A Nose Dive in Business Profits Injured the US Economy
MANY factors contributed to the 1990-91 recession. Tight money and the shock of the Gulf crisis played critical roles. Most important, however, was the collapse in corporate profits over the past two years. This was the Achilles' heel of the longest United States peacetime business expansion. Falling profits were symptomatic of fundamental imbalances that could not be corrected short of recession. Though mid-1990, employment was going up while profits were going down. This indicated that payrolls were bloated with workers who were producing losses for their employers. The more people companies hired, the more money they were likely to lose.
Such trends could not continue. Layoffs were inevitable. As they occurred, the recession deepened.
Preliminary, unpublished estimates by the Commerce Department show that pretax profits of US companies were at an annual rate of $286 billion in the fourth quarter, down at a rate of 16 percent from the summer months. Earnings were down or flat in every industry. The private finance sector lost money for the sixth quarter in a row.
Profits from current operations - which measure economic, not accounting, results - were weaker. Operating profits totaled $284 billion in the fourth quarter, down at an annual rate of more than 20 percent from the July-September period. This drop was part of a continuing trend. Operating profits have declined in seven of the past 10 quarters.
The crackup in profits underlined the basic weakness in the economy. The Labor Department reported that total civilian employment declined 652,000 in January.
Since the recession began last July, 1.3 million people have lost their jobs. The National Association of Purchasing Management reported that its index of industrial activity dropped to 37.7 in January, in line with the reading at the bottom of the 1982 recession.
The cut in the Federal Reserve's discount rate to 6 percent last week was belated recognition that the economy is in a steep downward slide. The Fed said it acted ``in light of further declines in economic activity, continued sluggish growth trends in money and credit, and evidence of abating inflationary pressures, including weakness in commodity prices.''
That is an accurate description. The wonder is that it took the Fed - with its army of staff economists - so long to figure this out.
In reality, the economy is weaker than the preliminary report of a 2.1 percent decline in gross national product (GNP) in the fourth quarter suggested. Because of the rise in oil prices, the US had a marked deterioration in its terms of trade (the ratio of export to import prices) at the end of last year. In the arcane algebra of GNP, this created an artificial aura of strength.
To correct for such distortions, the government calculates an alternative measure which it calls ``command-basis GNP.'' This is the same as plain vanilla GNP except that both imports and exports are adjusted for price change with the index for prices of imported products.
On this basis, real output of goods and services declined at a rate of 5.3 percent in the fourth quarter. Furthermore, command-basis GNP was down at an annual rate of 0.5 percent from the third quarter of 1989. In perspective, the economy has been stagnant for a long time.
Business investment has held up remarkably well so far in the recession. However, these outlays are sure to fall victim to the profit crunch. Internally generated cash is the principal source of funding for business investment.
Net cash flow of US companies - retained earnings plus depreciation is headed south. In the fourth quarter, cash flow covered 77 percent of outlays for plant and equipment. That was well below both the peak of 90 percent in the first half of 1987 and the postwar norm of 84.2 percent.
Cash flow has dropped in seven of the last eight quarters. It was lower in the fourth quarter of 1990 than in the third quarter of 1987.
As a consequence, business fixed investment has now started to slide. Real outlays were $513 billion in the fourth quarter, down at an annual rate of 4.6 percent from the summer. With the sole exception of jet aircraft, which are in an orbit all their own, further declines are certain this year, particularly over the next six months. The worst is yet to come in the 1990-91 recession.