Blog Post

Blogs review: Profits without investment in the recovery

What’s at stake: Paul Krugman has kicked off an interesting debate in the blogosphere about a new disconnect between profits and production, which may have slowed the recovery. In contrast to previous downturns, investment has been especially slow to recover. This seems paradoxical given that profits have recovered from the slump. Krugman provides an explanation for this puzzle based on the growing importance of monopoly rents in the 21st century economy.

By: Date: February 18, 2014 Global Economics & Governance Tags & Topics

What’s at stake: Paul Krugman has kicked off an interesting debate in the blogosphere about a new disconnect between profits and production, which may have slowed the recovery. In contrast to previous downturns, investment has been especially slow to recover. This seems paradoxical given that profits have recovered from the slump. Krugman provides an explanation for this puzzle based on the growing importance of monopoly rents in the 21st century economy.

Paul Krugman writes that the growing importance of monopoly rents is producing a new disconnect between profits and production. Since around 2000, the big story has been one of a sharp shift in the distribution of income away from wages in general, and toward profits. But here’s the puzzle: Since profits are high while borrowing costs are low, why aren’t we seeing a boom in business investment?

Private Nonresidential Fixed Investment (PFNI, red) and Corporate Profits After Tax (CP, blue)

Note to Brad DeLong: you’re getting that PNFI is back to its pre-crisis level because you express it in terms of potential GDP.

Buttonwood writes that US business investment has not recovered from the slump even though profits have. The Cleveland Fed notes that in the United States, private fixed investment has averaged about 15.3 percent of GDP over the postwar period; however, more recently it has run below this ratio. It crashed down to 10.5 percent in 2009 and has since hovered around 13 percent. This is unusual since investment is more volatile than income. Typically, investment will fall more than GDP during recessions, and it did in the last recession; but historically it then rebounds just as sharply. This gives the ratio of investment-to-GDP a “V-shape” over recessions. So far the most recent case has not displayed this same pattern. In contrast to previous downturns, investment has been especially slow to recover after this most recent recession.

Paul Krugman writes that you might suspect that this can’t be good for the broader economy, and you’d be right. If household income and hence household spending is held down because labor gets an ever-smaller share of national income, while corporations, despite soaring profits, have little incentive to invest, you have a recipe for persistently depressed demand. I don’t think this is the only reason our recovery has been so weak — weak recoveries are normal after financial crises — but it’s probably a contributory factor.

Explaining the gap between profits and investment

Paul Krugman writes that there’s no puzzle here if rising profits reflect rents, not returns on investment. A monopolist can, after all, be highly profitable yet see no good reason to expand its productive capacity. And Apple provides a case in point: It is hugely profitable, yet it’s sitting on a giant pile of cash, which it evidently sees no need to reinvest in its business.

Owen Zidar sends us to a paper by Loukas Karabarbounis and Brent Neiman that provides evidence consistent with the idea that markups may have increased in a non-trivial way. It’s a bit hard to see but many large countries, including the US, appear to be fairly close to the 45 degree line with both lower labor and capital shares, which is roughly consistent with the growing importance of markups. However, as shown by the best-fit line, labor has lost more than capital on average.

Buttonwood writes that there are alternative explanations than that of increasing rents: one might be that US companies are investing abroad, not at home; another might be that business are worried about the growth or regulatory outlook; a third might be that there not many capital-intensive projects that look attractive.

Sketching a model for explaining the decrease in both capital and labor shares

Paul Krugman considers an economy in which two factors of production, labor and capital, are combined via a Cobb-Douglas production function to produce a general input that, in turn, can be used to produce a large variety of differentiated products. Now consider two possible market structures. In one, there is perfect competition. In the other, each differentiated product is produced by a single monopolist. So, with perfect competition, labor receives a share a of income, capital a share 1-a, end of story. If products are monopolized, however, each monopolist will charge a price that is a markup on marginal cost that depends on the elasticity of demand. A bit of crunching, and you’ll find that the labor share falls to a(1-1/e). But who gains the income diverted from labor? Not capital — not really. Instead, it’s monopoly rents. In fact, the rental rate on capital — the amount someone who is trying to lease the use of capital to one of those monopolists receives — actually falls, by the same proportion as the real wage rate.

Paul Krugman explains that in national income accounts, of course, we don’t get to see pure capital rentals; we see profits, which combine capital rents and monopoly rents. So what we would see is rising profits and falling wages. However, the rental rate on capital, and presumably the rate of return on investment, would actually fall. What you have to imagine, then, is that some factor or combination of factors has moved us from something like version I to version II, raising the profit share while actually reducing returns to both capital and labor.

Brad DeLong writes that such a setup holds the possibility of explaining not just a rise in inequality, an extraordinary growth in the share of firms that have no visible support in production, falling unionization, and falling median wages, but also high average Q with low marginal Q, and hence depressed investment.

Nick Rowe tweaks Paul Krugman’s model. In the Krugman’s model, consumption and investment goods are perfect substitutes in production, with a marginal rate of transformation always equal to one, so that (under competition) the price of the capital good will always equal one (taking the consumption good as numeraire). This means that the rate of interest will always be equal to MPK. A decrease in ‘a’ will reduce labor’s share, MPL and wages for labor, increase capital’s share, MPK and rentals on capital, and raise the rate of interest. An increase in ‘A’ will raise both wages and capital rentals, and raise the rate of interest. In the second model, consumption and investment goods are still perfect substitutes in production, but the marginal rate of transformation now equals 1/A, so that (under competition) the price of the capital good will always equal 1/A. As A increases over time, capital goods become cheaper in terms of consumption goods. The rate of interest must equal the rate of return on owning capital goods, but that rate of return is lowered by the fact that the price of those capital goods is falling over time. Here is an explanation of a higher capital share but lower real rate of interest: (1-a) has increased; but Adot/A has increased too.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Pia Hüttl

Macroeconomics in the crossfire (again)

What’s at stake: After a first go at macroeconomics and its flaws a year ago, Paul Romer kicked off the debate again with a recent essay on how macroeconomics has gone backwards. The way that this debate, along with the debate of the role of economics in general, feeds into today's election woes, has also attracted attention in the blogosphere.

By: Pia Hüttl Topic: European Macroeconomics & Governance Date: December 5, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The Italian referendum

What’s at stake: on 4 December, Italy will hold a referendum on a proposed constitutional reform approved by Parliament in April. The reform, which was designed in tandem with a new electoral law, aims to overcome Italy’s “perfect bicameralism” by changing the structure and role of the Italian Senate. It also changes the distribution of competences between the state and regions. After the shocks of Brexit and the US election, polls are now drifting towards a defeat of the government’s position in Italy.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 28, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Trumpocalypse now: first reactions

What’s at stake: this question should probably be re-formulated as “what’s NOT at stake?” On Tuesday 8 November, the US elected Donald Trump as its next President. Several aspects of Trump’s political and economic agenda appear extreme (we have previously focused on his stance on trade). After the initial shock, we review economists’ opinions on what has happened and what may happen. We will be coming back to this topic regularly.

By: Silvia Merler Topic: Global Economics & Governance Date: November 21, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Brexit and the law

What’s at stake: last week, the UK High Court ruled that the triggering of Article 50 - and therefore the Brexit process - should involve the UK Parliament. The Government will appeal the decision but this has created a new wave of uncertainty about the timing of Brexit, and on what this involvement can mean in practice. We review the different opinions.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 14, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Monetary policy at the time of elections

What’s at stake: At this week’s meeting, the Federal Reserve left interest rates unchanged. While this was largely expected, the economic blogosphere has been discussing whether and to what extent this is linked to the election, and what can be expected for the future.

By: Silvia Merler Topic: Global Economics & Governance Date: November 7, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Should we rethink fiscal policy?

What’s at stake: there has been quite some discussion recently on whether we should rethink the framework of fiscal policy in order to make it more appropriate and effective in a world where demand seems to be chronically anemic, inflation is low and the interest rates are likely to stay close to zero (if not negative) for a long time. According to some of the authors, in the Eurozone these concerns are particularly pressing.

By: Silvia Merler Topic: Global Economics & Governance Date: October 24, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Brexit, the pound and the UK current account

What’s at stake: UK PM Theresa May announced the intention to trigger article 50 by March 2017, the Pound Sterling crashed, and a dispute among Tesco and Unilever has resulted in Marmite shortage. Brexit means Brexit, and it continues to be highly discussed. It would be impossible to summarise all the economic blogosphere on Brexit. Our aim is to periodically update our readers on selected important aspects of what promises to be a long-lived topic of discussion. This time we are looking at economists’ view on the Pound crash and the UK current account.

By: Silvia Merler Date: October 17, 2016
Read article More by this author

Blog Post

Silvia Merler

The Deutsche Bank Frenzy and what it says about European banks

What’s at stake: The IMF recently published its Fall Global Financial Stability Report, which points to a decrease in short-term risk but building of medium-term ones. At the same time, European market has been nervous last week on the news that Deutsche Bank (Germany’s biggest bank) has been demanded USD14bn by the US Department of Justice to settle allegations that the bank mis-sold mortgage-backed securities before the financial crisis. While reports point to a possible USD5.4bn settlement, this turmoil raises a question of whether the European financial system is still weak, eight years since the crisis. We try to summarize the reactions in the blogosphere.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 10, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Trumping Trade

What’s at stake: Trade is a central topic in the US presidential campaign, with both candidates expressing some degree of criticism about past trade policy. But while Hillary Clinton’s position could be described as a cautious scepticism, Donald Trump’s trade plans are more openly protectionist. His proposals include high tariffs on imports, renegotiating trade agreements and possibly US withdrawal from the WTO. After the first presidential debate, we review economists’ reactions and their assessment of Trumps trade policies.

By: Silvia Merler Topic: Global Economics & Governance Date: October 3, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Big in Japan

What’s at stake: This week saw two important Central Banks’ meetings, whose outcomes could hardly be more different. While the U.S. Federal Reserve left interest rates unchanged, the Bank of Japan introduced a big shift in its easing framework. BOJ committed itself to overshoot its inflation target of 2 percent, and introduced a targeting of the yield on ten-year Japanese government debt, initially at about zero percent. We review the economic blogosphere reaction to this latest monetary policy action.

By: Silvia Merler Topic: Global Economics & Governance Date: September 26, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The US infrastructure investment debate

What’s at stake: Infrastructure investment has been and will continue to be a prominent campaign theme in the run up to the US elections. Both Hillary Clinton and Donald Trump have promised significant public investment in infrastructure. For some time, the discussion has revolved around the opportunities and costs of increased government infrastructure spending.

By: Silvia Merler Topic: Global Economics & Governance Date: September 19, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The Apple of Discord

What’s at stake: On August 30th, following the results of an in-depth state aid investigation started in 2014, the European Commission concluded that Ireland granted undue tax benefits of up to €13 billion to Apple. The decision is based on state aid grounds: the Commission argues that two tax rulings issued by Ireland effectively granted Apple preferential treatment, which amounted to state aid. The Commission ordered Ireland to recover up to €13 billion (plus interest) from Apple, but the decision is controversial and opinion differ as to the effects it will have. We summarize reactions.

By: Silvia Merler Topic: Innovation & Competition Policy Date: September 12, 2016
Load more posts