth of stuff in constant dollars compared to almost double that in the late 1960s.

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Originally posted by Stephen Gordon:
Huh. Hey rasmus, remember this thread?

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Yes. The profits prediction was wrong, although they now present a different problem, don't they? But what I think I was right about, when I predicted it elsewhere around the same time, was that after the dot com/telecoms crash, surplus liquidity would continue to slosh around the system, creating new asset bubbles that would take a few years to unwind.

Right now, it seems to me, there are a couple of basic uncertainties. For instance, is inflationary pressure abating? Your view on this is coloured by whether you think current inflationary pressures are basically driven by energy costs, or are a consequence of global easy money policies, particularly the BoJ's zero interest policy.

However, what is less doubtful to me are the following problems:

--US real estate bubble and its wealth effect. If housing prices cool, ultimately, this will have an effect on consumer spending as well as credit quality
--US current account
--US consumer debt. Both of these items have been significantly underreported if you believe an analysis I read in the FT recently, which said some of the key data is misreported (I will try to find this later). At any rate, both of these will have to be unwound. The current account can't be dealt with meaningfully without appreciation of the Yuan, which has a number of knock-on effects we've discussed elsewhere
--the explosion of derivative products and the belief in their miraculous ability to protect the market from shocks. As Philip Coggan says above, what if the underlying bets are, in fact, correlated? We have seen recently that sometimes past events are not a reliable guide to future correlations. For example, recent behaviour of commodity prices has not fit previous models.

Two interesting commentaries over at itulip.com:

Financial markets are polluted with risk

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The most toxic financial market innovations today that have polluted the financial system with risk, and helped keep the housing bubble alive, are:
- Credit derivatives
- Asset-backed securities
- Secondary-market syndicated loans
- Home-equity lines of credit
- Interest-only mortgages
- Negative-amortization mortgages
- Sub-prime mortgages and consumer loans

Warren Buffet weighed in with a less sanguine assessment of this class of derivatives in his annual letter to shareholders, March 2003. Note that Buffet gets right to the point. The purpose of these innovations is to make money for the people who sell them, not to help society:

“We view them as time bombs, both for the parties that deal in them and the economic system… Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values… Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands."

[...]

We are experiencing a replay of an out-of-control credit expansion and a classic battle between the public good and corporate gain play out in the market for unregulated financial innovations. Hedge funds, banks, mortgage companies and other financial institutions are busy cranking out and selling new financial innovations faster than central banks and governments can control or monitor them. Many of these products help society, for example by giving households access to credit that did not have access before and deserved it. But let’s not lose sight of the reason financial institutions are creating and selling these products: not to help society, but to make money. Due to lack of regulation, much of the potential future costs of financial toxins to society have been externalized. They are making a lot of money and in the process polluting the financial system with risk.

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Peak risk

And here is itulip's latest weekly commentary:

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Stagflation Godzilla Returns, Attacks Finance-Based Economy!

“The Federal Reserve raised key short-term interest rates Wednesday [today] for the first time in more than four years, launching a risky campaign to suppress inflation without stamping out economic growth,” MSNBC’s Chief economics correspondent Martin Wolk reported on June 30, 2004. A few months earlier, Bill Gross of PIMCO wrote his classic post stock market bubble reflation era analysis The Last Vigilante(PDF) about the Finance-Based Economy, from which this piece takes its name. In it he pondered what might happen when the Fed reversed direction after running short-term rates well below the rate of inflation for more than three years to keep the deflation at bay that hit a trough in 2001 following the collapse of the stock market bubble. During those years, a U.S. centric global economic and financial system that had over several decades increasingly become dependent on credit was after years of low interest rates additionally dependent on cheap credit. Once the result of the flood of free or nearly free money started to show up in all-goods prices as inflation, the Fed was sure going to start raising rates. Can the Fed raise rates fast enough to tame inflation without imploding the Finance Based Economy?

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[ 17 June 2006: Message edited by: rasmus raven ]

I think the point to note here is that this share doesn't seem to have much of a trend. Profits are more procyclical than wages, so the labour share is countercycical.